Gitlitz, David, et ux. et al. v. Commissioner of Internal Revenue (01/09/2001)

By: Heather MacDonald, Medill News Service

Questions presented

Whether a Subchapter S corporation can pass through indebtedness income exclusions to individual shareholders?

Brief

In 1991, the Internal Revenue Service assessed tax penalties against David and Louise Gitlitz and Philip and Eleanor Winn after finding that they improperly calculated their corporate taxes.

David Gitlitz and Philip Winn each owned a 50 percent interest in PDW&A, a partner in Parker Properties Joint Venture, a Colorado real estate corporation.

That year, Parker Properties paid off $4.1 million of its debts.

But PDW&A was insolvent, owing $2.1 million to creditors. Because it was insolvent, PDW&A was excluded from having to pay taxes on its share of the discharge of the $4.1 million debt.

Ordinarily, the Internal Revenue Code requires a taxpayer that pays off a debt — in whole or in part — to pay taxes on the amount of the reduction. But an exception is provided if the debt is discharged in a bankruptcy proceeding or at a time when the taxpayer is insolvent.

On their joint 1991 and 1992 tax returns, Gitlitz and Winn claimed increases in the bases of their PDW&A stock in the amount of their share of the debt that Parker Properties paid off. They claimed that, as shareholders in an insolvent subchapter S corporation, they were entitled to use the corporations untaxed discharge of indebtedness income to increase the basis of their corporate stock.

Gitlitz and Winn believed that because PDW&A was insolvent in 1991, it is exempt from having to recognize Parker Properties debt reduction as income. And because it is a subchapter S corporation, that exemption is ""passed through"" to their individual tax returns.

Subchapter S of the Internal Revenue Code, permits certain corporations to elect to be taxed in a similar, but not identical, fashion to partnerships. A subchapter S corporation does not generally pay taxes as an entity. Instead, the corporations profits and losses ""pass through"" directly to its shareholders individual tax returns.

The IRS determined that Gitlitz and Winn could not claim those increases, and denied the business partners ordinary loss deductions.

Gitlitz and Winn appealed the IRS' decision to the United States Tax Court, which initially ruled in their favor. But on reconsideration, the court upheld the decision of the IRS commissioner.

In November 1999, a 10th Circuit Court of Appeals panel affirmed the lower courts ruling in a unanimous decision.

""If we embrace Gitlitz and Winns position subchapter S corporate shareholders would receive a windfall. Not only would shareholders avoid taxation on the corporations discharged debt, they would also receive an upward basis adjustment, thereby permitting them to report a larger capital loss from the sale of the stock. In addition, shareholders would be able to reduce the corporations net operating losses by the amount of the corporations discharged debt,"" the opinion read.

Since the Supreme Court had previously ruled that the Internal Revenue Code should not be interpreted to allow taxpayers a double deduction unless Congress clearly meant to establish a double deduction, the appeals panel found that standard also applied to windfalls.

""Although the taxpayers make some compelling arguments,"" the opinion read, in calling the case one of first impression, ""we do not believe Congress intended to confer such a windfall upon individuals in their position.""

On May 1, 2000, the U.S. Supreme Court granted certiorari.

On Jan. 9, 2001, the Court, by an 8-1 vote, reversed, holding for Gitlitz that the statute's plain language establishes that excluded discharged debt is an ""item of income,"" which passes through to shareholders and increases their bases in an S corporation's stock.

In so holding, the Court rejected the IRS' contention that the discharge of indebtedness is not really income or that it is not tax-exempt income.

Justice Clarence Thomas wrote the majority opinion.

Justice Stephen Breyer, the lone dissenter, wrote that the majority's opinion allows for a significant tax loophole.

""That loophole—preserved by the majority—would grant a solvent shareholder of an insolvent S corporation a tax benefit in the form of permission to take an otherwise unavailable deduction, thereby sheltering other, unrelated income from tax,"" Breyer wrote.