James H. Pugh, Jr. v. Comm. IRS , 213 F.3d 1324 ( 2000 )

[PUBLISH]
IN THE UNITED STATES COURT OF APPEALS
FOR THE ELEVENTH CIRCUIT FILED
U.S. COURT OF APPEALS
________________________ ELEVENTH CIRCUIT
JUNE 5 2000
THOMAS K. KAHN
No. 99-12646 CLERK
________________________
T. C. Docket No. 27237-96
JAMES H. PUGH, JR. and ALEXIS PUGH,
Petitioners,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent.
________________________
Appeal from a Decision of the United States Tax Court
_________________________
(June 5, 2000)
Before CARNES, BARKETT and WILSON, Circuit Judges.
WILSON, Circuit Judge:
This case features a taxpayer who seeks to take personal tax advantage from
his S corporation’s insolvency. Put simply, the taxpayer owned shares in an S
corporation. The corporation owed money, was forgiven the debt, and then
liquidated. The taxpayer sought to have the cancellation-of-debt (COD) income
flow through to him and increase his basis in his S corporation stock. Then the
taxpayer claimed a tax deduction for a capital loss based on the increased basis.
The Tax Court ruled that the COD income belonged only to the S corporation, did
not flow through to the taxpayer, and did not increase his basis. We hold that
although the tax treatment urged by the taxpayer seems contrary to the Code’s
spirit, it is dictated by the Code’s plain language. We therefore reverse the
decision of the Tax Court.
BACKGROUND
Appellant James Pugh (“Pugh”)1 owned shares in Epoch Capital Corporation
(”Epoch”), an S corporation that fell on hard times in 1990. Being insolvent,
Epoch was forgiven $661,357 in debt, realized the same amount in cancellation-of-
debt (COD) income, liquidated, and filed articles of dissolution. At the time of
liquidation, Pugh owned 97% of Epoch’s then-worthless stock. He did not receive
any distribution from Epoch when it liquidated.
On its 1990 tax return, Epoch excluded the COD income from its gross
income. In preparing his personal tax returns, Pugh treated Epoch’s COD income
by applying the “pass-through” principles and basis adjustment provisions
1
Mr. Pugh’s wife Alexis is party to the appeal solely because she filed joint returns with her
husband for the years at issue.
2
normally applicable to subchapter S corporate shareholders. Pugh adjusted his
basis upward by $612,245, his share of Epoch’s COD income. By increasing his
basis, Pugh sought to take advantage of the losses resulting from the precipitous
decline in the value of his stock. Pugh claimed a capital loss for the Epoch stock
on his 1990 return and a carry-forward loss on his 1991 return.2 Pugh had no other
losses carrying forward from previous years.
The Commissioner determined that Pugh was not entitled to increase his
basis by the amount of the COD income, and asserted deficiencies against Pugh.
Pugh contested the deficiencies by filing a petition in the tax court. The tax court,
relying on Nelson v. Commissioner, 110 T.C. 114 (1998),3 ruled that “COD income
realized and excluded from gross income under section 108(a) does not pass
through to shareholders of an S corporation as an item of income in accordance
with section 1366(a)(1) so as to enable an S corporation shareholder to increase the
basis of his stock under section 1367(a)(1).” This appeal followed.
DISCUSSION
2
On Pugh’s personal return, he reported his distributive share of Epoch’s ordinary losses
($199,857) and an additional loss of $100,000. Taking only these loss adjustments into account,
Pugh’s basis was $394,802 at the end of 1990.
3
The Tenth Circuit affirmed Nelson on the rationale of its opinion in Gitlitz v. Commissioner,
182 F.3d 1143 (10th Cir. 1999), cert. granted, __U.S.__, 68 U.S.L.W. 3497 (May 1, 2000) (No.
99-1295). See Nelson v. Commissioner, 182 F.3d 1152 (10th Cir. 1999).
3
We have jurisdiction to review the decisions of the Tax Court “in the same
manner and to the same extent as decisions of the district courts in civil actions
tried without a jury.” 26 U.S.C. § 7482(a)(1). The Tax Court’s statutory
interpretation receives de novo review. See Estate of Wallace v. Commissioner,
965 F.2d 1038, 1044 (11th Cir. 1992) (quoting Young v. Commissioner, 926 F.2d
1083, 1089 (11th Cir. 1991)).
At issue in this appeal is the amount of loss Pugh can deduct as a capital loss
on his tax return. Pugh’s capital loss is determined with reference to his adjusted
basis in his Epoch stock;4 Pugh and the Commissioner disagree on whether Pugh’s
basis could reflect his pro rata share of Epoch’s cancellation-of-debt (COD)
income.
This Circuit has not addressed the issue of whether COD income realized
and excluded from gross income under 26 U.S.C. § 108(a) passes through to
shareholders of an S corporation as an item of income under 26 U.S.C. §
1367(a)(1), and whether S corporation shareholders can increase their individual
stock basis to reflect the corporation’s COD income. The answer involves the
4
See 26 U.S.C. §§ 165(b), 1001(a), 1011.
4
interplay between the way the Code treats COD income and the way the Code
treats the tax liability of S corporation shareholders.5
Our analysis begins with the language of the Code itself. See Griffith v.
United States (In re Griffith), 206 F.3d 1389 (11th Cir. 2000) (en banc). “[I]f the
language of the statute is plain, then our interpretative function ceases and we
should ‘enforce [the Code] according to its terms.’” Id. at 1393 (quoting Caminetti
v. United States, 242 U.S. 470 (1917)). Because the Code clearly provides that all
S corporation income passes through to the corporation’s shareholders and
increases their basis by the amount of the pass-through, we must reverse the tax
court.
5
The proper treatment of an S corporation’s COD income has been the subject of much
discussion by the courts and commentators. The Supreme Court has granted certiorari review in
one case, with two petitions for certiorari review pending as of the date of this opinion. See
Gitlitz v. Commissioner, 182 F.3d 1143 (10th Cir. 1999), cert. granted, __ U.S. __, 68 U.S.L.W.
3497 (May 1, 2000) (No. 99-1295); United States v. Farley, 202 F.3d 198 (3d Cir.), petition for
cert. filed, 68 U.S.L.W. 3670 (U.S. Apr. 17, 2000) (No. 99-1675); Witzel v. Commissioner, 200
F.3d 496 (7th Cir.), petition for cert. filed, (U.S. Apr. 17, 2000) (No. 99-1693); see also Nelson
v. Commissioner, 182 F.3d 1152 (10th Cir. 1999); Hogue v. United States, 85 A.F.T.R.2d (RIA) 2000-
426 (D. Ore., 2000) (No. 99-302-K1, Jan. 3, 2000). For commentary, see, e.g., Richard Gore,
Quandary for S Corp. COD Income Pass-Throughs, 56 Tax’n for Acct. 157 (1996) (discussing
dilemma that accountants face in advising their clients on COD treatment); Richard M. Lipton,
Different Courts Adopt Different Approaches to the Impact of COD Income on S Corps., 92 J.
Tax’n 207 (2000); Richard M. Lipton, The Impact of Excluded COD Income on S
Shareholders–The 10th Cir. Gets Lost in Gitlitz, 91 J. Tax’n 197 (1999); Richard M. Lipton, Tax
Court Rejects S Corp. Basis Step-Up for COD Income in Nelson, 88 J. Tax’n 272 (1998); James
D. Lockhart & James E. Duffy, Tax Court Rules in Nelson that S Corp. Excluded COD Income
Does Not Increase Shareholder Basis, 25 Wm. Mitchell L. Rev. 287 (1999); Stephen R. Looney,
S Corp. Prop. Regs. – No Surprises, but Two Potentially Controversial Provisions, 90 J. Tax’n
69 (1999) (discussing controversy surrounding IRS’s position on treatment of COD income).
5
1) Pass-through income.
S corporations allow many small business owners to enjoy the limited
liability of the corporate structure without, for the most part, being subject to
taxation at the corporate level. See 26 U.S.C. § 1363(a); Beard v. United States,
992 F.2d 1516, 1518 (11th Cir. 1993). Congress implemented this mechanism by
providing that the tax repercussions of an S corporation’s income and losses pass
directly through to its shareholders. See 26 U.S.C. § 1366; Beard, 992 F.2d at
1518 (noting that S corporation “generally does not pay income taxes as an
entity”).
Accordingly, shareholders of S corporations determine their tax liability by
taking into account their pro rata share of the S corporation’s “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, and [] nonseparately
computed income or loss.” 26 U.S.C. § 1366(a)(1). The character of these pass-
through items “shall be determined as if such item were realized directly from the
source from which realized by the corporation, or incurred in the same manner as
incurred by the corporation.” 26 U.S.C. § 1366(b). Therefore, to determine
whether Epoch’s COD income passes through to Pugh, we must determine whether
it is the type of income suitable for pass-through treatment.
6
Nature of Cancellation-of-Debt Income.
Forgiveness of debt is income because it frees up assets that the taxpayer
previously had to dedicate toward repaying its obligations. See, e.g., United States
v. Centennial Savings Bank FSB, 499 U.S. 573, 582 (1991); United States v. Kirby
Lumber Co., 284 U.S. 1 (1931). Normally, COD income is included in gross
income and would thus pass through to an S corporation’s shareholders. See 26
U.S.C. §§ 61(a)(12), 1366(a).
But there is an exception for insolvent debtors. For them forgiveness of debt
means little, for even after forgiveness the debtors still owe more than they have.
Because insolvents cannot enjoy the freed-up assets, courts have ruled that they
need not include the COD amounts in gross income. See, e.g., Dallas Transfer &
Terminal Warehouse Co. v. Commissioner, 70 F.2d 95, 96 (5th Cir. 1934) (noting
that cancellation of insolvent’s debt “did not have the effect of making the
respondent’s assets greater than they were before that transaction occurred. . . . A
transaction whereby nothing of exchangeable value comes to or is received by a
taxpayer does not give rise to or create taxable income.”). Congress codified this
7
exception in 26 U.S.C. § 108, which excludes COD income from gross income if
the taxpayer is insolvent. See 26 U.S.C. § 108(a)(1)(B).6
In granting the exemption, Congress exacted a price. Taxpayers who
exclude COD income must offset the exclusion against favorable tax attributes
such as net operating losses and capital loss carryovers. See 26 U.S.C. § 108(b)(1),
(b)(2)(A), (b)(2)(D). These reductions occur after determining tax liability “for the
taxable year of the discharge.” 26 U.S.C. § 108(b)(4)(A). Further, for S
corporations the reductions apply “at the corporate level.” 26 U.S.C. §
108(d)(7)(A). Because neither Pugh nor Epoch had unused net operating losses or
carryover losses, the offset does not apply directly to this case. However, the
Commissioner argues that these provisions show Congress’s intent for COD
income to stop at the corporate entity and not pass through to S corporation
shareholders. To address this argument, we must consider how § 108 applies to S
corporations in particular.
Effect on S Corporation Pass-Through.
In the case of S corporations, § 108's exclusion (and reduction of tax
attributes) “shall be applied at the corporate level.” 26 U.S.C. § 108(d)(7)(A).
6
“‘Insolvent’ means the excess of liabilities over the fair market value of assets.” 26 U.S.C. §
108(d)(3). No one disputes that Epoch was insolvent.
8
Further, “any loss or deduction which is disallowed for the taxable year of the
discharge under section 1366(d)(1)”–that is, losses normally belonging to the
shareholders themselves–“shall be treated as a net operating loss for such taxable
year.” 26 U.S.C. § 108(d)(7)(B).
This language, standing alone, does not explicitly trump the usual S
corporation pass-through rules. All income that flows through an S corporation
begins “at the corporate level.” Nothing in § 108 expressly marks COD income for
special bottlenecking–that is, that COD income “at the corporate level” means “at
the corporate level and no further.” To see whether COD income passes through to
S corporation shareholders, we must inquire whether COD income is an “item of
income . . . the separate treatment of which could affect the liability for tax of any
shareholder.” 26 U.S.C. § 1366(a)(1).7
The Commissioner’s position is that COD income does not pass through
under § 1366(a)(1) because it is not an item of income that can pass to
shareholders. The Commissioner argues that § 108 is merely a tax deferment
provision, and that COD income not used to reduce corporate tax attributes
7
S corporation shareholders also include in their income “nonseparately computed income or
loss.” 26 U.S.C. § 1366(a)(1)(B). This provision does not apply here because “nonseparately
computed income” means gross income (less the corporation’s deductions), see 26 U.S.C. §
1366(a)(2), and Epoch’s COD income was excluded from gross income. See 26 U.S.C. §
108(a)(1).
9
becomes a nullity. The Commissioner relies on legislative history to show
Congress’s intent that once a taxpayer reduces its tax attributes, “Any further
remaining debt discharge . . . does not result in income or have other tax
consequences.” S. Rep. No. 96-1035, at 2 (1980), reprinted in 1980 U.S.C.C.A.N.
7017.
If the S corporation cannot use the COD income to reduce attributes, the
Commissioner argues, it never flows through to the S corporation’s shareholders.
This position was expressed by Judge Beghe in his concurrence in Nelson, 110
T.C. 131-132 (Beghe, J. concurring) (opining that an insolvent S corporation’s
COD income could not pass through to a solvent shareholder and the “equivalence
rule of section 1366(b)” could not apply).
But as the Third Circuit pointed out, “This statement, made without
elaboration by Judge Beghe, is simply incorrect.” United States v. Farley, 202
F.3d 198, 208 (3d Cir. ), petition for cert. filed, 68 U.S.L.W. 3670 (U.S. Apr. 17,
2000) (No. 99-1675). The Commissioner’s argument ignores the clear language of
§ 1366, which provides that all items of corporate income that could affect
shareholders’ tax liability pass through to them as if “incurred in the same manner
as incurred by the corporation.” See 26 U.S.C. § 1366(a)(1)(A), (b). Accordingly,
the Commissioner’s argument has been rejected by every circuit that has
10
considered it. See Farley, 202 F.3d at 205 n.4 (“the language of section
108(b)(4)(A) is clear and unambiguous . . . COD income excluded from gross
income under section 108 passes through to the S corporation’s shareholders”);
Witzel v. Commissioner, 200 F.3d 496, 498 (7th Cir.) (noting that COD income
flows through to S corporation shareholder), petition for cert. filed (U.S. Apr. 17,
2000) (No. 99-1693); Gitlitz v. Commissioner, 182 F.3d 1143, 1148 (10th Cir.
1999) (“the items must pass through to shareholders unless they are absorbed by
tax attribute reductions”), cert. granted, ___ U.S. ___, 68 U.S.L.W. 3497 (May 1,
2000) (No. 99-1295).
One important difference, however, separates Pugh from the taxpayers in the
above cases. Gitlitz, Witzel and Farley all personally carried suspended losses into
the years their corporations received COD income. See § 1366(d)(1) and (2)
(requiring that S corporation shareholders carry over losses that exceed their
adjusted basis in their S corporation stock). A suspended loss “disallowed for the
taxable year of the discharge under section 1366(d)(1) shall be treated as a net
operating loss for such taxable year.” 26 U.S.C. § 108(d)(7)(B). Therefore,
Gitlitz, Witzel and Farley–either in the year of discharge or in years
thereafter–potentially faced direct changes in their tax liability relating to their
11
suspended losses.8 By contrast, when Pugh’s S corporation realized its COD
income, Pugh had no suspended losses. Even if Pugh treated Epoch’s COD
income as his own,9 it would not have altered his tax liability directly because he
possessed no suspended losses to be affected. Therefore, Epoch’s COD income
does not at first blush fall within the category of items of income to be passed
through to Pugh. See 26 U.S.C. § 1366(a)(1)(A) (allowing for pass-through of
“items of income . . . which could affect the liability for tax of any shareholder”).10
8
See Gitlitz, 182 F.3d at 1150 n.6 (setting out illustrative examples, including Examples 3
and 4, where taxpayer’s suspended losses are characterized as part of the S corporation’s net
operating losses); Witzel, 200 F.3d at 498 (holding that shareholder’s suspended losses are
“offset at the corporate level by the amount of his corporation’s COD income”); Gore, supra
note 5 (“Because Section 108 may reduce a shareholder’s suspended losses, the COD income
must pass through to the shareholders.”). Contra Farley, 202 F.3d at 205 (COD income “shall
be applied to reduce the tax attributes of the corporation, rather than the individual
shareholder”). The Farley court further noted that even if § 108(d)(7)(B) required a
shareholder’s suspended losses to be considered as net operating losses, “nowhere does section
108(d)(7)(B) indicate that S corporation [COD] income should reduce such net operating losses
‘for the taxable year of discharge.’” Id. at 207 (quoting 26 U.S.C. § 108(d)(7)(B)). See also
Lockhart & Duffy, supra n. 5, at 299 (“Section 108(d)(7) does not operate to convert shareholder
suspended losses into S corporation NOLs. . . . Section 108(d)(7)(B) provides the mechanism by
which the shareholder attribute (suspended losses) will be subject to the existing corporate
attribute reduction regime under 108(b)(2)(A).”). Because Pugh possessed no suspended losses,
we need not today reach the issue of how to treat an S corporation shareholder’s suspended
losses.
9
See 26 U.S.C. § 1366(b) (pass-through income is characterized “as if such item were
realized directly from the source from which realized by the corporation”).
10
The Tenth Circuit appears to consider that COD income cannot pass through to
shareholders without suspended losses, as shown by its affirmance in Nelson, where the
shareholder had no suspended losses, and as shown in one of the examples the court used to
illustrate its reasoning in Gitlitz. See Gitlitz, 182 F.3d at 1150 n.6 (Example 1).
12
Of course, the COD income ultimately affects Pugh’s tax liability by
flowing through under § 1366 and thus increasing Pugh’s basis pursuant to §
1367(a)(1)(A). In addition, § 1366(a)(1) does allow one type of income to pass
through that might not affect taxpayers’ liability initially, namely “tax-exempt
income.” 26 U.S.C. § 1366(a)(1)(A). Congress provided for pass-through of tax-
exempt income to preserve its nature: if tax-exempt income did not flow through
under § 1366 and increase shareholders’ bases, they would have to pay tax when
they sold their stock. See 11 Jacob Mertens, Law of Fed. Income Taxation §
41B:154 (“A shareholder’s increase in basis for tax-exempt income allows the
shareholder to avoid recognition of gain as a result of receiving such income
(reduced by any distributions) upon the sale of such stock.”).
The Commissioner argues that COD income is not “truly” tax-exempt
because, unlike other sources of tax-exempt income, COD income is never
distributed to shareholders with a corresponding reduction in basis.11 This
11
In Farley and Witzel, the Commissioner argued that § 108 income was not tax-exempt but
only tax-deferred, because it would eventually be offset against tax attributes. See Farley, 202
F.3d at 209-10 (rejecting argument); Witzel, 200 F.3d at 498 (rejecting argument and similar
dicta of United States v. Centennial Sav. Bank, 499 U.S. 573, 580 (1991) (although the Supreme
Court described § 108 income as tax-deferred, it did so in passing while interpreting a now-
deleted provision of § 108).
The IRS does not treat § 108 income as tax-exempt in its final regulations. See 26 C.F.R.
§ 1.1366-1(a)(2)(viii):
[T]ax-exempt income is income that is permanently excludible from gross income
13
distinction is not supported by the plain language of the Code, which simply
designates “tax-exempt” income without any limitation on whether or not the
income eventually becomes distributed to shareholders. See 26 U.S.C. §
1366(a)(1)(A).
The COD exemption is located in the part of the Code titled “Items
Specifically Excluded from Gross Income.” This section includes various types of
tax-exempt income, such as tax-exempt bond income and life insurance proceeds.
See 26 U.S.C. §§ 101-136. The language in § 108 excluding COD income from
gross income is virtually identical to that in other sections. Compare 26 U.S.C. §
108(a)(1) (excluding COD income from gross income) with 26 U.S.C. § 101(a)(1)
(excluding life insurance proceeds from gross income).12 Nothing in the Code
distinguishes COD income from its cohort as being not “really” tax-exempt.
This is particularly true here, where neither Epoch nor Pugh possessed tax
attributes to offset the tax-exempt status of Epoch’s COD income. As Judge
in all circumstances . . . .For example, income that is excludible in gross income
under section 101 (certain death benefits) or section 103 (interest on state and
local bonds) is tax-exempt income, while income that is excludible from gross
income under section 108 . . . is not tax-exempt income.
Id. The regulations became effective August 18, 1998 (see 64 FR 245) and do not apply to this
case; accordingly, we do not address their validity.
12
This point is made by Lockhart & Duffy, supra n.5, at 304 (“in light of the identical
statutory language of Sections 101 and 108, it is unclear why” COD income should be treated
differently than insurance proceeds).
14
Posner noted, absent suspended losses, COD income flows through to S
corporation shareholders “tax exempt in the fullest sense.” Witzel, 200 F.3d at 498.
See also Farley, 202 F.3d at 210 (acknowledging Commissioner’s concession that
“discharge of indebtedness income is sometimes tax-exempt”); Gitlitz, 182 F.3d at
1147 n.3 (“If a taxpayer’s attributes are insufficient to absorb all of his cancellation
of indebtedness income, § 108 effectively provides a permanent exception from
taxation on that income.”). We join these circuits in ruling that an S corporation’s
COD income passes through pro rata to its shareholders under § 1366(a)(1),13 and
add that this is so even when the shareholder possesses no suspended losses to
offset the COD income.
2) Increase in Basis.
The real sticking point, of course, is not whether Pugh can include Epoch’s
COD income as an item of income, but whether he can take a personal capital loss
deduction boosted by his share of that same COD income. Pugh’s loss deduction
is determined with reference to his basis;14 the question thus is whether Pugh can
increase his basis to reflect the passed-through COD income.
13
The circuits are split on whether the tax attribute reduction occurs at the corporate level
before the pass-through, e.g., Witzel, 200 F.3d 496; Gitlitz, 182 F.3d 1143; or whether the
reduction occurs after the pass-through of COD income; see Farley, 202 F.3d 198. Because
neither Pugh nor Epoch possessed tax attributes to reduce, we need not reach the issue.
14
See 26 U.S.C. §§ 165(b), 1001, 1011.
15
In general, S corporation shareholders’ initial basis corresponds to their cost
of the stock plus capital contributions. See 26 U.S.C. §§ 1011-1016; 11 Jacob
Mertens, Law of Fed. Income Taxation § 41B:147. Shareholders’ basis in their S
corporation stock increases by “the items of income described in subparagraph (A)
of section 1366(a)(1)” and decreases by “the items of loss and deduction described
in subparagraph (A) of section 1366(a)(1).” 26 U.S.C. § 1367(a). These “items of
income” include not only gross income but also other types of income, including
tax-exempt income. See 26 U.S.C. § 1366(a)(1); Farley, 202 F.3d at 206; Witzel,
200 F.3d at 498; 15 Collier on Bankruptcy ¶ TX6.03[5][c] (“If discharge income is
excluded at the S corporation level under I.R.C. Section 108(a), the shareholders
should be entitled to increase the basis of their stock and debt under I.R.C. Section
1367 for their ratable share of excluded income. Under a plain reading of the
statutory language, a step-up in basis is allowed for all income, including tax-
exempt income.”) Therefore, § 1367 requires that Pugh’s basis be increased by the
amount of COD income that passed through to him from Epoch.
We recognize that this statutory scheme can lead to the result that
shareholders actually benefit from their S corporations’ insolvency. Not only do
they avoid taxation on the corporation’s COD income, but also they may receive
capital loss deductions based on their share of the COD income. This jars with the
16
general rule that basis should increase only to the extent of a taxpayer’s actual
“economic outlay.” See, e.g., Sleiman v. Commissioner, 187 F.3d 1352, 1357
(11th Cir. 1999) (quoting Selfe v. United States, 778 F.2d 769, 772 (11th Cir.
1985)); see also Gitlitz, 182 F.3d at 1151.
Normally, basis increases to the extent the taxpayer reports income from the
S corporation; otherwise, the taxpayer would pay double tax upon receiving a
distribution or selling the shares. See 26 U.S.C. § 1367(a)(1)(A). But if the S
corporation receives tax-exempt income that passes through to the shareholder, the
shareholder’s basis is increased to preserve the tax-exempt nature of the income.
See id., 26 U.S.C. § 1366(a)(1)(A). This is so even without an “economic outlay”
by the shareholder. See, e.g., Farley, 202 F.3d at 207 n.5 (noting that “numerous
exceptions” to economic outlay rule exist, including treatment of COD income as
well as life insurance benefits and tax-exempt bond income: “section 108 cannot be
distinguished from sections 101 and 103 on the basis of economic outlay
considerations”); Lockhart & Duffy, supra n.5, at 304 (noting that in light of
identical statutory language, “it is unclear why the absence of an economic outlay
results in excluded COD income being treated differently”); cf. CSI Hyrdostatic
Testers, Inc. v. Commissioner, 62 F.3d 136 (5th Cir. 1995) (adopting Tax Court’s
rejection of argument that S corporation’s parent should not receive benefit of
17
subsidiary’s COD income because parent had not “paid for” it (see 103 T.C. 398,
409 (U.S. Tax Court 1994))); but see Gitlitz, 182 F.3d at 1151 (distinguishing COD
income because taxpayer made no initial economic outlay).
The Commissioner argues that §§ 108, 1366 and 1367 should be read
together to prevent Pugh from enjoying twice the tax-exempt status of COD
income. We must acknowledge the justice of the Commissioner’s position, for
unlike other sources of tax-exempt income, COD income becomes tax-exempt
merely from the infelicitous combination of corporate insolvency and a lack of tax
attributes to offset the COD income. But we cannot ignore the language of the
statute, which clearly requires that all items of income included in § 1366 must be
used to increase the shareholder’s basis under § 1367. “The relevant question is
not whether, as an abstract matter, the rule advocated by petitioners accords with
good policy. . . . Courts are not authorized to rewrite a statute because they might
deem its effects susceptible of improvement.” Badaracco v. Commissioner, 464
U.S. 386, 398 (1984). While we agree with the Third Circuit that Congress may
not have intended the result dictated by the statute,15 we must leave rewriting the
Code to Congress.
CONCLUSION
15
See Farley, 202 F.3d at 212 n.10.
18
Pugh is entitled to increase the basis in his Epoch stock by his pro rata share
in the corporation’s COD income for 1990. This case is REVERSED and
REMANDED for proceedings in light of this opinion.
19