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 REVENUE
2

 (Tax Court No. 11-17595)

_____________

ETHEL BALL FOR A L BALL AS APPT

v.

COMMISSIONER OF INTERNAL 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 Court

(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.

(Filed: 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 

corporation 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 election to treat its subsidiary as a “qualified 

subchapter S subsidiary” (“Qsub”) under Internal Revenue 

Code § 1361.

1

Specifically, the parties disagree as to whether 

the Qsub election and subsequent sale of the S Corp. parent

creates an “item of income” under § 1366(a)(1)(A)2thereby 

 

1

26 U.S.C. § 1361. All statutory citations refer to the Internal 

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 shareholder 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), loss, deduction, or credit the separate 

treatment of which could affect the liability for tax 

of any shareholder . . . . 
6

requiring the parties who held stock in the parent S Corp. to 

adjust their bases in stock under § 1367(a)(1)(A).3For 

reasons which follow, we affirm the decision of the Tax 

Court, finding an increase in stock bases and declared losses

to be improper.

II. FACTS

In June 1997, ten trusts for the benefit of the Ball 

family (“Trusts”)4acquired 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 12/22/1976; R. Ball for A. 

L. Ball By Appt.; R Ball Jr. Children Trust 1/29/1970; R. Ball 

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

9/9/1967. 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 purposes 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 Appellants.
7

American Insurance Service, Inc. (“AIS”)5 with an aggregate 

basis in AIS stock totaling $5,612,555. In 1999, 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.

Effective 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).6Prior to 

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

Wind River stock was $15,246,099. Following the Qsub 

election, the Trusts increased their bases 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 insurance-affiliated corporations. Prior to 

acquiring direct ownership of all AIS shares, the Trusts had 

previously indirectly 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 assets, 

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 of 

$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

Following 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.8Even 

though they had received $230,111,857 from the sale, the

Trusts claimed a loss in the amount of $12,247,229.9This was

calculated as the difference between the amount actually

received for the sale and the new basis in the Wind River 

stock. The Trusts shareholders’ 2003 tax returns were filed 

citing the aforementioned capital loss.

The Internal Revenue Service (“IRS”) determined the 

Trusts should not have increased their bases 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 been 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 notices 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 Court Rule 122,11as R. Ball for R. Ball III By 

Appt., et al. v. Commissioner, 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.

III. 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 dealings in property and, therefore, 

 

10 26 U.S.C. § 332. § 332 governs the liquidation of a whollyowned 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 bases and resulting tax losses are proper. If it 

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

bases and declared tax losses are improper.

More specifically, before the Tax Court, the Trusts 

argued that the deemed liquidation of AIS was, under § 331, a 

sale or exchange of property creating a realized gain to Wind 

River. They further claimed that gains from dealings in 

property are expressly included in gross 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 income)” 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, 

the Trusts raised several contentions to the Commissioner’s 

deficiency finding: (1) their bases were properly 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 cited United States v. Farley13 and Gitlitz v. 

Commissioner,

14 arguing that the “realized” liquidation gain 

under §§ 331 and 61(a)(3), allowed 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 dealings 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 §§ 1367, 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 calculated 

under § 1001,15 yet it is not “recognized” due to the nonrecognition 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 

nonrecognition treatment.”). Furthermore, the Court found, 

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

rise 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 

election 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 

section1366(a)(1)(A).” Id. at *10. Accordingly, the Trusts

were found deficient for improperly adjusting their bases in 

Wind River stock following the Qsub election and this appeal 

followed. Id..

IV. JURISDICTION

Section 7482(a) provides exclusive jurisdiction by this 

Court over decisions before the United States 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 

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

 

17 The 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 income” 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 shareholders, § 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 following 

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 contributions . . . 

(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 includes “[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 have 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, tax-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: 

Compensation 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 

contracts; 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, this premise is undermined by 

regulations corresponding to § 61(a).21 Under the § 61(a) 

Treasury Regulations, gains from the sale or exchange of 

property, including those derived under § 331, are not 

“recognized,” and thus “not included in or deducted from 

gross 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 gain 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

The Internal Revenue Code 

defers the tax consequences of a gain or loss in 

property 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 or other disposition of property’ 

as the difference between ‘the amount realized’

from the sale or disposition of the property and its 

‘adjusted basis.’

Cottage Sav. Ass’n v. Comm’r, 499 U.S. 554, 559 (1991) 

(quoting 26 U.S.C. § 1001(a-b)). “To realize a gain 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” 

under § 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 that the Tax Court “confused the concepts 

of realization and recognition.” (Appellants’ Opening Br. at 

14.) They argue that the Tax Court reached the 
17

“unprecedented conclusion that because ‘no gain was 

recognized, . . . the unrecognized gain did not create an 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 the 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 then 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 shareholders 

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 stock.” The 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 becomes 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 income 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 gain 
18

is considered an “item of income” and they are permitted to 

increase their bases 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 nonrecognition 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 holds 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 corporation.” 26 U.S.C. § 332(a) (emphasis added); 

see also § 337(a) (“No gain or loss shall 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 “Section 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 section 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 loss 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 

liquidation 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 

receipt 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 other 
20

Ultimately, the Tax Court rejected the Trusts’ 

arguments under § 331, 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 liquidation. 

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 plan 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 qualified 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 subsidiary” 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 corporation 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). This, 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 sections 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 § 331. 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 Farley
22

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 gains 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 insolvent 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 discharge 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 bases 

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 Court in Gitlitz acknowledged that all “items

of income” need not qualify as gross income 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 

cannot 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 income 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 when 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 Code 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, 

cannot be deemed an “item of income” under § 1366. In sum,

the S Corp. shareholders could not increase their bases 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.