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1999 Term, Number 13 / May 1, 2000

Today the Supreme Court granted certiorari in two cases, one of which is of potential interest to the business community. Amicus briefs in support of the petitioner are due on Thursday, June 15, 2000, and amicus briefs in support of the respondents are due on Monday, July 17, 2000. Any questions about these cases should be directed to Donald Falk (202-263-3245) or Eileen Penner (202-263-3242) in our Washington office.

Taxation — Insolvent Subchapter S Corporations — Tax Treatment of Discharged Indebtedness. Under the Internal Revenue Code, corporations organized under Subchapter S pass through corporate income, losses, deductions and credits to their individual shareholders in a manner similar to the tax treatment of partnerships. Because an S corporation’s profits and losses pass through to the shareholders, the shareholders’ basis in the stock of the corporation may change every year to reflect the corporation’s performance during that year. Corporate losses may be passed through to a shareholder only to the extent of the shareholder’s basis. See 26 U.S.C. § 1366(d)(2).

Although a corporation’s cancellation of debt is ordinarily recognized as taxable income, the Code provides that cancellation of debt by an insolvent corporation does not result in taxable corporate income. See 26 U.S.C. § 108(a)(1)(B). The Court granted certiorari in Gitlitz v. Commissioner of Internal Revenue, No. 99-1295, to decide whether the cancellation of an insolvent S corporation’s debt nonetheless may alter a shareholder’s basis in the stock of the S corporation under Sections 1366 and 1367 of the Code, so that additional losses of the S corporation may be passed through to the shareholders’ returns.

During the 1991 taxable year, petitioners David Gitlitz and Philip Winn each owned a 50% interest in an S corporation. During that year, the corporation discharged over $2,000,000 of debt, but remained insolvent. The shareholders had exhausted their basis in the corporate stock by deductions taken in prior years. Accordingly, unless their basis in the corporate stock increased, they could not take deductions for the S corporation’s suspended losses (i.e., past S Corporation losses that had not been passed through because the shareholders had no remaining basis) or for its current-year losses. In order to gain a benefit from those losses, Gitlitz and Winn claimed on their tax returns that the discharge of debt by the insolvent S corporation qualified as an "item[] of income" under 26 U.S.C. § 1366(a)(1)(A), and increased their basis in their stock. See 26 U.S.C. § 1367(a)(1)(A).

After the Commissioner of Internal Revenue disallowed the deductions, Gitlitz and Winn challenged the disallowance in the United States Tax Court. The Tax Court initially ruled for the taxpayers, but reversed itself on reconsideration.

The Tenth Circuit affirmed. 182 F.3d 1143 (1999). Although it considered the matter "a close question," id. at 1149, the court of appeals declined to construe the Code to produce an increase in shareholders’ basis in the S corporation without resulting in any taxable income. In the absence of a clear declaration of congressional intent, the court declined to interpret the Code to produce what, in its view, would be a windfall to the taxpayers. See id. at 1147-1148.

The United States acquiesced in the taxpayers’ petition for a writ of certiorari, noting that the Third Circuit has entered into an acknowledged conflict with the Tenth Circuit’s decision in this case. See United States v. Farley, 202 F.3d 198, 205 n.4, 208-209 (3d Cir. 2000).

This case is of potential importance to all shareholders in S corporations.

This Mayer, Brown, Rowe & Maw Supreme Court Docket Report provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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