Gitlitz v. Commissioner, (531 U.S. 206 (2001), A U.S. Supreme Court decision regarding the tax treatment of discharge of indebtedness income for insolvent subchapter S corporations.
Summary
David Gitlitz and Philip Winn each owned a fifty percent stake in P.D.W.&A., Inc. (PDWA), a Subchapter S corporation and partner in Parker Properties, a real estate venture firm. In 1991, Parker Properties realized a discharge of indebtedness (DOI). PDWA realized a pro rata share of the discharge in the amount of $2,021,296. At the time of the discharge, PDWA was insolvent in the amount of $2,181,748, allowing the discharge to be excluded from gross income under section 108(a)(1)(B). Typically, such losses are passed through to shareholders as deductions on their personal returns, but may not exceed the shareholder’s basis.[1] Corporate losses in excess of shareholder basis are treated as suspended losses until the basis becomes large enough to permit the deduction.
However, citing specific terminology from § 1366(a)(1)(A), Gitlitz and Winn each maintained that the discharge was an “item of income (including tax exempt income),” and therefore could be used to raise their respective stock bases by $1,010,648 each. This increase in basis allowed each shareholder to then take ordinary loss deductions of the same amount from unrelated suspended losses on their personal returns. The IRS disallowed the deductions arguing that the discharge was not an “item of income” and thereby could not be used to increase shareholder bases.[2] The shareholders brought their case to the Tax Court.
Initially, the Tax Court ruled in favor of the shareholders; that the DOI was an ‘item of income’ that could be used to increase shareholder stock basis. However, the court later accepted the Commissioner’s motion for reconsideration following a review of their decision in Nelson v. Commissioner[3]. In Nelson, it was determined that the DOI and any accompanying tax attributes occurred at the corporate level and did not pass through to shareholders. Shareholders appealed to the Tenth Circuit.
The Tenth Circuit affirmed, holding that the discharge could be passed through to shareholders, but must first reduce any tax attributes at the corporate level. In Gitlitz, the NOL exceeded the DOI, and therefore none remained to passed through to shareholders. This prevened shareholders from deducting their current and suspended losses.[4] The court reasoned that reducing any tax attributes at the corporate level first would prevent a tax ‘windfall’ and special treatment only available to subchapter S shareholders. The sixth and seventh circuits agreed with the ruling; the third circuit ruled in favor of the shareholders. The case was then referred to, and accepted by the U.S. Supreme Court.
Key Issues
There were two key issues that needed to be decided by the Supreme Court. First, the court needed to decide whether the DOI of an insolvent subchapter S corporation was an ‘item of income’ under § 1366(a)(1)(A) and § 1367(a). Second, the court needed to decide on the timing issue of whether any tax attributes were realized at the corporate level or shareholder level. In brief, the shareholders argued the plain language of the statutes. The IRS essentially relied on the substance over form doctrine, an 80 year old precedent of characterizing transactions based on their underlying substance for federal tax purposes.[5] The Commissioner argued that it was not the intent of Congress to give solvent taxpayers this advantageous windfall treatment.
Supreme Court Decision
The United States Supreme Court ruled 8-1 in favor of the shareholders. In an opinion delivered by Justice Thomas, the court stated that DOI was an item of income as IRC 61(a)(12) specifically states that DOI is generally included in gross income. The opinion went on to proclaim that section 108 “merely permits insolvent S corporations to exclude DOI from gross income” and that 108(e)(1) specifically “presumes that DOI remains an ‘item an income.’” Therefore, because the DOI of an insolvent subchapter S corporation is an ‘item of income’, it is then subject to the pass through provisions as an ‘item of income’ under section 61. Under 108(b)(4)(A), the court determined that any tax attributes reductions were to be imposed at the corporate level, because in order for shareholders to determine shareholder taxable income, all items of income must first be passed through to shareholders.[6]
Justice Breyer issued a dissenting opinion, pointing out that if these statutes were to be taken literally in lieu of substance over form, ‘specific rules for S corporations’ under § 108(d)(7)(A) would specifically limit DOI exclusions to be taken at the corporate level under § 108(a) along with any tax attribute reductions under § 108(b).[7] Under the dissenting opinion, taking the literal translation of the statute, a DOI would not be available to increase shareholder basis of an insolvent subchapter S corporation, and thereby would prevent shareholders from taking otherwise unavailable personal deductions of suspended losses. The dissenting opinion also gives greater consideration to the congressional intent of section 108, pointing to a House Committee report that stated, “[T]he exclusion and basis reduction are both made at the S corporation level (sec. 108(d)(7)). The shareholders’ basis in their stock is not adjusted by the amount of debt discharge income that is excluded at the corporate level.”[8]
Discussion of Significance
The court’s decision is significant because the court used a literal approach and applied the ‘plain meaning’ of the statute to reach a decision. Of course, there are problems with both sides of this argument. Using a strict literal approach puts a burden on Congress to write legislation that would presumably anticipate every possible deviation from the codes, which is unrealistic. On the other hand, using substance over form may put an undue burden on the courts to create rules for gaps in the code left by Congress.
Reaching a reasonable balance between these two arguments is difficult, but I believe the court should interpret the congressional intent of the code. This case contrasts 80 years of legislative precedent where the substance over form doctrine has been used to interpret IRC and congressional intent rather than the plain language of the statute.[9] As Justice Breyer pointed out in the House Committee's communiqué, the pass through provisions were not intended by congress to provide a windfall tax benefit or special treatment to solvent shareholders.
In addition, oral arguments in the case revealed that such pass through provisions would have been disallowed prior to changes made to IRC section 108 in 1984 (effective 1998). The changes addressed how basis reductions from discharge of indebtedness were applied to shareholders under § 108(b)(2)(e), specifically, that the basis adjustments occur “at the beginning of the taxable year following the year in which the discharge occurs."[10] Prior to this change, adjustments to basis were taken immediately after the discharge occurred. This reader contends that the terminology has had unintended consequences in allowing solvent shareholders to realize ordinary losses without first taking adjustments to their subchapter S bases.
Either way, Gitlitz v. Commissioner is significant because it signals the potential of a new direction for tax jurisprudence.
[1] 26 U.S.C. § 1366(d)(1)(A)
[2] David Gitlitz v. Comm., 182 F.3d 1143 (10th Cir. 1999)
[4] David Gitlitz v. Comm., 182 F.3d 1143 (10th Cir. 1999)
[6] Gitlitz v. Commissioner, 531 U.S. 206 (2001) (Opinion Announcement)
[7] Gitlitz v. Commissioner, 531 U.S. 206 (2001) (Breyer, C.J., dissenting)
[8] H.R.Rep. No. 103–111, pp. 624–625 (1993)
Paulsen v. Commissioner , 469 U.S. 131 (1985)
Knetsch v. United States, 364 U.S. 361 (1960)
[10] Internal Revenue Service, T.D. 8787, 63 FR 56563, Oct. 22, 1998
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