T.C. Memo. 2013-39
UNITED STATES TAX COURT
R BALL FOR R BALL III BY APPT, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 17593-11, 17594-11, Filed February 6, 2013. 17595-11, 17596-11, 17597-11, 17598-11, 17599-11, 17600-11, 17601-11.
Dennis Lawrence Stein, for petitioners.
Paul L. Darcy, for respondent.
1 Cases of the following petitioners are consolidated herewith: R Ball Children Trust 9/9/1969, docket No. 17594-11; Ethel Ball For R Ball III Apt 2/9/1967, docket No. 17595-11; Ethel Ball For A L Ball As Appt, docket No. 17596-11; R Ball Jr. Children Trust 1/29/1970, docket No. 17597-11; R Ball Jr F/B/O R Ball III 12/22/1976, docket No. 17598-11; R Ball For A L Ball By Appt, docket No. 17599-11; R Ball Children Trust 1/24/1973, docket No. 17600-11; and Russell Ball Jr Sec First 9/9/1967, docket No. 17601-11. -2-
[*2] MEMORANDUM OPINION
KERRIGAN, Judge: In these consolidated cases respondent determined the
following deficiencies and revised deficiencies2 with respect to petitioners’ Federal
income tax for tax year 2003:
Petitioner Deficiency Revised deficiency R Ball for R Ball III by Appt $5,919,407 $5,924,028 R Ball Children Trust 9/9/1969 5,374,764 5,378,663 Ethel Ball For R Ball III Apt 2/9/1967 4,438,105 4,441,316 Ethel Ball For A L Ball As Appt 4,439,848 4,441,316 R Ball Jr. Children Trust 1/29/1970 3,402,808 3,251,740 R Ball Jr F/B/O R Ball III 12/22/1976 545,775 337,445 R Ball For A L Ball By Appt 5,919,744 5,924,028
R Ball For Children 1,839,276 1,840,593 Trust 1/24/1973
2 The parties stipulated that each statutory notice contained one or more errors that resulted in an incorrect deficiency computation. If respondent prevails, petitioners will be liable for the revised statutory deficiencies. -3-
[*3] Russell Ball Jr Sec 2,207,131 2,208,729 First 9/9/1967
Unless otherwise indicated, all section references are to the Internal Revenue
Code (Code) in effect for the year in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure. We round all monetary amounts to the
nearest dollar and all percentage points to the second decimal place.
After concessions the issue remaining for our consideration is whether
petitioners properly increased their adjusted bases in shares of an S corporation
pursuant to sections 1366 and 1367 after the S corporation made a qualified
subchapter S subsidiary election (Qsub election) pursuant to section 1361, which
resulted in a deemed section 332 liquidation of a subsidiary.
Background
These consolidated cases were submitted fully stipulated under Rule 122.
The stipulated facts are incorporated in our findings by this reference. Petitioners,
electing small business trusts,3 had legal residence in Pennsylvania when they filed
3 Sec. 1361(e)(1)(A) defines electing small business trusts as any trust if (i) such trust does not have as a beneficiary any person other than (I) an individual, (II) an estate, (III) an organization described in para. (2), (3), (4), or (5) of sec. 170(c), or (IV) an organization described in sec. 170(c)(1) which holds a contingent interest (continued...) -4-
[*4] their petitions. In June 1997 petitioners and a 10th shareholder not party to this
consolidated action (10th shareholder) directly owned 100% of American Insurance
Service, Inc. (AIS). Petitioners and the 10th shareholder had an aggregate adjusted
basis of $5,612,555 in their shares of AIS.
In 1999 petitioners and the 10th shareholder organized Wind River
Investment Corp. (WRIC). Petitioners and the 10th shareholder contributed 100%
of their shares of AIS to WRIC in exchange for 100% of the stock in WRIC,
resulting in a tax-deferred incorporation under section 351. After the completed
transaction petitioners and the 10th shareholder directly owned 100% of WRIC, and
WRIC directly owned 100% of AIS. During the 2003 taxable year ended
September 4, 2003, petitioners owned 99.01% of WRIC. Individually, petitioners
owned the following percentages of WRIC:
3 (...continued) in such trust and is not a potential current beneficiary; (ii) no interest in such trust was acquired by purchase; and (iii) an election under sec. 1361(e) applies to such trust. Electing small business trusts are subject to further restrictions. See sec. 1361(e)(1)(B), (2). The parties do not dispute that petitioners are valid electing small business trusts. -5-
[*5] WRIC Petitioner percent ownership R Ball for R Ball III by Appt 17.38 R Ball Children Trust 9/9/1969 15.78 Ethel Ball For R Ball III Apt 2/9/1967 13.03 Ethel Ball For A L Ball As Appt 13.03 R Ball Jr. Children Trust 1/29/1970 9.54 R Ball Jr F/B/O R Ball III 12/22/1976 0.99 R Ball For A L Ball By Appt 17.38 R Ball Children Trust 1/24/1973 5.40 Russell Ball Jr Sec First 9/9/1967 6.48
Effective June 4, 1999, WRIC elected to be taxed as an S corporation.4 From
June 4, 1999, through September 4, 2003, WRIC continued to own 100% of AIS.
During WRIC’s taxable year ended September 4, 2003, WRIC made a Qsub
4 Small business electing trusts like petitioners are permitted to hold shares of an S corporation. Sec. 1361(c)(2)(A)(v); see sec. 1361(b)(1)(B). The parties do not dispute that petitioners were valid S corporation shareholders. -6-
[*6] election pursuant to section 1361(b)(3)(B) with respect to AIS, effective
February 28, 2003. After the election WRIC treated AIS as a qualified subchapter
S subsidiary (Qsub). Petitioners claimed that the Qsub election produced an item of
income pursuant to section 1366(a)(1)(A) and adjusted their bases accordingly
pursuant to section 1367(a)(1)(A). Petitioners had the following adjusted bases in
their WRIC stock before the Qsub election, and petitioners claimed the following
adjusted bases in their WRIC stock after the Qsub election: -7-
[*7] Claimed adjusted Adjusted basis basis after Qsub Petitioner before Qsub election election R Ball for R Ball III by Appt $2,649,773 $42,143,293 R Ball Children Trust 9/9/1969 2,405,834 38,263,589 Ethel Ball For R Ball III Apt 2/9/1967 1,986,567 31,595,345 Ethel Ball For A L Ball As Appt 1,986,567 31,595,345 R Ball Jr. Children Trust 1/29/1970 1,454,478 23,132,739 R Ball Jr F/B/O R Ball III 12/22/1976 150,936 2,400,567 R Ball For A L Ball By Appt 2,649,773 42,143,293 R Ball Children Trust 1/24/1973 823,289 13,094,003 Russell Ball Jr Sec First 9/9/1967 987,947 15,712,804
On September 5, 2003, petitioners and the 10th shareholder sold all of their
WRIC shares to an unaffiliated third party. Collectively, petitioners and the 10th
shareholder received $230,111,857. Less transaction costs, petitioners received
individually the following amounts from the sale of WRIC: -8-
[*8] Petitioner Amount received R Ball for R Ball III by Appt $39,993,441 R Ball Children Trust 9/9/1969 36,311,651 Ethel Ball For R Ball III Apt 2/9/1967 29,983,575 Ethel Ball For A L Ball As Appt 29,983,575 R Ball Jr. Children Trust 1/29/1970 21,952,671 R Ball Jr F/B/O R Ball III 12/22/1976 2,278,107 R Ball For A L Ball By Appt 39,993,441 R Ball Children Trust 1/24/1973 12,426,040 Russell Ball Jr Sec First 9/9/1967 14,911,248
Because of this sale, WRIC ceased to be taxed as an S corporation as of
September 4, 2003, and became taxable as a C corporation.
Petitioners timely filed their Forms 1041, U.S. Income Tax Return for Estates
and Trusts, for tax year 2003. In their income tax returns petitioners claimed the
following losses from their sale of WRIC stock: -9-
[*9] Petitioner Claimed loss R Ball for R Ball III by Appt $2,149,852 R Ball Children Trust 9/9/1969 1,951,938 Ethel Ball For R Ball III Apt 2/9/1967 1,611,770 Ethel Ball For A L Ball As Appt 1,611,770 R Ball Jr. Children Trust 1/29/1970 1,180,068 R Ball Jr F/B/O R Ball III 12/22/1976 122,460 R Ball For A L Ball By Appt 2,149,852 R Ball Children Trust 1/24/1973 667,963 Russell Ball Jr Sec First 9/9/1967 801,556
Petitioners calculated these claimed losses using the adjusted bases in the WRIC
stock that they increased after the Qsub election.
On May 18 and 19, 2011, respondent sent notices of deficiency regarding
tax year 2003 to petitioners. The notices of deficiency disallowed petitioners’
claimed bases adjustments in their WRIC shares following the Qsub election.
Because of a computational error, the notices of deficiency failed to fully disallow - 10 -
[*10] petitioners’ claimed bases adjustments. For seven petitioners,5 the notices of
deficiency understated the capital gains adjustments. Respondent asserts increased
deficiencies for those seven petitioners. For two petitioners,6 the notices of
deficiency provided incorrect alternative minimum tax calculations. Respondent
asserts decreased deficiencies for those two petitioners.
In the notices of deficiency respondent also determined that petitioners were
liable for accuracy-related penalties under section 6662(d) for tax year 2003.
Respondent has waived the accuracy-related penalties for all petitioners.
Discussion
An S corporation is defined as a small business corporation for which an
election under section 1362(a) is in effect for the year. Sec. 1361(a)(1).
Generally, an S corporation is not subject to Federal income tax at the entity level.
Sec. 1363(a); see also Taproot Admin. Servs., Inc. v. Commissioner, 133 T.C. 202,
204 (2009), aff’d, 679 F.3d 1109 (9th Cir. 2012). Like a partnership, an S
corporation is a conduit, through which income flows to its shareholders, resulting
5 Petitioners 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 For A L Ball By Appt; R Ball Children Trust 1/24/1973; and Russell Ball Jr Sec First 9/9/1967. 6 Petitioners R Ball Jr. Children Trust 1/29/1970 and R Ball Jr F/B/O R Ball III 12/22/1976. - 11 -
[*11] in only one level of taxation. See Taproot Admin. Servs., Inc. v.
Commissioner, 133 T.C. at 204.
Generally, a shareholder in an S corporation begins with a tax basis in his or
her stock equal to the amount of the contributions he or she makes to the capital of
the S corporation; the shareholder’s capital contributions are not included in the
income of the S corporation. Secs. 118, 1016(a)(1), 1371(a); Commissioner v.
Fink, 483 U.S. 89, 94 (1987); Edwards v. Cuba R.R. Co., 268 U.S. 628, 633
(1925); sec. 1.118-1, Income Tax Regs.
Pursuant to section 1367(a)(1)(A), a shareholder’s tax basis in the stock of an
S corporation is adjusted to reflect the shareholder’s pro rata share of income,
losses, deductions, and credits of the S corporation, as calculated under section
1366(a)(1). More specifically, under section 1367(a)(1)(A), a shareholder’s tax
basis in the stock of an S corporation is increased by the shareholder’s share of the
S corporation’s income items (including tax-exempt income), among other things.
Under section 1367(a)(2), a shareholder’s tax basis in the stock of an S corporation
is decreased (but not below zero) by the shareholder’s pro rata share of losses and
deductions, among other things, as specified in section 1367(a)(2). - 12 -
[*12] Pursuant to section 1361(b)(3)(B), a parent S corporation may elect to treat a
wholly owned domestic corporation7 as a Qsub. Once the parent S corporation has
made the Qsub election, the Qsub is no longer treated as a separate corporation;
rather, all assets, liabilities, items of income, deductions, and credits of the Qsub are
treated as the assets, liabilities, items of income, deductions, and credits of the
parent S corporation. Sec. 1361(b)(3)(A). The Qsub is deemed to have liquidated
into the parent S corporation. Sec. 1.1361-4(a)(2)(i), Income Tax Regs.
I. Petitioners’ Arguments and Analysis
Petitioners contend that they properly adjusted their bases in the WRIC
shares after the Qsub election pursuant to section 1367(a)(1)(A) and that they
properly claimed losses from the sale of WRIC on their 2003 income tax returns.
Specifically, petitioners contend that the Qsub election resulted in an item of income
pursuant to section 1366(a)(1)(A).
Notably, petitioners have not cited and we have not found any cases in which
a Qsub election has been held to create an item of income for the parent S
corporation.
7 The wholly owned domestic corporation must also meet the specifications set forth in sec. 1361(b)(2). - 13 -
[*13] A. Section 61(a)(3) and Nonrecognition
Petitioners contend that the Qsub election resulted in a gain derived from
dealings in property and, therefore, created an item of income under section 61(a).
Section 61(a) defines gross income as “all income from whatever source derived”,
which includes gains derived from dealings in property. Sec. 61(a)(3). In their
opening brief, petitioners claim that “the exchange of the S corporation’s shares of
stock in the subsidiary for the subsidiary’s assets * * * [is] plainly ‘gains derived
from dealings in property.’”
Petitioners overlook the role of realization and recognition in determining
what constitutes gain from the sale or disposition of property. Any gain from the
sale or disposition of property must first be realized. See Cottage Sav. Ass’n v.
Commissioner, 499 U.S. 554, 559 (1991) (“Rather than assessing tax liability on the
basis of annual fluctuations in the value of a taxpayer’s property, the Internal
Revenue Code defers the tax consequences of a gain or loss in property value until
the taxpayer ‘realizes’ the gain or loss.”).
Once a realization event has occurred, the amount of realized gain must be
calculated pursuant to section 1001. Section 1001 provides, in pertinent part, the
following: - 14 -
[*14] SEC. 1001. DETERMINATION OF AMOUNT OF AND RECOGNITION OF GAIN OR LOSS.
(a) Computation of Gain or Loss.--The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.
(b) Amount Realized.--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. ***
(c) Recognition of Gain or Loss.--Except as otherwise provided in this subtitle, the entire amount of the gain or loss, determined under this section, on the sale or exchange of property shall be recognized.
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. Sec. 1001(c). Unrecognized gains “are not included in or deducted from
gross income at the time the [nonrecognition] transaction occurs.” Sec. 1.61-6(b),
Income Tax Regs.
Recognition is a cardinal and longstanding principle of tax law. There are
many Code sections that provide for nonrecognition treatment, including sections
351(a), 354, 361(a), 371(a)(1), 371(b)(1), 721, 1031, 1035, and 1036, among
others. Sec. 1.1002-1(c), Income Tax Regs. These sections describe “certain - 15 -
[*15] specific exchanges of property in which at the time of the exchange particular
differences exist between the property parted with and the property acquired, but
such differences are more formal than substantial.” Id. Because these differences
are more formal than substantial, the Code provides that “such differences shall not
be deemed controlling, and that gain or loss shall not be recognized at the time of
the exchange.” Id. The underlying assumption for nonrecognition treatment is that
“the new property is substantially a continuation of the old investment still
unliquidated”. Id.
Notably, “[t]hese [nonrecognition] provisions do not forgive taxation of the
realized gain; they merely defer its recognition and inclusion in gross income until
the property is disposed of in a taxable transaction.” Boris I. Bittker et al., Federal
Income Taxation of Individuals, para. 30.01[1], at 30-3 (3d ed. 2002).
Nonrecognition transactions generally preserve unrecognized gain by assigning a
“substituted” or “carryover” basis to the acquired property. Id. Nonrecognition
transactions “can be viewed as refinements of the pervasive concept of realization,
which postpones the taxation of appreciation in the value of property (and the
deduction of a decline in value) until the taxpayer sells or otherwise disposes of the
property.” Id. - 16 -
[*16] In sum, nonrecognition provisions prevent realized gain from being included
in a taxpayer’s gross income. When a gain derived from dealings in property is
realized but not recognized, then the realized gain will not be included in gross
income pursuant to section 61(a)(3) and section 1.61-6(b), Income Tax Regs.
B. Sections 331 and 332
The making of a Qsub election is considered an adoption of a plan of
liquidation immediately before the deemed liquidation, which qualifies the deemed
liquidation for tax-free treatment under sections 332 and 337. Sec. 1.1361-
4(a)(2)(iii), Income Tax Regs.; see sec. 1.1361-4(a)(2)(iv), Income Tax Regs.; cf.
Dover Corp. & Subs. v. Commissioner, 122 T.C. 324, 333 (2004) (like the making
of a Qsub election, “[t]he making of a disregarded entity election ‘is considered to
be the adoption of a plan of liquidation immediately before the deemed liquidation’,
thereby qualifying the parties to the deemed liquidation for tax-free treatment under
sections 332 and 337. Sec. 301.7701-3(g)(2)(ii), Proced. & Admin. Regs.”). A
Qsub election thus results in a section 332 liquidation.
Section 332(a) specifies that no gain or loss shall be recognized by a parent
corporation on the receipt of property distributed in complete liquidation of a
subsidiary corporation. Section 332(a) is clear and unambiguous. Under a plain - 17 -
[*17] reading of the statute the phrase “no gain or loss shall be recognized” means
that the parent ignores any gain or loss realized in a section 332 liquidation when
property is distributed from the subsidiary. This reading is also consistent with the
congressional intent behind section 332 and other nonrecognition transactions: A
taxpayer is not taxed on realized gain at the time of a nonrecognition transaction.
See S. Rept. No. 83-1622 at 48 (1954), 1954 U.S.C.C.A.N. 4621, 4678-4679
(contrasting a general liquidation, in which the taxpayer receiving assets is taxed
upon receipt, with a section 332 liquidation, in which the taxpayer receiving assets
is not taxed because no gain or loss is recognized); see also S. Rept. No. 67-275
(1921), 1939-1 C.B. (Part 2) 181, 188 (when a taxpayer receives no cash profit in a
transaction, the taxpayer should not be taxed on the transaction at that time).
Because a Qsub election is a deemed section 332 liquidation, the parent S
corporation shall not recognize gain or loss from the Qsub election.
Petitioners contend that any gain realized from a Qsub election constitutes
income under section 331, but then section 332(a) exempts the realized gain from
income with nonrecognition. Section 331(a) provides: “Amounts 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.” Section 331 does not provide for the
nonrecognition of any gain realized in a section 331 liquidation. - 18 -
[*18] Petitioners’ interpretation of sections 331 and 332 is incorrect. Sections 331
and 332 govern two different types of liquidations. Section 332, on the one hand,
governs the liquidation of a subsidiary into a parent corporation when the parent
corporation owns 80% or more of the vote and value of the subsidiary. Secs.
332(b)(1), 1504(a)(2). If a section 332 liquidation occurs, then the subsidiary does
not recognize any gain or loss on the distribution of property to an 80% distributee,
sec. 337(a); the parent corporation takes a carryover basis in the subsidiary’s assets,
sec. 334(b)(1); and the parent corporation succeeds to the subsidiary’s tax
attributes, sec. 381(a)(2). Section 331, on the other hand, governs all other
liquidations, namely when the parent corporation owns less than 80% of the vote
and value of the subsidiary. See sec. 331(a). Sections 334(b)(1), 337(a), and
381(a)(2) are not triggered by a section 331 liquidation.
Either a liquidation meets the section 332(b) specifications and falls within
section 332, or it does not meet the section 332(b) specifications and falls within
section 331. A liquidation cannot be governed by both.
Petitioners’ contention that section 331 governs all liquidations but section
332(a) exempts certain liquidations from creating income is erroneous. When
WRIC made the Qsub election, WRIC engaged in a deemed liquidation of AIS - 19 -
[*19] pursuant to section 332 because WRIC held more than 80% of the vote and
value of AIS. WRIC did not first engage in a section 331 liquidation.
Accordingly, no gain was recognized when WRIC made the Qsub election,
and the unrecognized gain did not create an item of income pursuant to section
61(a)(3).
C. Item of Income Under Section 1366(a)(1)(A)
Petitioners contend that the realized but unrecognized gain from the Qsub
election created tax-exempt income--and therefore, an item of income--pursuant to
section 1366(a)(1)(A). Section 1366(a) provides the following, in pertinent part:
SEC. 1366(a). Determination of Shareholder’s Tax Liability.--
(1) In general.--In determining the tax under this chapter of a shareholder [of an S corporation] for the shareholder’s taxable year in which the taxable year of the S corporation ends * * * 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, * * *
Section 1.1366-1(a)(2)(viii), Income Tax Regs., defines tax-exempt income as
“income that is permanently excludible from gross income in all circumstances in
which the applicable provision of the Internal Revenue Code applies.” - 20 -
[*20] As discussed above unrecognized gain is not an item of income or tax-exempt
income under section 1366(a)(1)(A) because unrecognized gain does not rise to the
level of income. Nonrecognition treatment prevents realized gain from becoming
income at the time of the nonrecognition transaction. Therefore we hold that
unrecognized gain does not create an item of income under section 1366(a)(1)(A).
This holding is consistent with our reasoning in McLaulin v. Commissioner,
115 T.C. 255 (2000), aff’d, 276 F.3d 1269 (11th Cir. 2001). The taxpayers in
McLaulin owned 100% of Ridge Pallets, Inc. (Ridge). Ridge coowned Sunbelt
Forest Products, Inc. (Sunbelt), with an individual until Sunbelt redeemed all of the
individual’s shares. Ridge then owned 100% of Sunbelt. Soon after the redemption
Ridge made a pro rata distribution of its Sunbelt stock to the taxpayers in McLaulin.
The sole issue for decision was whether Ridge recognized gain on account of that
distribution. Id. at 259. We reasoned that if Ridge, an S corporation, did not
recognize gain from the distribution, then section 1366(a) would not require the
taxpayers to take their pro rata shares of gain into account. Id. at 259-260. Our
reasoning in McLaulin is the same as ours in these consolidated cases:
Unrecognized gain does not create an item of income under section 1366(a)(1)(A). - 21 -
[*21] Petitioners claim that the Qsub election created realized gain that began as an
item of income under section 61(a)(3) but was exempted from gross income
pursuant to the nonrecognition provision in section 332(a). Petitioners argue that
this result is consistent with United States v. Farley, 202 F.3d 198 (3d Cir. 2000),
and Gitlitz v. Commissioner, 531 U.S. 206 (2001), which petitioners claim are
“squarely on point” and therefore control in these consolidated cases. Petitioners’
reliance on Farley and Gitlitz, however, is misguided.
The facts in Farley and Gitlitz were similar. Both cases involved insolvent S
corporations that received a discharge of indebtedness. Pursuant to section
61(a)(12), gross income includes income from discharge of indebtedness. Section
108(a)(1)(B) excludes discharge of indebtedness income from the gross income of
an insolvent taxpayer. Because of this exclusion, these insolvent S corporations
determined that the discharge of indebtedness created tax-exempt income. They
passed the discharge of indebtedness income to their shareholders pursuant to
section 1366(a)(1)(A), and the shareholders adjusted their bases in the S
corporations accordingly pursuant to section 1367(a)(1)(A).
The Supreme Court in Gitlitz and the Court of Appeals for the Third Circuit
in Farley both held that the excluded discharge of indebtedness income was tax-
exempt income. They reasoned that the discharge of indebtedness began as - 22 -
[*22] income under section 61(a)(12) but was excluded from the S corporations’
gross income pursuant to section 108(a)(1)(B) because these S corporations were
insolvent. Gitlitz v. Commissioner, 531 U.S. at 212-213; Farley, 202 F.3d at 206.
In particular the Supreme Court reasoned that excluded discharge of indebtedness
does not cease to be an item of income when the S corporation is insolvent; rather,
the excluded discharge of indebtedness simply “ceases to be included in gross
income.” Gitlitz v. Commissioner, 531 U.S. at 213.
Although Farley and Gitlitz both addressed the meaning of item of income
and tax-exempt income as used in section 1366(a)(1)(A), neither case is squarely on
point. Gitlitz and Farley addressed payments that section 61(a) includes explicitly
in gross income and that section 108(a)(1)(B) excludes from gross income. See
Nathel v. Commissioner, 615 F.3d 83, 91 (2d Cir. 2010), aff’g 131 T.C. 262 (2008).
In these consolidated cases the realized gain from the Qsub election was never
included explicitly in gross income and was never excluded from gross income. As
discussed above, nonrecognition is not an exclusion provision. Nonrecognition
merely prevents realized gain from rising to the level of income. Gitlitz and Farley
did not create new items of income; they held only that the nature of discharge of
indebtedness as income was not changed by the exclusion of section 108(a). See id. - 23 -
[*23] Gitlitz and Farley are also not squarely on point because unrecognized gain
is conceptually different from discharge of indebtedness income. When a taxpayer
receives a discharge of indebtedness, the taxpayer’s economic net worth increases.
The discharge of indebtedness income thus changes the taxpayer’s situation
substantially. When a taxpayer engages in a nonrecognition transaction, the
taxpayer’s economic net worth stays the same. The nonrecognition transaction
changes the taxpayer’s situation only formally. Additionally, unlike unrecognized
gain, excluded discharge of indebtedness income may affect the tax liability of S
corporation shareholders. Section 108(b)(1) specifies that the amount of discharge
of indebtedness income excluded from gross income is applied to reduce the tax
attributes of the taxpayer. Unrecognized gain, however, does not reduce the tax
attributes of the taxpayer. Therefore unrecognized gain does not affect the tax
liability of S corporation shareholders.
Because neither Farley nor Gitlitz is squarely on point, we are not bound to
follow them. Even if Gitlitz and Farley were squarely on point, Congress reversed
them prospectively in 2002 when it amended section 108(d)(7)(A). See Job
Creation and Worker Assistance Act of 2002, Pub. L. No. 107-147, sec. 402, 116
Stat. at 40. Pursuant to section 108(d)(7)(A), any discharge of indebtedness
income excluded from gross income by section 108(a) is no longer an item of - 24 -
[*24] income under section 1366(a). Congress believed that “it was inappropriate
for a shareholder of an insolvent or bankrupt S corporation to take into account
excluded income from the discharge of the S corporation’s indebtedness and thereby
increase the shareholder’s adjusted basis in the stock.” H.R. Rept. No. 107-251, at
52 (2002), 2002-3 C.B. 44, 95. Moreover, Congress believed “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.” Id. Thus, Congress not only reversed Gitlitz and Farley
prospectively as they pertained to excluded discharge of indebtedness income;
Congress also proscribed any application of Gitlitz and Farley that would result in
an inappropriate reduction of tax liability. Petitioners’ application of Gitlitz and
Farley to these consolidated cases would result in such an inappropriate reduction.
This is not the first time that we have declined to extend Gitlitz. In Nathel
we declined to interpret Gitlitz as overriding the cardinal and longstanding
principle of tax law that capital contributions are not treated as income. Nathel v.
Commissioner, 131 T.C. at 270. The taxpayers in Nathel argued that “because
section 118 excludes capital contributions from the gross income of an S - 25 -
[*25] corporation in all circumstances, capital contributions to an S corporation are
‘permanently excludible’ from the gross income of the S corporation and are thus
tax-exempt income’ under section 1.1366-1(a)(2)(viii), Income Tax Regs.”. Id. at
269. The taxpayers relied heavily on Gitlitz. They claimed that Gitlitz should apply
to other items of income specifically excluded from gross income under sections 101
through 136. Id.
We rejected the taxpayers’ reasoning and distinguished Nathel from Gitlitz,
noting that contributions to the capital of an S corporation are not listed in section
61 as items of gross income. Id. at 270-271. We held that capital contributions are
not items of income under section 1366(a)(1)(A). Id. at 270. The Court of Appeals
for the Second Circuit affirmed our decision, concluding that the taxpayers could not
“rely on Gitlitz alone to overcome the long-standing treatment of capital
contributions as distinct from income.” Nathel v. Commissioner, 615 F.3d at 91.
We likewise decline to interpret Gitlitz and Farley as overriding a cardinal
and longstanding principle of tax law, namely that unrecognized gain is not an item
of income. We thus decline to extend the holdings in Gitlitz and Farley to
nonrecognition provisions. - 26 -
[*26] Accordingly, unrecognized gain from a Qsub election does not constitute an
item of income or tax-exempt income under section 1366(a)(1)(A). We note that
any other conclusion would lead to absurd results. Our reasoning preserves single-
level taxation of S corporations by preventing S corporation shareholders from
creating noneconomic basis adjustments from nonrecognition transactions. Our
reasoning also preserves double-level taxation for C corporations. Before 1986 the
General Utilities doctrine permitted a C corporation to escape corporate-level tax on
certain distributions of appreciated property to its shareholders. See Gen. Utils. &
Operating Co. v. Helvering, 296 U.S. 200, 206 (1935); see also H.R. Conf. Rept.
No. 99-841 (Vol. II), at II-198 (1986), 1986-3 C.B. (Vol. 4) 1, 198. Congress
repealed the General Utilities doctrine in the Tax Reform Act of 1986, thus ensuring
a corporate-level tax on the distribution of appreciated property. H.R. Conf. Rept.
No. 99-841, supra at II-199, 1986-3 C.B. (Vol. 4) at 199. Congress noted that the
General Utilities doctrine undermined the corporate income tax. H.R. Rept. No. 99-
426, at 282 (1985), 1986-3 C.B. (Vol. 2) 1, 274. Congress further cemented the
repeal of the General Utilities doctrine by enacting section 1374 in the Tax Reform
Act of 1986, Pub L. No. 99-514, sec. 632(a), 100 Stat. at 2275. Section 1374
prevents a C corporation from avoiding corporate-level taxation on the sale of
appreciated assets by converting to an S corporation. - 27 -
[*27] When the S corporation sells assets that it held before the conversion, the S
corporation is taxed at the entity level on the net recognized gain from the sale. Sec.
1374(a). The shareholders are also taxed on the recognized gain under section
1366(a)(1)(A).
Petitioners’ position would create noneconomic basis adjustments which
would reduce or eliminate tax at the shareholder level. This would not only convert
the single-level taxation of S corporations into a zero-level taxation of S
corporations; it would also undermine the double-level taxation of C corporations,
as preserved in section 1374, and circumvent the repeal of the General Utilities
doctrine. Additionally, these absurd results would open the door to a myriad of
abusive transactions. Using these noneconomic basis adjustments, petitioners
attempted to turn what should have been a $202 million aggregate taxable gain into
a $12 million aggregate loss. Had WRIC sold any of AIS’ appreciated assets at a
gain after the Qsub election, petitioners would have increased their adjusted bases in
WRIC a second time, thus reducing or eliminating more tax.
D. Section 1367(a)(1)(A) Basis Adjustment
Petitioners contend that they properly increased their adjusted bases in
WRIC pursuant to section 1367(a)(1)(A) because the Qsub election created an - 28 -
[*28] item of income under section 1366(a)(1)(A). Section 1367(a) provides, in
pertinent part, the following:
SEC. 1367(a). General Rule.--
(1) Increase in basis.-- 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), * * *
As discussed above, the Qsub election did not result in an item of income described
in section 1366(a)(1)(A). Accordingly, petitioners improperly increased their
adjusted bases in the WRIC stock following the Qsub election.
II. Conclusion
We hold that the unrecognized gain resulting from the Qsub election did not
create an item of income or tax-exempt income pursuant to section 1366(a)(1)(A).
We further hold that petitioners improperly adjusted their bases in their WRIC stock
following the Qsub election pursuant to section 1367(a)(1)(A). In reaching
our decision we have considered all arguments made by the parties. To the extent
not mentioned or addressed they are irrelevant or without merit. - 29 -
[*29] To reflect the foregoing,
An appropriate decision will be
entered.