PRECEDENTIAL

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

______

No. 13

- 2247

______

R BALL FOR R BALL III BY APPT

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 11

- 17593)

_____________

R BALL CHILDREN TRUST 9/9/1969

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 11

- 17594)

_____________

ETHEL BALL FOR R BALL III APT 2/9/1967

v.

COMMISSIONER OF INTERNAL REVENUE2 (Tax Court No. 11

- 17595)

_____________

ETHEL BALL FOR A L BALL AS APPT

v.

COMMISSIONER OF INTE RNAL REVENUE

(Tax Court No. 11

- 17596)

_____________

R BALL JR. CHILDRENTRUST 1/29/1970

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 11

- 17597)

_____________

R BALL JR. F/B/O R BALL III 12/22/1976

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 11

- 17598)

_____________

R BALL FOR A L BALL BY APPT

v.3 COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 11

- 17599)

_____________

R BALL CHILDREN TRUST 1/24/1973

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 11

- 17600)

_____________

RUSSELL BALL JR SEC FIRST 9/9/1967

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 11

- 17601)

_____________

R BALL FOR R BALL III BY APPT; R BALL CHILDREN TRUST 9/9/1969; ETHEL BALL FOR R BALL III APT 2/9/1967; ETHEL BALL FOR A L BALL AS APPT; R BALL JR. CHILDRENTRUST 1/29/1970; R BALL JR. F/B/O R BALL III 12/22/1976; R BALL FOR A L BALL BY APPT; R BALL CHILDREN TRUST 1/24/1973; RUSSELL

BALL JR SEC FIRST 9/9/1967,

Appellants

______4 On Appeal from the United States Tax C ourt ( Tax Court Nos. 17593

- 11, 17594

- 11, 17595

- 11, 17596

- 11,

17597

- 11, 17598

- 11

, 17599

- 11, 17600

- 11

, 17601

- 11 )

Tax Court Judge: Honorable Kathleen Kerrigan

______

Argued: December 17, 2013

Before: JORDAN, VANASKIE

, and VAN ANTWERPEN,

Circuit Judges

.

(F iled : February 12, 2014 )

Nancy Winkelman , Esq. [ARGUED] Timothy K. Lewis , Esq. Schnader Harrison Segal & Lewis LLP 1600 Market Street, Suite 3600 Philadelphia, PA 19103 Attorneys for Appellants

Francesca Ugolini, Esq. [ARGUED] Richard Farber, Esq. Kathryn Keneally, Esq. United States Department of Justice

, Tax Division

P.O. Box 502 Washington, D.C. 20044 Attorneys for Appellee

______

OPINION OF THE COURT

______5 VAN ANTWERPEN, Circuit Judge

.

I. INTRODUCTION

An S corporation (“S Corp.”) is a small business

corp oration that is permitted to have its corporate income, losses, deductions, and credits attributed to its shareholders. This appeal arises out of nine consolidated cases before the United States Tax Court regarding the tax implications of an S Corp. ’s elec ti on to treat its subsidiary as a “qualified subchapter S subsidiary ” ( “ Qsub ” ) under Internal Revenue

Code § 136 1

. 1 Specifically, the parties disagree as to whether

the Qsub election and subsequent sale of the S Corp. parent creates an “item of income” und er § 1366(a)(1)(A) 2 thereby

1 26 U.S.C. § 1361 . All statutory citations refer to the Interna l

Revenue Code unless otherwise noted.

2 The relevant portion stating:

In determining the tax under this chapter of a

shareholder for the shareholder ’ s taxable year in which the taxable year of the S corporation ends (or for the final taxable year of a sh areholder who dies, or of a trust or estate which terminates, before the end of the corporation ’ s taxable year),

there shall be taken into account the shareholder ’ s pro rata share of the corporation ’ s

— (A) items of income (including tax

- exempt income), los s, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder . . . .6 requiring the parties who he ld stock in the parent S Corp. to adjust their base s in stock under § 1367(a)(1)(A). 3 For reasons which follow, we affirm the decision of the Tax

Court , finding an increase in stock bas e s and declared loss es to be improper.

I I. FACTS

In June 1997, ten trusts for the benefit of the Ball family (“Trusts”) 4 acquired direct ownership of all shares of

26 U.S.C. § 1366(a)(1)(A).

3 “The basis of each shareholder’s stock in an S corporation shall be increased for any period by the sum of the following items determined with respect to that shareholder for such period: (A) the items of income described in subparagraph (A) of section 1366(a)(1) . . . .” Id. § 1367(a)(1)(A).

4 The named Trusts are nine of ten total trusts: R. Ball for R.

Ball III, By Appt.; R. Ball Children Trust 9/9/1969; Ethel Ball for R. Ball III Apt. 2/9/1967; Ethel Ball for A.L. Ball as Appt.; R. Ball Jr. F/B/O R. Ball III 12/22/19 76 ; R. Ball for A. L. Ball By Appt.; R Ball Jr. Children Trust 1/29/1970; R. Ball

For Childr en Trust 1/24/1973; Russell Ball Jr. Sec. First

9/9/19 67 . The tenth trust has a related case stayed in the

United States District Court for the Eastern District of Pennsylvania pending this appeal. See R. Ball, Jr. For A. L. Ball Trust, December 22, 1976 v . United States , 2:12

- cv

- 921 (E.D. Pa. Feb. 22, 2012). For purp oses of this appeal, the term “Trusts” will include the tenth trust, though not a party, except that, in section V of this opinion, our use of the term generally refers only to the nine Appella nts.7 American Insurance Service, Inc. (“AIS”) 5 with an aggregate basis in AIS stock totaling $5,612,555. In 1 999, the Trusts

formed Wind River Investment Corporation (“Wind River”), a Delaware corporation. The Trusts then contributed their

shares in AIS in exchange for all of the shares of Wind River

. This resulted in Wind River owning all of the shares of AIS.

E ffective June 4, 1999, Wind River designated itself a subchapter S Corporation. On February 28, 2003, Wind River

elected to treat AIS as a Qsub under § 1361(b)(3). 6 Prior to

the Qsub election, the Trusts’ aggregate adjusted basis in the

Wind River stock wa s $15,246,099. Following the Qsub election, the Trusts increased their base s in the Wind River stock from $15,246,099 to a new basis of $242,481,544

. 7

5 AIS is a Pennsylvania corporation . Although it became a subsidiary of Wind River, AIS was also the parent company of a group of in surance

- affiliated corporations

. Prior to acquiring direct ownership of all AIS shares, the Trusts had previously indi rectly owned shares in AIS.

6 26 U.S.C. § 1361(b)(3). A Qsub is a wholly owned subsidiary of a parent S Corp., and as such, “all assets, liabilities, and items of income, deduction, and credit of a qualified subchapter S subsidiary shall be treated as asse ts, liabilities, and such items (as the case may be) of the S corporation.” Id. § (b)(3)(A)(ii).

7 The fair market value of AIS’s assets at the time it was absorbed by Wind River was $232,848,000 and by subtracting the prior aggregate basis of AIS stock o f $5,612,555, an increase of $227,235,445 results . When this

increase is added to the prior basis of $15,246,099, a new basis of $242,481,544 is arrived at for Wind River

. This basis

increase and its tax consequences are the subject of this appeal.8 F ollowing the Qsub election and stock basis adjustments

, the Trusts sold their interests in Wind River to a third party, Fox Paine

, on September 5, 2003. After transaction costs, this sale yielded $230,111,857 in cash and

securities in exchange for all of the Wind River stock. 8 Even though they had received $230,111,857 from the sale

, the

Trusts claimed a l oss in the amount of $12,247,229. 9 This was

calculated as the difference between the amount actually

received for the sale and the new basi s in the Wind River

stock. The Trusts shareholders ’ 2003 tax return s w ere filed citing the aforementioned capital los s.

The Internal Revenue Service (“IRS”) determined the

Trusts shou ld not have increased their base s in the Wind

River stock to $242,481,544 following the Qsub election. The IRS determined instead that a capital gain of approximately $214 million had bee n realized from the sale of Wind River to

Fox Paine. This resulted in a cumulative tax deficiency of $33,747,858 for the nine trusts that have filed appeals in this

case

. Deficiency n otices were sent to the Trusts on May 18 and 19, 2011, stating “the Qsub election and the resulting

8 The amount received individually by the Trusts was divided based on percentage of ownership.

9 The figures stated for the new basis, sale proceeds, and tax loss are totals for all ten trusts. As mentioned above, only nine trusts are parties to this suit and, accordingly, the actual figures for the new basis and stock sale proceeds are somewhat less, being approximately $240,080,978 for the new basis and $227,833,750 for the sale proceeds. Subtracting one from the other yields the loss of $12,247,228.9 deemed I.R.C. § 332 [ 10 ] liquidation did not give rise to an item of income under I.R.C. § 1366(a)(1)(A); therefore, [ the

Trusts ] could not increase the basis of their [Wind River] stock under I.R.C. [§] 1367(a)(1)(A).” (Appendix ( “App. ”) at A373.) The Trusts filed petitions with the United States Tax Court seeking a redetermination of deficiencies under the jurisdiction of §§ 6213(a) and 7442. The cases were consolidated and submitted for decision on stipulated facts,

under Tax Cou rt Rule 122, 11 as R. Ball for R. Ball III By Appt., et al. v. Comm issioner , 105 T.C.M. (CCH) 1257, 2013 WL 452722 (2013). As previously noted, the Tax Court found the increase in stock basis and declared loss to be improper.

I II. TAX COURT PROCEEDINGS

The main issue before the Tax Court and now on appeal is whether or not a Qsub election creates an “item of
income” for the parent corporation under § 1366(a)(1)(A).

The Trusts relied on their assertion that the election “resulted

in a gain derived from deali ngs in property and, therefore,

10 26 U.S. C. § 332. § 332 governs the liquidation of a wholly

owned subsidiary into its parent corporation. “ (a) General

rule.

-- No gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation .” Id.

11 “Any case not requiring a trial for the submission of evidence (as, for example, where sufficient facts have been admitted [or] stipulated . . .) may be submitted at any time after joinder of issue (see Rule 38) by motion of the parties

filed with the Court.” T.C. Rule 122(a).10 created an item of income under § 61(a).” 12 R. Ball , 2013 WL 452722, at *4. If the election resulted in an “item of income,” the new higher base s and resulting tax loss es are proper. If it

did not result in an “item of income ,” the increase in stock

bas e s and declared tax loss es are improper.

More specifically, before the Tax Court, the Trusts

argu ed that the deemed liquidation o f AIS was, under § 331, a sale or exchange of property cr eating a realized gain to Wind

R iver. T hey further claimed that gains from dealings in property are expressly included in gr o ss income under § 61(a). They then contended that, although § 332 provides for the nonrecognition of that gain, it was still “an item of income (including tax exempt inco me)” under § 1366(a)(1)(A), which passed through to them and increased their bases in Wind River stock under § 1367(a)(1)(A). To support their position,

t he Trusts ra ise d several contentions to the Commissioner’s deficiency finding : (1) their base s were pr operly adjusted pursuant to § 1367(a)(1)(A), (2) the losses were properly claimed from the sale of Wind River, and (3) “the Qsub

election resulted in an item of income pursuant to [§] 1366(a)(1)(A).” See R. Ball , 2013 WL 452722

, at *4. Lastly,

the Trusts c ited United States v. Farley 13 and Gitlitz v.

Comm issione r , 14 arguing that the “realized” liquidation gain

under § § 331 and 61(a)(3)

, allow ed an increase in basis

, but

12 The relevant sections state: “[e]xcept as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following

items: . . . (3) Gains derived from de alings in property. . . .” 26 U.S.C. § 61(a)(3).

13 202 F.3d 198 (3d Cir. 2000).

14 531 U.S. 206 (2001).11 that gain is not taxable under the non

- recognition provision of § 332(a)

. The Commissioner responded to the Trusts’ arguments by asserting that the Qsub election did not create
an “item of income (including tax exempt income) ” under § 1366(a)(1)(A).

The Tax Court rejected the Trusts ’ arguments, relying
on the differences between “realization ” and “ recognition” of

income in determining what constitutes an “ item of income ” under § 1366 as it relates to §§ 136 7, 331, 332 , and 61(a)

. R.

Ball , 2013 WL 452772, at * 4

- 5 (2013). The Tax Court held that gain from a Qsub election is “realized” and calcu lated under § 1001, 15 yet it is not “recognized” due to the non

recognition provision of § 332. Id. (“Once the amount of the realized gain has been calculated, the entire amount of the realized gain is recognized unless a Code section provides for

nonrecogn ition treatment.”)

. Furthermore, the Court found,

u nder § 1366, that when a gain is unrecognized, it “does not

ri se to the level of income” and is not an “item of income for
tax purposes. ” 16 Id. at *7. Finally, the Court distinguished
Gitlitz and Farley and determined that “neither case is squarely on point.” R. Ball , 2013 WL 452722, at *8. The

Court reasoned that Gitlitz and Farley only established that

the nature of “discharge of indebtedness” as income is not affected by an exclusion elsewhere in the Code

. See id. Here,

15 “The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.” § 1001(b).

16 In addition the Tax Court found no cases in which a Qsub election created an item of income for the parent S Corp. R.
Ball , 2013 WL 452722, at *4.12 however, “realized gain from the Qsub election was never included explicitly in gross income and was never excluded from gross income.” Id. Therefore, the Tax Court determined
Gitlitz and Farley were unpersuasive in qualifying the Qsub

elec tion as an “item of income” under § 1366. 17 Id.

In sum , the Court held that “ unrecognized gain resulting from the Qsub election did not create an item of

income or tax exempt income pursuant to
section 1366(a)(1)(A)

. ” Id. at * 10

. Accordingly, t he Trusts

were found deficient for improperly adjust ing their base s in

Wind R iver stock following the Qsub election and t his appeal

followed. Id.

.

IV

. JURISDICTION

Section 7482(a) provides exclusive jurisdiction by this

Court over decisions before the United State s Tax Court. Our
review of the Tax Court’s construction of the Internal Revenue Code is plenary. Nat’l Starch & Chem. Corp. v.

Comm’r

, 918 F.2d 426, 428 (3d Cir. 1990).

V. DISCUSSION

A. Items of Income

As previously noted, the main issue before us is

wh ether or not the Qsub election created an “item of income.”

17 Th e Court also noted that the cases have since been

overridden by Congressional action amending 26 U.S.C. § 108(d)(7)(A). Id. at *8; see also Job Creation and Worker Assistance Act of 2002, Pub.L. No. 107

- 147, 116 Stat. at 40.13 An “item of inc ome” is required for a shareholder of an S Corp. to increase the basis in his or her of the S Corp.

. See § 1366(a)(1)(A). 18 Despite use of the term “item of income” in § 1366, it is not defined in the Internal Revenue Code and the Treasury regulations provide only guidance

. 19 See 26 C.F.R. §

18 “To prevent double taxation of income upon distribution from the corporation to the shareh olders, § 1367(a)(1)(A) permits shareholders to increase their corporate bases by items of income identified in § 1366(a).” Gitlitz , 531 U.S. at

209.

19 The separately stated items [of income] of the S corporation include, but are not limited to, the follo wing

items

—

(i) The corporation’s combined net amount of gains and losses from sales or exchanges of capital

assets . . . (ii) The corporation’s combined net amount of gains and losses from sales or exchanges of
property . . . (iii) Charitable contribu tions . . . (vi) Each of the corporation’s separate items of gains and losses from wagering transactions (section 165(d)); soil and water conservation expenditures (section 175); deduction under an election to expense certain depreciable business

expenses (section 179); medical, dental, etc., expenses (section 213) . . .

. . . . (vii) Any of the corporation ’ s items of portfolio income or loss, and expenses related thereto . . .14 1.1366

- 1(a)(2) ; see also Comm ’ r v. Glenshaw Glass Co. , 348

U.S. 426 (1955)

. “Gross income,” however, is defined. It is governed by § 61, and incl udes “ [g]ains derived from dealings in property

, ” as well as “[i]ncome from discharge of

indebtedness

. ” 20 Id. § 61(a)(3), (12). Further, the Supreme
Court has defined “ gross income” as “ accessions to wealth

, clearly realized, and over which the taxpayers ha ve complete

dominion. ” Glenshaw Glass , 348 U.S. at 431. Gains derived

from the property obtained by electing and liquidating the Qsub are claimed by the Trusts to be “items of income” for

(viii) The corporation’s tax

- exempt income. For purposes of subchapter S, ta x

- exempt income is income that is permanently excludible from gross

income in all circumstances in which the applicable provision of the Internal Revenue Code applies . . . .

26 C.F.R. § 1.1366

- 1(a)(2).

20 Other gross income measurements are:

Compensati on for services, including fees, commissions, fringe benefits, and similar items; Gross income derived from business; Interest; Rents; Royalties; Dividends; Alimony and separate maintenance payments; Annuities;

Income from life insurance and endowment

cont racts; Pensions; Income from discharge of indebtedness; Distributive share of partnership gross income; Income in respect of a decedent; and

Income from an interest in an estate or trust.

26 U.S.C. § 61(a).15 the purpose of § 1366. Fundamentally, the Trusts claim

there was a gain from liquidation (§ 61(a)), that gain was “realized” (§ 331) and calculated (§ 1001), and thus is an “item of income” (§ 1366). (Appellant Br. at 17.) The Trusts summarily dismiss the effect of non

- recognition on whether a gain is income; however, thi s premise is undermined by regulations corresponding to § 61(a). 21 Under the § 61(a) Treasury R egulations, gains from the sale or exchange of property, including those derived under § 331, are not “recognized,” and thus “not included in or deducted from

gro ss income at the time the transaction occurs.” 22 26 C.F.R. § 1.61

- 6(b)(1).

While “item of income” is a broad and undefined term, it is not one without limits. § 61(a) provides a “broad definition of ‘gross income,’” that is “sweeping [in] scope,”

unless “excepted by another provision in the tax code.”

Comm’r v. Schleier , 515 U.S. 323, 328

- 29 (1995). The Supreme Court concluded that “income” requires an

21 The Trusts state, “[i]n sum, that realized ga in is not recognized does not alter the fact that the realized gain is income . . . .” (Appellant Br. at 18.)

22 Appellants assert that the quoted language from 26 C.F.R.

1.61

- 6(b)(1) only addresses issues of timing, namely that realized but unrecognized gain is not taken into account when the transaction occurs. They support that assertion with examples of income defined under subsections of § 61(a) but then subject to nonrecognition treatment elsewhere. Those examples are distinguishable from the gains at issue here because the examples of income are expressly provided for under § 61(a) and are not analogous to the unique treatment of Qsub liquidations under the Code.16 “accession to wealth.” Glenshaw Glass , 348 U.S. at 431. The Qsub election did not add wealth, it merely changed the tax treatment of the income flowing from the Qsub. This reformation by liquidation did not provide an “accession to wealth” for the corporation and therefore could not create
“income” for the Trusts.

B. Realization and Recognition of Gains

T he Internal Revenue Code

defers the tax consequences of a gain or loss in

pro perty value until the taxpayer ‘realizes’ the gain or loss. The realization requirement is implicit in § 1001(a) of the Code, which defines ‘ [t]he gain [or loss] from the sale o r other disposition of property’
as the difference between ‘the amount realized’ from the sale or dispo sition of the property and its ‘adjusted basis.’

Cottage Sav. Ass’n v. Comm ’ r , 499 U.S. 554, 559 (1991) (quot ing 26 U.S.C. § 1001(a

- b) ). “T o realize a g ain or loss in the value of property, the taxpayer must engage in a ‘ sale or other disposition of [the] property. ’ ” Id. (quoting § 1001(a)).

The Commissioner and the Trusts differ as to whether “realizing” a gain is enough to create an “item of income”

un der § 1366, or whether this section requires the gain to be “recognized.” The Tax Court concluded that “nonrecognition provisions prevent realized gain from being included in a taxpayer’s gross income.” R. Ball , 2013 WL 452722, at *5.

The Trusts contend th at the Tax Court “confused the concepts of realization and recognition.” (Appellants’ Opening Br. at 14.) They argue that the Tax Court reached the17 “unprecedented conclusion that because ‘no gain was recognized, . . . the unrecognized gain did not create a n item

of income under § 61(a)(3),’ or § 1355(a)(1)(A).” ( Id. at 15 (quoting App. at 24.) The Trusts assert that the “crux of the Tax Court’s error” is its determination that “unrecognized gain does not rise to the level of income.” ( Id. ) They argue

that t he Code cannot be parsed to create some realized gain that is income and some realized gain that, by virtue of nonrecognition, is not. According to the Trusts, realized gain is always income, a categorization that does not change if that realized gain is t hen unrecognized.

Inherent in this conflict is which statutory provision

, §§ 331 or 332, applies to the liquidation of AIS via Qsub

election. Section 331 , governing “gain or loss to shareho lders in corporate liquidations,” states “[a] mounts received by a shareholder in a distribution in complete liquidation of a corporation shall be treated as in full payment in exchange for

the stoc k.” Th e payment via liquidation is realized and calculated by adding “ any money received plus the fair

market value of the property (other than money) received. ” 26 U.S.C. § 1001(b). At this point, the Trusts argue that the realized gain become s an “item of income” by way of § 61(a)(3) and the Supreme Court’s holding in Gitlitz

. Id. § 61(a)(3) (“[G]ross income means all incom e from whatever source derived, including . . . [g]ains derived from dealings in
property . . . .”); 531 U.S. at 213. The Trusts argue § 331 applies to “realize” the gain. The Trusts claim the gain is

defined in § 61(a) and that it is then calculated under § 1001(a). The Trusts deem § 332’s non

- recognition provision to apply only after realization under § 331, without effect on whether the gain is an “item of income.” 26 U.S.C. § 331

. The Trusts position is that this realized but unrecognized gain18 is consid ered an “item of income” and they are permitted to

increase their base s in their Wind River stock

.

In contrast, the Commissioner claims the gain must

first be “ recognized ” to qualify as an “ item of income, ” and the gain in this case is not recognized due to § 332’s non

recognition provision. Section 332 governs “complete liquidations of subsidiaries .” Id. § 332 (emphasis added)

. An S Corp. may elect Qsub status for its subsidiary if “(1) the [S Corp.] parent hold s 100 percent of the subsidiary’ s stock, (2 ) the subsidiary is otherwise eligible to qualify as an [S Corp.] on its own, but for the fact that it has a corporate shareholder, and (3) the [S Corp.] parent makes the appropriate election . .

. .” In re Majestic Star Casino, LLC , 716 F.3d 736, 743 n.6 (2013) After a Qsub election , for tax purposes, “the subsidiary is deemed to have liquidated into the parent under I.R.C. §§ 332 and 337.” 26 C.F.R. § 1.1361

- 4 (2012) . Thus, “[a] Qsub does not even exist for federal tax purposes.” Majestic Star Casino , 716 F.3d at 759

. Section 332 then states “[n]o gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporati on.” 26 U .S.C. § 332(a) (emphasis added);

see also § 337(a) (“ No gain or loss s hall be recognized to the liquidating corporation on the distribution to the 80

- percent distributee of any property in a complete liquidation to which section 332 applies. ”).19 The Treasury Regulations further distinguish between §§ 331 and 332. 23 “ Sectio n 332 applies only to those cases in which the recipient corporation receives at least partial payment for the stock which it owns in the liquidating corporation.” 24 26 C.F.R. § 1.332

- 2(b)

.

23 The relevant distinguishing language states:

Under the general rule prescribed by s ection 331 for the treatment of distributions in liquidation of a corporation, amounts received by one corporation in complete liquidation of another corporation are treated as in full payment in exchange for stock in such other corporation, and gain or lo ss from the receipt of such amounts is to be determined as provided in section 1001. Section 332 excepts from the general rule property received, under certain specifically described circumstances, by one corporation as a distribution in complete liquidati on of the stock of another corporation and provides for the nonrecognition of gain or loss in those cases which meet the statutory requirements.

26 C.F.R. § 1.332

- 1.

24 The regulations further state :

The nonrecognition of gain or loss is limited to the

r eceipt of such property by a corporation which is the actual owner of stock (in the liquidating corporation) possessing at least 80 percent of the total combined voting power of all classes of stock

entitled to vote and the owner of at least 80 percent of the total number of shares of all other20 Ultimately, the Tax Court rejected the Trust s’ arguments under § 3 31, specifically noting that § 332, which governs the liquidation of a subsidiary of which the parent corporation owns eighty percent or more, applies here, not § 331, which governs “all other liquidations.” R. Ball , 2013 WL 452722, at *6. The Court held that a liquidation cannot be governed by both § 331 and § 332, thereby foreclosing the

Trusts ’ argument that the gain was first realized under § 331 and then subject to nonrecognition treatment under § 332.

The Tax Court is correct. The Trusts fail to address the fact that § 332, by its plain text, applies to a special set of liquidations that are treated under a different statutory scheme
and do not create “items of income.” Under the Internal Revenue Code, a Qsub election results in a § 332 liquidati on. See 26 C.F.R. § 1.1361

- 4 (providing that a Qsub election is a

classes of stock (except nonvoting stock which is limited and preferred as to dividends). The recipient corporation must have been the owner of the specified amount of such stock on the date of the adoption of the pl an of liquidation and have continued so to be at all times until the receipt of the property. If the recipient corporation does not continue qualified with respect to the ownership of stock of the liquidating corporation and if the failure to continue qual ified occurs at any time prior to the completion of the transfer of all the property, the provisions for the nonrecognition of gain or loss do not apply to any distribution received under the plan.

26 C.F.R. § 1.332

- 2(a).21 deemed liquidation into the parent corporation); 26 U.S.C. § 332 (covering the complete liquidation of a wholly owned subsidiary). Section 332 applies to the liquidation of a
“controlled s ubsidiary” into its parent. Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations

& Shareholders ¶ 10.20 (7th ed. 2006). A Qsub is a wholly owned subsidiary under § 1361(b)(3)(B)(i) (“[one hundred] percent of the stock of such corpor ation is held by the S corporation.”).

The Trusts argue that § 332(d) (“Recognition of gain on liquidation of certain holding companies”) provides that “subsection (a) and section 331 shall not apply to such

distribution. ” 26 U.S.C § 332(d)(1)(A). Thi s , according to them, is proof that the sections are not mutually exclusive, because, if they were, there would be no need for the exception. That subsection, however, does not affect the analysis of a Qsub liquidation at issue here. Instead, it

focuses on “distribution[s] to foreign corporation in complete liquidation of an applicable holding company.” Id . It is not incongruous to say that a Qsub liquidation, governed by § 1361, is only covered by § 332 but that other liquidations, covered by other sec tions of the Code, may be covered by both § 332 and § 331. Rather, the complexities of intersecting provisions should be maintained. The tax treatise cited by both parties states that § 332 is an “important exception” to the general rule provided in § 33 1. Bittker & Eustice ¶ 10.20. As such, a liquidation is either governed by the general rule in § 331, or it is covered by the exception in § 332. As the Tax Court correctly held, “[a] liquidation cannot be governed by both.” R. Ball , 2013 WL 452722, at * 6.

C. Gitlitz and Farley22 The Trusts contend, however , regardless of “ whether or not Sections 331 and 332 are viewed as separate corporate liquidation schemes does not alter the result .” ( Appellants’ Opening Br. at 42.) Rather, the results of Gitlitz and Farley

and the treatment of gain s as income under § 61(a) are dispositive.

The Trusts rely on the holdings of Gitlitz and Farley

, allowing a discharge of indebtedness to pass through to

shareholders as an “item of income,” as justification for their

own “items of income” argument

. 25 Specifically, the Trusts argue that an “ item of income” may be defined as gross income under one provision of the Code

, yet not recognized under another provision

, and still remain an “item of income” for the purpose of § 1366

. In Gitlitz , petitioners were shareholders of an insolvent S corporation, which realized over two million dollars of discharge of indebtedness income

in 1991. 531 U.S. at 208

. Even after the discharge of indebtedness income, the S Corp. was still insolv ent and so the entire discharge of indebtedness was excluded from gross income under §§ 108(a) and 108(d)(7)(A). Id. at 209

- 10. On their tax returns, the Gitlitz petitioners increased their bases in the S corp.’s stock by their pro rata share of the disc harge of indebtedness income under the theory that the discharge of
indebtedness income was an “item of income” that was passed through to the taxpayers under § 1366(a)(1)(A). Id. at 210. The petitioners in Gitlitz then used the increased base s to deduct their total losses. Id. The Supreme Court agreed, finding “[ that] section [1366] is worded broadly enough to include any item of income, even tax

- deferred income, that

25 The Trusts state “[t] his case falls squarely within Gitlitz

and Farley .” (Reply Brief at 9.)23 ‘could affect the liability for tax of any shareholder.’” Id. at 216 (quoting § 1366(a) (1)(A)).

This Circuit in Farley issued a similar, and even more expanded, holding. 202 F.3d at 206.

We hold that because the controlling statutes clearly provide that tax attribute reduction takes place after income has passed through the S corporation to its shareholders (pass through being a necessary prerequisite to “determin[ing] the tax imposed by this chapter for the taxable year of discharge”), in the case of an insolvent S corporation, discharge of indebtedness income that is excluded from gross income by section 108(a), passes through to the shareholders, increases the shareholder's basis in their S corporation stock, thus allowing the shareholders to take deductions for S corporation losses suspended under section 1366(d)(1).

Id. The Supreme Co urt in Gitlitz acknowledged that all “items of income” need not qualify as gross inc ome and the

indebtedness in Gitlitz still was “income ” as included under § 61(a)(12). Id. at 213. In contrast to Gitlitz , a similar inclusion under § 61(a) is not present in the “gain” in the appeal before

us

. See Nathel v. Comm’r , 615 F.3d 83, 91 (2d Cir. 2010) (“The argument ignores the crucial difference between Gitlitz

and this case: Gitlitz addressed payments that explicitly were included in gross income under § 61(a). ”). Rather, the “gain” under § 61(a) is not recognized nor is it income, and thus it

can not be an “ item of income. ”24 The Tax Court noted that any conclusion other than a holding that “unrecognized gain from a Qsub election does

not constitute an item of i ncome or tax

- exempt income under § 1366(a)(1)(A),” would lead to “absurd results” and “open the door to a myriad of abusive transactions.” R. Ball , 2013 WL 452722, at *9

- 10

. The Supreme Court in Gitlitz

, however, refused to address this policy argument wh en the

text of the Code was clear. Gitlitz , 531 U.S. at 220 (“Because the Code’s plain text permits the taxpayers here to receive these benefits, we need not address this policy concern.”). Although statutory text cannot be read in a way that creates

an absurdity, the payment of some taxes and not others is not an absurdity, but rather a policy choice rightly left to Congress. Id

. Indeed, Congress

, subsequent to Gitlitz

, made changes to the statute at issue in that case to prevent further

uses of the tax code loophole. 26

26 See supra note 17 . “As a general matter, the Committee believes that where, as in the case of the present statute under section 108, the plain text of a provision of the Internal

Revenue Cod e produces an ambiguity, the provision should be read as closing, not maintaining, a loophole that would result in an inappropriate reduction of tax liability.” H.R. Rep.

No. 107

- 251, at 52 (2002). Congress provides a further illustration of why the change , similar to issues presented on appeal.25 Interconnecting these regulations demonstrates that the gain is not recognized and under the definition of the Supreme Court is not income, and therefore if not income,

cann ot be deemed an “item of income” under § 1366

. In sum

, the S C orp . shareholders could not increase their base s under § 1367. The Trusts fail to cite any authority for the

alternative.

For the foregoing reasons, we will affirm the Order of

the Tax Court

.

To illustrate these rules, assume that a sole shareholder of an S corporation has zero basis in its stock of the corporation. The S corporation borrows $100 from a third party and loses the entire $100. Because the shareholder has no basis in its stock, the $100 loss is “suspended” at the corporate level. If the $100 debt is forgiven when the corporation is in bankruptcy or is insolvent, the $100 income from the discharge of indebtedness is excluded from income, and the $100 “suspended”

loss should be eliminated in order to achieve a tax

result that is consistent with the economics of the

transactions in that the shareholder has no economic gain or loss from these transactions.

Id.