Court Opinion

ID: 767225
Source: CourtListenerOpinion
Date Created: 2012-04-18 08:29:07+00
Date Added: 2024-06-11T17:55:26.652522
License: Public Domain

200 F.3d 496 (7th Cir. 2000)
William C. Witzel and Gene E. Witzel,    Petitioners-Appellants,v.Commissioner of Internal Revenue,    Respondent-Appellee.
No. 99-2482
In the  United States Court of Appeals  For the Seventh Circuit
Argued December 9, 1999Decided January 18, 2000

Appeal from the United States Tax Court  No. 6592-97--Juan F. Vasquez, Judge.
Before Posner, Chief Judge, and Coffey and Manion, Circuit Judges.
Posner, Chief Judge.

1
This is an appeal by taxpayers from a decision by the Tax Court (77 T.C.M. 1487 (1999)) holding, consistently  with Gitlitz v. Commissioner, 182 F.3d 1143 (10th  Cir. 1999), and Nelson v. Commissioner, 110 T.C. 114 (1998), that "discharge of indebtedness"  (equivalently, "cancellation of debt") income  that is excluded from gross income under 26  U.S.C. sec. 108(a) does not pass through to a  shareholder of a subchapter S corporation and  therefore does not increase the shareholder's  basis.

2
A debt that is cancelled is income to the  debtor, since he has been enriched by the amount  of the debt. sec. 61(a)(12); see also United  States v. Kirby Lumber Co., 284 U.S. 1 (1931).  But when, as in the present case, the debtor is  in bankruptcy under Chapter 11 of the Bankruptcy  Code, section 108(a) of the Internal Revenue Code  exempts the debtor's cancellation-of-debt (COD)  income from federal income tax. Mr. Witzel is the  sole shareholder of a subchapter S corporation  that as part of its discharge from Chapter 11 was  permitted to cancel some $5.4 million in debts.  Income received by a subchapter S corporation is  taxed to each shareholder pro rata as if he had  received the income directly, 26 U.S.C. sec.  1366, but by virtue of section 108(a) Witzel  incurred no liability to pay tax on any of the  $5.4 million in additional cancellation of debt  income.

3
So far, so good; but at the time of his  discharge from bankruptcy, Witzel had loss  carryforwards arising from the operation of the  subchapter S corporation that he would have liked  to offset against his other, taxable income but  could not because the basis of his S corporation  stock was too low (was in fact zero). These are called "suspended losses," because their use as a  tax deduction is suspended until the corporation  generates income that can be offset against them.  sec. 1366(d). As Witzel points out, the income of  a subchapter S corporation is added to the basis  of the shareholder's stock (or pro rata to the  basis of each shareholder's stock if there is  more than one shareholder) and then subtracted  when the income is distributed to the  shareholder. sec. 1367. If it were not  subtracted, the shareholder might have to pay  capital-gains tax on the amount of the  distribution if he sold his stock, and that would  be the kind of double taxation that the Internal  Revenue Code allows shareholders in a subchapter  S corporation to escape.

4
What Witzel wanted to do in this case, and the Tax Court forbade, was to use his corporation's  $5.4 million of tax-exempt COD income to increase the basis in his stock by that amount and by doing so offset a portion of his loss carryforwards (which at the time totaled almost  $3 million) against his current income and so  reduce the tax on that income. This would be a kind of double dipping. Witzel received a tax break on the $5.4 million; it is not taxable income to him. He wants to get another tax break by using that amount to reduce his other, taxable income by a portion of his suspended losses that, were it not for his $5.4 million in tax-free  income, he could not use to obtain a tax benefit,  at least not yet. He wishes to parlay a $5.4 million tax exemption into a more than $8 million tax exemption.

5
It is hard to understand the rationale for using  a tax exemption to avoid taxation not only on the  income covered by the taxation but also on  unrelated income that is not tax exempt. The  Witzels' lawyer admitted at argument that his  clients are seeking a windfall. See also James S.  Eustice & Joel D. Kuntz, Federal Income Taxation  of S Corporations para. 14.04[2], pp. 14-10 to  14-11 (3d ed. 1993). But of course not all tax  statutes have a public-interest rationale, many  being the product of favoritism and interest-  group pressures. So we must attend to the  statute.

6
In excluding COD income from gross income, the  Code requires, among other things, that the  taxpayer's net operating losses be reduced by the  amount of the excluded income. sec. 108(b)(2)(A).  In the case of subchapter S corporations, this  provision "shall be applied at the corporate  level." sec. 108(d)(7)(A). Because suspended  losses are deemed "net operating losses," sec.  108(d)(7)(B), the government argues that they  must be reduced by the amount of tax-exempt COD  income and so they are unavailable to offset  against Witzel's other income. He argues that the  suspended losses, like other gains and losses of  subchapter S corporations, passed through the  corporation to him and so there is nothing "at  the corporate level" to offset against the  corporation's tax-exempt income, which also  passes through to him and is thus available to  offset his suspended losses. The government  argues, to the contrary, that "at the corporate  level" means that the suspended losses and COD  income stick there.

7
The government's interpretation is not  inevitable. Application of section 108 "at the  corporate level" could mean just that the  relevant bankruptcy status which triggers a tax  exemption for COD income is that of the  corporation, not the shareholder. But this would  leave out of account the reference in subsection  (d) (the "at the corporate level" subsection) to  subsection (b), the subsection that reduces tax  "attributes" (here, the suspended losses) by the  amount of the excluded income. If (b) is to be  applied at the corporate level, the implication,  as the government argues, is that the excluded  income must be set off against the suspended  losses and the latter reduced accordingly. The  argument is not conclusive; the interpretive  question could be resolved either way; but in  these circumstances of dubiety the sensible  result--denying the taxpayers the double  windfall--seems to us the preferable one.

8
We are unpersuaded, however, by the government's  further argument, which the Tenth Circuit  accepted in Gitlitz and which the Tax Court  accepted not only in Gitlitz but also in Nelson  and the present case, that COD income does not  increase the basis of the shareholder's stock in  the subchapter S corporation. 182 F.3d at 1149-  51. (For criticism, see Stephen R. Looney, "S  Corp. Prop. Regs.--No Surprises, But Two  Potentially Controversial Provisions," 90 J.  Taxation 69, 72 (1999).) In effect, the  government wants the courts to do for subchapter  S corporations by interpretation what the  Internal Revenue Code does explicitly in the case  of partnerships--simultaneously with increasing  the partner's basis by his share of the  partnership's COD income decrease the partner's  basis by the same amount because "any decrease in  a partner's share of the liabilities of a  partnership . . . shall be considered as a  distribution of money to the partner by the  partnership." 26 U.S.C. sec. 752(b); see S. Rep.  No. 1035, 96th Cong., 2d Sess. 21-22 (1980);  Looney, supra, at 72.

9
Recall that section 1367 of the Internal Revenue  Code increases the basis of the shareholder's  stock in the subchapter S corporation by the  amount of corporate income passed through to him.  Section 1366 is explicit that the pass through  includes tax-exempt income. sec. 1366(a)(1)(A).  The Tax Court believes that COD income is not  really tax exempt, because, as we know from  section 108(b)(2)(A), such income reduces  suspended losses by a dollar for every dollar of  COD income and thus operates to defer rather than  to eliminate tax. (The tax is paid when the  suspended losses, having been reduced, are not  available to offset taxable income in the  future.) The Supreme Court said the same thing in  passing in United States v. Centennial Savings  Bank FSB, 499 U.S. 573, 580 (1991), but, with all  due respect, the Court's observation is not  accurate. To the extent that the recipient of COD  income (Witzel, to whom the income passed through  his subchapter S corporation) never accrues  suspended losses which that income reduces (thus  reducing the tax benefits that they generate),  his COD income will be tax exempt in the fullest  sense; it will not generate tax liability even  indirectly. More important, section 1366 is not  limited to tax-exempt income, so if COD income is  not "really" tax exempt this would not take it  out of the section.

10
We think, therefore, that while Witzel was  rightly forbidden to deduct his existing  suspended losses, because they were offset at the  corporate level by the amount of his  corporation's COD income, the basis in his stock  was increased by that income, and this may enable  him someday to deduct future suspended losses. We  offer this view tentatively, in part because the  Tenth Circuit has held the contrary and we are  reluctant to precipitate an intercircuit  conflict, in part because Mr. Witzel may never  again have suspended losses, making the issue  rather moot as to him unless he someday sells his  stock and his capital-gains tax liability is  affected by his basis (higher in our view than in  the Tax Court's), and in part because a recently  promulgated Treasury Regulation (not applicable  to this case, however, because it applies only to  tax years beginning on or after August 18, 1998)  adopts the Tax Court's interpretation of section  1366 that we are criticizing. Treas. Reg. sec.  1.1366-1(a)(2)(viii), 64 Fed. Reg. 71641 (Dec.  22, 1999). The validity of the regulation is for  the future; it is enough to rule today that  section 108(d)(7)(A) requires that COD income of  a subchapter S corporation be offset against any  existing suspended losses arising from the  operation of the corporation.

11
Affirmed.