T.C. Memo. 1998-175

UNITED STATES TAX COURT

CHESAPEAKE OUTDOOR ENTERPRISES, INC., ABEL TRUST,

JOHN E. MAGEE, JR., TRUSTEE, TAX MATTERS PERSON, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21830-96. Filed May 12, 1998.

C, an S corporation subject to the unified audit

and litigation provisions of the Subchapter S Revision

Act of 1982, Pub. L. 97-354, sec. 4(a), 96 Stat. 1691-

1692, was insolvent within the meaning of sec.

108(d)(3), I.R.C., during its TYE Mar. 19, 1992. In

that year, C realized cancellation of indebtedness

(COD) income of approximately $995,000. Sec.

61(a)(12), I.R.C. In accordance with sec. 108(a),

I.R.C., C excluded from its gross income the entire

amount of COD income realized in that year. C asserts

that such income is exempt from tax, and also that the

characterization of such income is not a subchapter S

item to which the FSAA relates for purposes of

conferring jurisdiction under sec. 6226(f), I.R.C.

R concedes that any proposed adjustment to

shareholder basis is inappropriate at the corporate

level. See Nelson v. Commissioner, 110 T.C. 114

(1998). 
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* Subsequent to the briefing of this case, James C. Diana,

Esq., withdrew as counsel of record in this case.

1. Held: The characterization of COD income is a

subchapter S item to which the FSAA relates, and is

therefore properly determined by this Court in an S

corporation proceeding. Secs. 6226(f), 6241, 6244,

6245, I.R.C.; sec. 301.6245-1T(a)(1)(iv) and (b),

Temporary Proced. & Admin. Regs., 52 Fed. Reg. 3003-

3004 (Jan. 30, 1987). Accordingly, this Court has

jurisdiction to hear this case. Clovis I v.

Commissioner, 88 T.C. 980, 982 (1987), applied.

2. Held, further, excluded COD income of an S

corporation does not qualify as a separately stated

item of tax-exempt income for purposes of sec.

1366(a)(1)(A), I.R.C. Nelson v. Commissioner, supra,

followed. 

James R. O'Neill and John B. Spirtos, for petitioner.*

Bettie N. Ricca and Kathleen E. Whatley, for respondent.

MEMORANDUM OPINION

NIMS, Judge: By Notice of Final S Corporation

Administrative Adjustment (FSAA), respondent determined a

$317,583 adjustment to the S corporation return of income filed

by Chesapeake Outdoor Enterprises, Inc. (Chesapeake) for its

taxable year ending (TYE) March 19, 1992. Respondent further

determined an adjustment to Chesapeake's shareholders' aggregate

stock basis in the amount of $995,000. 
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Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the year at

issue. All Rule references are to the Tax Court Rules of

Practice and Procedure.

After concessions, the remaining issues for decision are: 

(1) Whether we have jurisdiction in this case, and, if so, (2)

whether cancellation of debt (COD) income excluded from the 

gross income of an S corporation pursuant to section 108(a)

qualifies as a separately stated item of tax-exempt income for

purposes of section 1366(a)(1)(A).

This case was submitted fully stipulated. The Stipulation

of Facts and attached exhibits, and the Stipulation of Agreed

Adjustments, are incorporated herein by this reference. 

Chesapeake maintained its principal place of business at 519 West

Pratt Street, Baltimore, Maryland, at the time the petition for

readjustment was filed. 

Background

Chesapeake was incorporated on February 9, 1989, under

Delaware law. During the relevant period, Chesapeake was engaged

in the business of maintaining and renting outdoor billboards. 

Chesapeake filed its income tax returns on a calendar year basis. 

During the year at issue, Chesapeake was an S corporation within

the meaning of section 1362(a), with three shareholders,

including Abel Trust (petitioner), the tax matters person. 
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On March 23, 1989, Chesapeake entered into a credit

agreement with Chase Manhattan Bank, N.A. (Chase Manhattan),

pursuant to which Chase Manhattan agreed to make loans to

Chesapeake from time to time in an aggregate principal amount not

to exceed $14,100,000. A general security agreement and a

promissory note were also executed on that date between

Chesapeake and Chase Manhattan in connection with the borrowings

under the credit agreement. Chesapeake borrowed a total of

$13,424,443.37 from Chase Manhattan under the credit agreement. 

During 1989, Chesapeake acquired certain assets of Tec

Media, Inc. (Tec Media). As part of the consideration for this

purchase, Chesapeake issued a note to Tec Media in the amount of

$506,000. 

Chesapeake subsequently defaulted on its debt to both Chase

Manhattan and Tec Media. The defaults occurred prior to, and

were continuing on, August 7, 1991. On that date, Chase

Manhattan terminated its commitment under the terms of the credit

agreement and demanded that Chesapeake immediately pay the

outstanding principal amount of $13,424,443, together with all

interest thereon, as well as any other amounts payable under the

credit agreement and promissory note. 

On January 14, 1992, a judgment in favor of Chase Manhattan

as plaintiff, and against Chesapeake as defendant, was entered by

the Supreme Court of the State of New York, New York County, in

the amount of $15,513,914.87. As of March 19, 1992, Chesapeake
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was indebted to Chase Manhattan for $13,424,443.37 in principal

and $2,481,720.46 in interest, for a total of $15,906,163.83. 

Pursuant to an Amended and Restated Credit Agreement

(amended agreement) dated March 19, 1992, between Chesapeake,

Chase Manhattan, and Tec Media, Chesapeake's indebtedness to

Chase Manhattan and Tec Media was restructured. Chesapeake was

released from indebtedness to Chase Manhattan in the amount of

$906,163.83. In addition, Chesapeake was released from

indebtedness to Tec Media in the amount of $6,000, plus accrued

and unpaid interest, for a total of approximately $88,815. 

As of January 1, 1992, Chesapeake had total assets of

$10,858,689, and total liabilities of $16,139,334. Chesapeake

was insolvent, within the meaning of section 108(d)(3),

immediately prior to the discharge of its indebtedness pursuant

to the amended agreement. The total amount of Chesapeake's

discharged indebtedness (approximately $995,000) did not exceed

the amount by which Chesapeake was insolvent. 

On March 20, 1992, Chase Manhattan acquired ownership of

Chesapeake in accordance with the terms of the amended agreement,

and Chesapeake's status as an S corporation was thereafter

terminated. Accordingly, Chesapeake filed a short-year Form

1120S, U.S. Income Tax Return for an S Corporation, for the

period ending March 19, 1992. 

Chesapeake reported its excluded COD income on line 18,

Other tax-exempt income, of the Schedule K, Shareholders' Share
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of Income, Credits, Deductions, Etc., and Schedules K-1,

Shareholder's Share of Income, Credits, Deductions, Etc.,

attached to its return for the year in issue. 

On July 15, 1996, respondent issued an FSAA with respect to

Chesapeake's TYE March 19, 1992. Respondent disallowed

deductions for accrued interest expenses in the amount of

$317,583 forgiven by Chase Manhattan and Tec Media in the same

year as the accrual. Furthermore, under the heading "Other

Adjustment: Basis of Shareholders", respondent determined an

adjustment to the shareholders' aggregate basis in Chesapeake

stock in the amount of $995,000. In "Remarks" included on the

Schedule of Adjustments, respondent stated that 

The discharge of indebtedness income that is excluded

from gross income under section 108(a) * * * does not

pass through to the Subchapter S Corporation's

shareholders as a separately stated item of tax-exempt

income under section 1366(a)(1). Accordingly, the

shareholders' stock basis under Section 1367 is not

increased.

Petitioner timely filed a petition for readjustment of subchapter

S items on October 9, 1996. 

Pursuant to a Stipulation of Agreed Adjustments filed on

September 29, 1997, petitioner conceded the correctness of

respondent's adjustment relating to the disallowed deductions for

accrued interest expenses. On brief, respondent conceded that

the proposed adjustment to Chesapeake's shareholders' stock basis

was inappropriate at the corporate level. 
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Discussion

As previously stated, respondent has conceded that the

adjustment to shareholder basis was inappropriate at the

shareholder level. Consequently, the remaining issues are: (1)

Whether we have jurisdiction to decide this case, and, if so, (2)

whether COD income excluded from the gross income of an S

corporation pursuant to section 108(a) qualifies as a separately

stated item of tax-exempt income for purposes of section

1366(a)(1)(A).

The question of jurisdiction is fundamental and can be

raised at any time by either party or by the Court. Naftel v.

Commissioner, 85 T.C. 527, 530 (1985); Estate of Young v.

Commissioner, 81 T.C. 879, 880-881 (1983). We have jurisdiction

to determine whether we have jurisdiction. Pyo v. Commissioner,

83 T.C. 626, 632 (1984); Kluger v. Commissioner, 83 T.C. 309, 314

(1984).

In the instant case, our jurisdiction turns on whether the

unified subchapter S audit and litigation provisions in effect

for the year at issue, set forth at sections 6241 through 6245,

are applicable. (Sections 6241 through 6245 were repealed by the

Small Business Job Protection Act of 1996, Pub. L. 104-188, sec.

1307(c)(1), 110 Stat. 1755, 1781, for tax years beginning after

December 31, 1996.) If not, we must dismiss this case for lack

of jurisdiction. See Albatrick, Inc. v. Commissioner, T.C. Memo.

1995-119. 
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The S corporation audit and litigation procedures were

enacted by Congress in 1982 in order to provide a method for the

unified treatment of subchapter S items among shareholders. 

Subchapter S Revision Act of 1982, Pub. L. 97-354, sec. 4(a), 96

Stat. 1691-1692; see Dial USA, Inc. v. Commissioner, 95 T.C. 1, 3

(1990). A subchapter S item is defined as "any item of an S

corporation to the extent regulations prescribed by the Secretary

provide that, for purposes of * * * [subtitle F of the Code

(Procedure and Administration)], such item is more appropriately

determined at the corporate level than at the shareholder level." 

Sec. 6245. Pursuant to section 301.6245-1T(a), Temporary Proced.

& Admin. Regs., 52 Fed. Reg. 3003 (Jan. 30, 1987), subchapter S

items are those "items which are required to be taken into

account for the taxable year of an S corporation under subtitle A

of the Code". See University Heights at Hamilton Corp. v.

Commissioner, 97 T.C. 278, 281 (1991). Section 301.6245-1T(a)(1)

and (b), Temporary Proced. & Admin. Regs., supra, more

specifically defines subchapter S items, in part, as follows: 

(1) The S corporation aggregate and each

shareholder's share of, and any factor necessary to

determine, each of the following:

* * * * * * *

(iv) Items of income of the corporation that

are exempt from tax;

* * * * * * *

(b) Factors that affect the determination of

subchapter S items. The term "subchapter S item"
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includes the accounting practices and the legal and

factual determinations that underlie the determination

of the existence, amount, timing, and characterization

of items of income, credit, gain, loss, deduction, etc.

* * *

Except as otherwise provided by regulations, the tax

treatment of subchapter S items must be determined in one unified

proceeding at the corporate level as opposed to individual

proceedings at the shareholder level. Sec. 6241; Eastern States

Cas. Agency, Inc. v. Commissioner, 96 T.C. 773, 775 (1991).

The Subchapter S Revision Act of 1982 was enacted shortly

after the Tax Equity and Fiscal Responsibility Act of 1982, Pub.

L. 97-248, 96 Stat. 324, which added the partnership audit and

litigation procedures (sections 6221 through 6233) to the Code. 

Section 6244 provides that, except to the extent modified or made

inapplicable by regulations, the partnership provisions which

govern the judicial determination of partnership items and those

that relate to partnership items are generally made applicable to

subchapter S items. Eastern States Cas. Agency, Inc. v.

Commissioner, supra at 775-776; Hang v. Commissioner, 95 T.C. 74,

78 (1990). The partnership provisions concerning judicial

review, sections 6226 through 6228, are applicable to S

corporations. Hang v. Commissioner, supra at 79.

Section 6226(f) provides in pertinent part as follows:

Scope of Judicial Review.--A court with which a

petition is filed in accordance with this section shall

have jurisdiction to determine all partnership items of

the partnership for the partnership taxable year to
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which the notice of final partnership administrative

adjustment relates * * *. 

Section 301.6241-1T(c)(2)(ii), Temporary Proced. & Admin.

Regs., 52 Fed. Reg. 3003 (Jan. 30, 1987), creates an exception to

the unified procedures for certain S corporations having 5 or

fewer shareholders for any taxable year of an S corporation

having a due date for its return on or after January 30, 1987. 

However, the small S corporation exception does not apply where,

as here, any of an S corporation's shareholders is a trust.

Primco Management Co. v. Commissioner, T.C. Memo. 1997-332; sec.

301.6241-1T(c)(2)(iii), Temporary Proced. & Admin. Regs., 52 Fed.

Reg. 3003 (Jan. 30, 1987). 

Although respondent has conceded that shareholder basis is

not a subchapter S item over which this Court has jurisdiction in

a corporate-level proceeding, see Dial USA, Inc. v. Commissioner,

supra, respondent nevertheless maintains that the foregoing

concession does not alter the fact that Chesapeake erroneously

characterized its excluded COD income as an item of separately

stated tax-exempt income on its return for the year at issue. 

Respondent contends that the characterization of such an item of

income is a subchapter S item pursuant to section 6245 to which

the FSAA relates, which may only be determined by this Court in a

unified proceeding under section 6226(f).

Petitioner does not dispute that an adjustment to the

characterization of excluded COD income on Chesapeake's return
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constitutes a subchapter S item. Rather, petitioner maintains

that respondent did not propose any such adjustment in the FSAA. 

In the alternative, petitioner argues that respondent's position

that COD income is tax-deferred rather than tax-exempt "creates a

distinction without a difference" for purposes of the subchapter

S conduit rules, and that a "question as important as whether

this Court has jurisdiction over a case cannot turn on a

distinction that has no bearing on the substantive application of

the Code." 

Notwithstanding petitioner's principal claim, we think that

respondent determined an adjustment in the FSAA to the character

of the COD income reported on Chesapeake's return. The Notice of

Adjustment states in "Remarks" included in the FSAA that "The

discharge of indebtedness income * * * does not pass through to

the Subchapter S Corporation's shareholders as a separately

stated item of tax-exempt income under section 1366(a)(1)." 

(Emphasis added.) We think that this statement suffices to

confer jurisdiction, even though the principal thrust of the FSAA

appears to be an erroneous corporate-level denial of basis

adjustment to shareholders. In Clovis I v. Commissioner, 88 T.C.

980, 982 (1987), we stated that "Because of the similar functions

of the FPAA and the statutory notice of deficiency, we are

convinced that the long established principle applicable to

notices of deficiency, viz, that no particular form is necessary,

should apply with equal force to a FPAA." An adjustment to the
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characterization of excluded COD income is more appropriately

determined at the S corporation level than at the shareholder

level and is, therefore, a subchapter S item subject to the

unified audit and litigation procedures. Sec. 6245; sec.

301.6245-1T(a)(1)(iv) and (b); see, e.g., Michaelis Nursery, Inc.

v. Commissioner, T.C. Memo. 1995-143 (indicating that the proper

characterization of payments as advance payments or refundable

deposits is a subchapter S item). 

Finally, we do not find petitioner's alternative argument

convincing. See University Heights at Hamilton Corp. v.

Commissioner, 97 T.C. at 282. In University Heights, we held

that, once an S corporation has received a valid FSAA as required

by section 6223, and filed a timely petition as required by

section 6226 "the scope of our judicial review allows us to

determine all subchapter S items of the corporation * * * to

which the notice of FSAA relates". Id. (Emphasis added.) Based

on the above, we hold that we have jurisdiction in this

proceeding to review the correctness of respondent's

determination that Chesapeake's excluded COD income is not a

separately stated item of tax-exempt income for purposes of

section 1366(a)(1)(A). Secs. 6226(f), 6241, 6244. 

Since the opening and reply briefs were filed in this case,

Nelson v. Commissioner, 110 T.C. 114 (1998) (Court-Reviewed), has

been released. (By Order, we requested the parties to file
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additional briefs addressing the applicability, if any, of

Nelson.) 

In Nelson, a shareholder-level case, we held that COD income

realized and excluded from gross income under section 108(a) does

not pass through to shareholders of a subchapter S corporation as

an item of income in accordance with section 1366(a)(1) so as to

enable an S corporation shareholder to increase the basis of his

stock under section 1367(a)(1). Nelson v. Commissioner, supra at

130. We held in that case that section 108 is not designed or

intended to be a permanent exemption from tax. Excluded COD

income is not "tax-exempt" pursuant to section 1366(a)(1) and,

thus, is not statutorily required to pass through to the S

corporation shareholders. Id. at 125.

We see no need to repeat our detailed exegesis on this issue

contained in Nelson v. Commissioner, supra. We simply hold,

following Nelson, that the COD income in the amount of $995,000

which was excluded from gross income under section 108(a) by

Chesapeake on its return for TYE March 19, 1992, is not a

separately stated item of tax-exempt income for purposes of

section 1366(a)(1)(A).

We have considered the parties' remaining arguments and, to

the extent they are not discussed herein, find them to be either

not germane or unconvincing.

To reflect the foregoing and issues previously conceded,
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Decision will be entered

under Rule 155.