Entity Selection Revisited: Will Gitlitz Provide Continuing Vitality for S Corporations?
In the alphabet soup of entity selection for Florida lawyers, S corporations have become second-class citizens to their more exotic cousins. LLCs, LLPs, and LLLPs offer the benefits of S corporation status (flow-through taxation with no owner subject to personal liability for the debts and obligations of the entity) without the restrictions imposed on S corporations (no corporate or nonresident alien shareholders, limited number of shareholders, one class of stock requirement, etc.). The recent decision of the U.S. Supreme Court in Gitlitz v. Commissioner, 121 S. Ct. 701 (2001), however, confirms that S corporations offer a significant advantage over other flow-through entities with respect to the tax consequences of cancellation of indebtedness (COD) income.
The Issue
The issue addressed by the Supreme Court in Gitlitz, and considered by numerous other courts as cited below, was whether S corporation shareholders can increase stock basis on account of COD income realized by the S corporation, and thereby deduct previously suspended S corporation losses. Specifically, the Supreme Court was asked to answer the following questions:
1) Is a shareholder of an insolvent S corporation entitled to increase his tax basis in the stock of such corporation on account of COD income realized by the corporation that is not currently taxable, and may never be taxable, to such shareholder?
2) If so, is the shareholder then entitled to deduct previously suspended S corporation losses to the extent of such increased basis?
As discussed below, the answers to those questions are of great consequence to S corporation shareholders.
The Law
An S corporation shareholder is not entitled to deduct S corporation losses that exceed the sum of his tax basis in the stock of the corporation plus his tax basis in monies loaned to the corporation directly by such shareholder.1 Such losses are suspended and carried forward indefinitely until such time as the shareholder has sufficient tax basis to deduct the losses. Financially troubled S corporations typically have suspended losses.
Ordinarily, income realized by an S corporation flows through to the corporation’s shareholders, and the shareholders’ tax bases in the corporation are increased by the amount of such income.2 Shareholders of an insolvent S corporation, however, are not taxed currently (and may never be taxed) on COD income realized by the corporation.3 The S corporation, however, is required to reduce the amount of certain tax attributes, such as net operating losses (NOLs), by the amount of COD income that is not taxed to its shareholders.4 For this purpose, if an S corporation has suspended losses at the end of a taxable year, those losses are treated as an NOL for such year.5
The Stakes
For purposes of illustration, the following example is used throughout this discussion:
Individuals A and B each contributed $100,000 to a subchapter S corporation (S Corp.) in exchange for 50 shares of S Corp. stock, representing 100 percent of the issued and outstanding stock of S Corp. S Corp. borrowed $2,000,000 to purchase an improved parcel of real property and operate a business on that property. The debt was secured solely by the property and improvements.
In year one, S Corp. spent $1,000,000 to purchase the parcel and incurred $1,200,000 of deductible expenses in connection with its unsuccessful business. In year two, S Corp. abandoned the project, the lender took title to the property (having a fair market value of $1,000,000) and the lender forgave the remaining $1,000,000 owed by S Corp.
For tax purposes, S Corp. recognized a loss of $1,200,000 in year one. $200,000 of such loss flowed through to A and B equally, and the remaining $1,000,000 of loss was suspended. In year two, S Corp. realized $1,000,000 of COD income.
Because S Corp. is insolvent in year two, the $1,000,000 of COD income realized by S Corp. will not be taxable currently to A or B, regardless of whether A and/or B are solvent. If A and B are entitled to increase the basis of their S Corp. stock by the $1,000,000 of COD income realized by S Corp., then A and B will have $1,000,000 of tax basis. If S Corp.’s suspended losses are then allowed to flow through to A and B, S Corp. will not have any suspended losses “at the end of the year,” and no portion of the suspended losses will be treated as an NOL to be reduced by the amount of excluded COD income.6 A and B will thus be able to immediately deduct the $1,000,000 of losses previously suspended. Even if S Corp.’s suspended losses are deemed to become NOLs before they flow through to A and B and, therefore, are reduced to zero, A and B would receive the benefit of the increased tax basis if and when they sell the stock of the corporation or the corporation is liquidated.
In contrast, if A and B are not entitled to increase their tax bases on account of the COD income, then A and B will not be able to currently deduct the amount of S Corp.’s suspended losses. Moreover, S Corp.’s suspended losses will become NOLs which will be reduced to zero, and A and B will never be able to deduct those losses.
The Arguments
Both taxpayers and the Internal Revenue Service have raised highly technical issues and arguments to support their theories. Those arguments are well summarized in the many articles that have been written on the subject.7 The argument of taxpayers seeking to deduct suspended losses, and the argument ultimately accepted by eight of the nine Supreme Court Justices in Gitlitz, is simply an argument of statutory construction: The plain language of the Code permits deduction of the suspended losses. Specifically, S corporation shareholders are entitled to increase their S corporation stock bases by the amount of income realized by an S corporation, regardless of whether that income is COD income that is not taxable to the shareholders. Moreover, such shareholders are allowed to deduct such suspended losses, to the extent of the increase in their stock bases, before such suspended losses become NOLs that are reduced under Code §108.
The Internal Revenue Service, in contrast, has argued that COD income of an insolvent S corporation does not flow through to the corporation’s shareholders, and that suspended losses of an insolvent S corporation become NOLs that must be reduced by the amount of COD income excluded from the taxable income of the corporation’s shareholders.8 The IRS has countered taxpayers plain-language argument by pointing out that allowing the deduction of suspended losses results in an unintended “windfall” to S corporation shareholders.9 Under the facts of the example discussed above, a literal reading of the statute would permit A and B to deduct total losses of $1,200,000, when A and B only invested $200,000 of their own money in the project. It was the lender, not A and B, that bore the economic consequences of the additional $1,000,000 loss. As discussed below, several courts and many commentators have agreed with one or more of the IRS’ arguments.
The Cases
The early authority on the issue of whether COD income realized by an insolvent S corporation allows shareholders of the corporation to deduct suspended losses was in the form of technical advice memoranda (TAMs) issued by the IRS.10 In those TAMs, the IRS ruled that excluded COD income does not pass through to S corporation shareholders and, accordingly, shareholders are not entitled to increase their stock bases by the amount of such excluded COD income.
The Tax Court first addressed the issue in the case of Winn v. Commissioner, 73 T.C.M. 3167 (1997), withdrawn and superseded, 75 T.C.M. 1840.11 The Tax Court in Winn agreed with the taxpayer’s plain-language argument and allowed the taxpayer to increase the basis of his S corporation stock by the amount of excluded COD income realized by the corporation.12 Shortly after issuing its opinion in Winn, the Tax Court changed its conclusion in Nelson v. Commissioner, 110 T.C. 114 (1998), aff d, 182 F. 3d 1152 (10th Cir. 1999).13 While the Tax Court unanimously agreed that the taxpayer in Nelson was not entitled to increase his stock basis on account of excluded S corporation income, the judges employed three distinct rationales for reaching that conclusion. Following the Tax Court’s decision in Nelson, the issues raised have been considered by the Third, Sixth, Seventh, 10th, and 11th circuits, and, ultimately, the U.S. Supreme Court, with varying results.
In Gitlitz (formerly Winn) and Nelson, the 10th Circuit held that excluded COD income does not increase stock basis.14 In United States v. Farley, the Third Circuit held that excluded COD income does increase stock basis, and permitted the taxpayer to deduct suspended losses.15 In Gaudiano v. Commissioner and Witzel v. Commissioner, the Sixth and Seventh circuits, respectively, held that excluded COD income does increase stock basis, but also held that the corporation’s suspended losses became NOLs that were reduced by the amount of excluded COD income.16 In Gitlitz, the Supreme Court agreed with the reasoning of the Third Circuit in Farley, and held that, under the plain language of the Code, excluded COD income does increase stock basis and, as a result, S corporation shareholders are permitted to deduct suspended losses (without those losses being treated as NOLs subject to reduction).
The IRS Regulation
While the various courts were considering the interaction of excluded COD income and suspended losses, the IRS promulgated Treas. Reg. §1.1366-1(a)(2)(viii), effective August 18, 1998, which provides that excluded COD income is not “tax-exempt” income that flows through to S corporation shareholders.17 Presumably, this regulation is of no further practical effect following the Supreme Court’s ruling in Gitlitz.
Comparison to Partnerships
As a result of the Supreme Court’s decision in Gitlitz, the tax consequences to A and B in the example above differ materially from the tax consequences that would result if A and B were members of an insolvent limited liability company (LLC) taxed as a partnership. There is no exclusion for COD income recognized by an insolvent partnership; rather, the insolvency exception is applied at the partner (member) level.18 Accordingly, assuming A and B are solvent, they would be required to include the $1,000,000 of COD income realized by the LLC in their taxable income.19 Unlike shareholders of an S corporation, members of an LLC taxed as a partnership are generally entitled to include the amount of the LLC’s debt in their tax basis.20 Thus, in the LLC scenario, A and B would have been entitled to deduct the full $1,200,000 of losses realized by the LLC in year one.21 The inclusion of $1,000,000 of COD income in year two would essentially be a recapture of losses previously deducted in excess of the actual economic outlay of A and B.22 While A and B would have realized a timing benefit by virtue of having a deduction in a prior year followed by recapture in a later year, they would not be entitled to deduct losses in excess of their actual economic outlay (as they would under the S corporation scenario).
In the LLC scenario, A and B may be tempted to convert the LLC to an S corporation prior to realizing the COD income. The incorporation of the LLC, however, will give rise to a taxable deemed distribution of $1,000,000 to A and B under the rules of Code §752(b). Accordingly, A and B will not be able to obtain the favorable COD treatment afforded to S corporation shareholders by converting the LLC.
Conclusions
Gitlitz confirms that the tax consequences of COD income realized by an insolvent S corporation with solvent shareholders are more favorable than the tax consequences of COD income realized by an insolvent partnership with solvent partners (or an insolvent LLC with solvent members). The tax benefit realized by the shareholders of an insolvent S corporation is a windfall, allowing those shareholders to deduct losses in excess of their actual economic outlay. The IRS and several courts have struggled to craft theories to prevent such a windfall. The Supreme Court ultimately concluded that none of those theories was strong enough to overcome the plain language of the Code. The IRS has recently announced that it will not pursue any change to the law in response to Gitlitz.23 Accordingly, S corporations will continue to offer an advantage over other forms of flow-through entities with respect to the treatment of COD income. In addition, shareholders of S corporations that realized COD income in prior years may wish to file amended returns to take advantage of the Gitlitz position, if they are able to do so within the applicable statute of limitations. q
1 Section 1366(d)(1) of the Internal Revenue Code of 1986, as amended (the Code).
2 Code §§1366(a)(1) and 1367(a)(1).
3 Code §§108(a)(1) and 108(d)(7).
4 Code §108(b)(2). requiring the S corporation to reduce certain tax attributes by the amount of excluded COD income, the operation of Code §108 often results in a deferral of recognition of COD income, rather than a permanent exclusion of that income.
5 Code §108(d)(7)(B).
6 Code §108(b)(4)(A) provides that NOLs and other tax attributes are reduced “after the determination of the tax imposed. . . for the taxable year of the discharge.” Accordingly, taxpayers have argued that the suspended losses must be applied to reduce taxable income for the year of the discharge before the attribute reduction rules apply. In that case, the suspended losses used to reduce income never become an NOL subject to reduction.
7 See, e.g., Loebl, Does the Excluded COD Income of an Insolvent S Corporation Increase the Basis of the Shareholders Stock?, 52 U. Fla. L. Rev. 957 (2000); Lipton, Different Courts Adopt Different Approaches to the Impact of COD Income, 92 J. Tax’n 207 (2000); Burgess, Raby and Raby, DOI “Windfall” Resurrected for S Corporation Shareholders, 86 Tax Notes 819 (2000); Lockhart & Duffy, Tax Court Rules in Nelson that S Corporation Excluded COD Income Does Not Increase Shareholder Stock Basis, 25 Wm. Mitchell L. Rev. 287 (1999).
8 Specifically, the IRS has, at various times, argued that (i) Code §108(d)(7)(A) (which provides that the rules of Code §108 are generally applied at the corporate level) preempts the general flow-through of S corporation income under Code §1366(a); (ii) COD income of an insolvent S corporation is tax deferred, not tax exempt (see supra note 4), and, therefore, is not the type of S corporation income that flows through to S corporation shareholders under Code §1366(a); and (iii) under Code §108(d)(7)(A), suspended losses of an insolvent S corporation are treated as NOLs of the corporation that must be reduced by the amount of excluded COD income under Code §108(b)(2)(A).
9 In Gitlitz, the Supreme Court acknowledged the policy concern created by the potential “double windfall” to S corporation shareholders, but concluded that “[b]ecause the Code’s plain text permits the taxpayers here to receive these benefits, we need not address this policy concern.” 121 S. Ct. at 709.
10 See TAM 9423003, TAM 9541001, and TAM 9541006.
11 The Winn case was subsequently renamed Gitlitz v. Commissioner, and is the case recently decided by the Supreme Court. Accordingly, Winn was the first, and presumably the last, case on this issue.
12 See A Winn-Win Situation: Subchapter S Basis Increase for COD Income, 87 J. Tax’n 377 (1997).
13 As a result of the decision in Nelson, the Tax Court withdrew its prior opinion in Winn.
14 182 F.3d 1143 (10th Cir. 1999), rev’d, 121 S. Ct. 701 (2001); 182 F.3d 1152 (10th Cir. 1999).
15 202 F.3d 198 (3d Cir. 2000), cert. denied, 121 S. Ct 874 (2001). See also Pugh v. Commissioner, 213 F.3d 1324 (11th Cir. 2000), cert. denied, 121 S. Ct. 854 (2001), in which the 11th Circuit permitted a basis increase in a case in which the insolvent S corporation did not have any suspended losses.
16 216 F.3d 524 (6th Cir. 2000), vacated, 121 S. Ct. 852 (2001); 200 F.3d 496 (7th Cir. 2000), vacated, 121 S. Ct. 851 (2001).
17 See supra notes 4 and 9.
18 Code §108(d)(6). This is an important advantage of S corporations over entities taxed as partnerships that existed before Gitlitz.
19 If A and B were insolvent, then they would be entitled to exclude the COD income realized by the LLC and to increase their bases in the LLC membership interests by the amount of such excluded income. See TAM 9739002. Thus, Gitlitz places an S corporation shareholder (solvent or insolvent) in the same financial position as an insolvent partner (member).
20 Code §752.
21 Subject to possible limitation under the at-risk rules of Code §465 and the passive-activity rules of Code §469.
22 In addition to recognizing $1,000,000 of COD income, A and B would be deemed to have received a distribution of $1,000,000 under Code §752(b) as a result of the reduction of the LLC’s debt. Because A and B receive an additional $1,000,000 of tax basis as a result of the recognition of COD income, however, the deemed distribution should not result in any additional tax liability to A and B. Code §731(a).
23 See statement of Jeanne Sullivan, IRS senior technical reviewer (pass-throughs and special industries), published in BNA’s Daily Tax Report, April 26, 2001, at p. G-4.
Craig E. Behrenfeld is a member of Barnett, Bolt, Kirkwood & Long in Tampa. He received his B.A., cum laude, from the University of Pennsylvania in 1988, J.D., magna cum laude, from New York University in 1991, and LL.M. in taxation from New York University in 1993.
This column is submitted on behalf of the Tax Section, Marvin C. Gutter, chair, and Michael D. Miller and Lester B. Law, editors.
