Opinion ID: 767471
Heading Depth: 2
Heading Rank: 2

Heading: The Pass Through of the Discharge of Indebtedness Income

Text: 25 Turning to the merits of the Farleys' appeal, we focus first on the statutory language of the Internal Revenue Code. Section 61(a)(12) of the Internal Revenue Code states in relevant part, [e]xcept as otherwise provided in this subtitle, gross income means all income from whatever source derived, including... [i]ncome from discharge of indebtedness. 26 U.S.C. S 61(a)(12). This background rule, that discharge of indebtedness income is income, does not apply to insolvent taxpayers. Specifically, section 108(a)(1)(B) of the Internal Revenue Code states that gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if... the discharge occurs when the taxpayer is insolvent. 26 U.S.C. S 108(a)(1)(B). 26 The exclusion of discharge of indebtedness income from gross income provided for in section 108(a)(1)(B) is not without a price. A taxpayer excluding discharge of indebtedness income from gross income must make corresponding reductions in certain tax attributes, attributes that might otherwise yield future tax benefits. Pursuant to section 108(b)(1) of the Internal Revenue Code, [t]he amount excluded from gross income under [S 108(a)(1)(b)] shall be applied to reduce tax attributes of the taxpayer as provided in [S 108(b)(2)]. 26 U.S.C. S 108(b)(1). Discharge of indebtedness income is thus offset against the various tax attributes listed in section 108(b)(2)--net operating losses, general business credits, minimum tax credits, capital loss carryovers, basis (to the extent permitted under Section 1017(b) of the Internal Revenue Code), passive activity loss and credit carryovers, and foreign tax credit carryovers. See 26 U.S.C. S 108(b)(2)(A)-(G). 3 27 In challenging the District Court's grant of summary judgment, the Farleys argue that discharge of indebtedness income excluded from gross income under 26 U.S.C. S 108(a) passes through to the shareholders of an S corporation on a pro rata basis pursuant to section 1366 of the Internal Revenue Code. As support for this argument, the Farleys cite section 1366(a)(1)(A) of the Internal Revenue Code, which states that the determination of an S corporation's shareholder's tax liability for the shareholder's tax year during which the S corporation's tax year ends takes into account the shareholder's pro rata share of the S corporation's 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. 26 U.S.C. S 1366(a)(1)(A). The Farleys also cite section 1366(c) of the Internal Revenue Code, which states that in any case where it is necessary to determine the gross income of a shareholder for purposes of this title, such gross income shall include the shareholder's pro rata share of the gross income of the corporation. 26 U.S.C. S 1366(c). 28 The Farleys further argue that discharge of indebtedness income, after passing through to the shareholders of the S corporation pursuant to section 1366, increases the basis of the shareholders' stock pursuant to section 1367. Specifically, under section 1367(a)(1)(A), an S corporation's shareholder's basis in the stock of the corporation is increased for any period by, inter alia, items of income described in section 1366(a)(1)(A). See 26 U.S.C. S 1367(a)(1)(A). As section 1367(a)(1)(A) states, [t]he 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: the items of income described in subparagraph (A) of section 1366(a)(1).... 26 U.S.C. S 1367(a)(1)(A). 29 As the preceding discussion demonstrates, the key to unraveling this case is understanding how the relevant statutory provisions interact. As discussed above, section 1366, which describes how and when income, losses, deductions and credits pass through to S corporation shareholders, and section 1367, which sets forth the framework for increasing and decreasing the basis of S corporation stock, must be read in conjunction with the section 108. 30 As mentioned above, section 108(a)(1) provides that [g]ross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayers if... the discharge occurs when the taxpayer is insolvent. 26 U.S.C. S 108(a)(1). It is not disputed that the Farley S Corporations were insolvent at the time of the discharge of indebtedness. And as discussed above, discharge of indebtedness income excluded from gross income pursuant to section 108(b) offsets various tax attributes listed in section 108(b)(2). Pursuant to section 108(b)(4)(A), the reduction in tax attributes mandated by section 108(b)(2) is made after the determination of the tax imposed on the taxpayer (the S corporation shareholder) for the year of discharge. See 26 U.S.C. S 108(b)(4)(A) (The reduction made in [S 108(b)(2)] shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge.) (emphasis added). Furthermore, pursuant to section 108(d)(7)(A), discharge of indebtedness income exclusions (section 108(a)) and tax attribute reduction principles (section 108(b)) must be applied at the corporate level. See 26 U.S.C. S 108(d)(7)(A) (In the case of an S corporation, [S 108(a) and S 108(b)] shall be applied at the corporate level.). 31 The ultimate disposition of this case hinges on the interaction of section 108(d)(7)(A) with section 108(b)(4)(A). Section 108(d)(7)(A), which states that the discharge of indebtedness income exclusion and tax attribute reduction principles should be applied at the corporate level, has two primary effects. First, section 108(d)(7)(A) requires the solvency determination in section 108(a)(1)(b) to be made at the corporate level. That is, when determining whether the taxpayer is insolvent, and thus whether discharge of indebtedness income is excluded from gross income, one must determine whether the S corporation itself is insolvent, not whether a specific individual shareholder is insolvent. Second, and more importantly, section 108(d)(7)(A) requires that the tax attribute reduction principles set forth in section 108(b) be applied at the corporate level. That is, when reducing tax attributes as required by section 108(b), discharge of indebtedness income excluded from gross income pursuant to section 108(a)(1)(A) shall be applied to reduce the tax attributes of the corporation, rather than the individual shareholder. 32 Section 108(b)(4)(A) states that [t]he reductions described in [section 108(b)(2)] shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge. 26 U.S.C. S 108(b)(4)(A) (emphasis added). As the Tenth Circuit observed in Gitlitz: 33 The outcome of this case is ultimately determined by the timing of the pass-through. If the attribute reduction procedures precede the pass-through, the corporation's excluded discharge of indebtedness income is absorbed before it can pass through to shareholders and compel basis adjustments.... If, on the other hand, attribute reduction takes place after the pass-through, the taxpayers' theory must prevail. 34 Gitlitz v. Commissioner, 182 F.3d 1143, 1148 (10th Cir. 1999). 4 35 The language in section 108(b)(4)(A) clearly indicates that tax attributes are reduced on the first day of the tax year following the year of the discharge of indebtedness. The statutory language is unambiguous, and the operation of the statutory language is straightforward. Discharge of indebtedness income, considered income under section 61(a)(12), is excluded from gross income pursuant to section 108(a)(1)(B) if, as in this case, the S corporation is insolvent. This solvency determination is made at the corporate level rather than the individual shareholder level pursuant to section 108(d)(7)(A). Discharge of indebtedness income excluded from gross income under section 108(a)(1)(B) then passes through to the S corporation's shareholders pursuant to section 1366(a)(1)(A). Upon passing through to the S corporation shareholders, the discharge of indebtedness income causes an upward adjustment in the basis of the shareholders' S corporation stock pursuant to section 1367(a)(1)(A), thus allowing deductions for losses previously suspended because the corporation's stock lacked adequate basis. Finally, the tax attribute reduction required by section 108(b) takes place on the first day of the tax year following the year of the discharge of indebtedness, as mandated by section 108(b)(4)(A). 36 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). As such, the Farleys were entitled not only to increase the basis of their S corporation stock but also to take deductions for the Suspended Losses.