No. 99-1295 

In the Supreme Court of the United States 

DAVID A. AND LOUISE A. GITLITZ, ET AL., PETITIONERS 

v. 

COMMISSIONER OF INTERNAL REVENUE 

ON PETITION FOR A WRIT OF CERTIORARI 
TO THE UNITED STATES COURT OF APPEALS 
FOR THE TENTH CIRCUIT 

BRIEF FOR THE RESPONDENT 

SETH P. WAXMAN 

Solicitor General 

Counsel of Record 

PAULA M. JUNGHANS 

Acting Assistant Attorney 

General 

LAWRENCE G. WALLACE 

Deputy Solicitor General 

KENT L. JONES 

Assistant to the Solicitor 

General 

TERESA E. MCLAUGHLIN 
EDWARD T. PERELMUTER 

Attorneys 

Department of Justice 
Washington, D.C. 20530-0001 
(202) 514-2217 

QUESTION PRESENTED 

Petitioners are shareholders in an insolvent Sub- 
chapter S corporation. During 1991, that corporation 
obtained a discharge of certain indebtedness. That 
discharge would have been treated as an item of 
“[i]ncome from discharge of indebtedness” (26 U.S.C. 
61(a)(12)) except that, because the discharge occurred 
when the corporation was insolvent, the item is ex- 
pressly “not include[d] * * * in gross income” under 
26 U.S.C. 108(a)(1)(B). The question presented in this 
case is whether the amount thus expressly excluded 
from “income” is nonetheless to be treated as if it 
were an item of “income” which, under 26 U.S.C. 
1366(a)(1)(A), flows through to petitioners as the 
shareholders of the Subchapter S corporation, thereby 
increasing their basis in the stock of the corporation 
under 26 U.S.C. 1367(a)(1)(A), and thereby allowing 
them to deduct losses they previously were unable to 
deduct because they had exhausted their basis by prior 
deductions. 

(I) 

TABLE OF CONTENTS 

Page 

Opinions below ............................................................................... 
1 

Jurisdiction ...................................................................................... 1 

Statement ........................................................................................ 2 

Argument ........................................................................................ 7 

Conclusion ....................................................................................... 18 

TABLE OF AUTHORITIES 

Cases: 

Astoria Marine Constr. Co. v. Commissioner, 

12 T.C. 798 (1949) ................................................................... 

10 

Bufferd v. Commissioner, 506 U.S. 523 (1993) ................ 

2 

CSI Hydrostatic Testers v. Commissioner, 

103 T.C. 398 (1994), aff ’d, 62 F.3d 136 (5th Cir. 

1995) ......................................................................................... 18 

Dallas Transfer & Terminal Warehouse Co. v. 

Commissioner, 70 F.2d 95 (5th Cir. 1934) ....................... 

10 

Eberle v. Commissioner, 78 T.C.M. (CCH) 366 

(1999), on appeal, No. 00-70159 (9th Cir.) .......................... 

8 

Friedman v. Commissioner, 75 T.C.M. (CCH) 

2383 (1998), on appeal, No. 98-2378 (6th Cir.) ................... 

7 

Gaudiano v. Commissioner, 76 T.C.M. (CCH) 858 

(1998), on appeal, No. 99-1294 (6th Cir.) ............................ 

7- 8 

Hogue v. United States, 2000-1 U.S. Tax Cas. 

(CCH) ¶ 50,149 ((D. Ore. Jan. 3, 2000), on appeal, 

No. 00-35208 (9th Cir.) .......................................................... 

8 

Nelson v. Commissioner, 110 T.C. 114 (1998), aff ’d, 

182 F.3d 1152 (10th Cir. 1999) ........................................... 

5, 14 

Pugh v. Commissioner, 77 T.C.M. (CCH) 1367 

(1999), on appeal, No. 99-12646 (11th Cir.) ........................ 

8 

United States v. Farley, 202 F.3d 198 (3d Cir. 

2000) ....................................................................................... 

7, 12 

United States v. Centennial Sav. Bank, 499 U.S. 

573 (1991) ............................................................................. 10, 15 

(III) 

IV 

Cases—Continued: Page 

United States v. Kirby Lumber Co., 284 U.S. 1 

(1931) ........................................................................................ 10 

United States v. Skelly Oil Co., 394 U.S. 678 

(1969) ........................................................................................ 6 

Witzel v. Commissioner, 200 F.3d 496 (7th Cir. 

2000) ..................................................................................... 

7, 14 

Statutes and regulations: 

Bankruptcy Tax Act of 1980, Pub. L. No. 96-589, 

§ 2, 94 Stat. 3389 .................................................................... 

11 

Internal Revenue Code (26 U.S.C.): 

§ 61(a)(12) ................................................................................ 

2, 4 

§ 101 ...................................................................................... 

14, 15 

§ 103 ...................................................................................... 

14, 15 

§ 108 ................................................................................ 

passim 

§ 108(a) .................................................................. 

4, 5, 6, 9, 13, 17 

§ 108(a)(1)(A) .......................................................................... 

8 

§ 108(a)(1)(B) ............................................................. 

2, 8, 13, 16 

§ 108(a)(1)(C) .......................................................................... 

8, 10 

§ 108(b) ........................................................................ 

6, 9, 13, 17 

§ 108(b)(1) ................................................................................ 

9 

§ 108(b)(1)-(2) .......................................................................... 

16 

§ 108(b)(2) .............................................................................. 

9, 16 

§ 108(b)(2)(A) ........................................................................ 

9, 13 

§ 108(b)(2)(A)-(G) ................................................................... 

9 

§ 108(b)(3)(A) .......................................................................... 

9 

§ 108(b)(3)(B) .......................................................................... 

9 

§ 108(b)(4)(A) ...................................................................... 

16, 17 

§ 108(b)(5) .............................................................................. 

9, 16 

§ 108(d)(3) ................................................................................ 

8 

§ 108(d)(6) ................................................................................ 

11 

§ 108(d)(7)(A) ................................................................ 

9, 13, 17 

§ 108(d)(7) .............................................................................. 

11 

§ 108(d)(7)(B) ........................................................................ 

9, 13 

§ 1017 ....................................................................................... 16 

V 

Statutes and regulations—Continued: 
Page 

§ 1017(a) ................................................................................... 

9 

§ 1017(a)(2) .............................................................................. 

9 

§§ 1361-1379 ............................................................................ 

2 

§ 1366 ........................................................... 

2, 6, 7, 8, 13, 15, 17 

§ 1366(a) ................................................................................... 

11 

§ 1366(a)(1) .......................................................................... 

14, 15 

§ 1366(a)(1)(A) .............................................................. 

3, 12, 15 

§ 1366(d)(1) .......................................................................... 

11, 13 

§ 1366(d)(2) ........................................................................ 

3, 4, 12 

§ 1367 ....................................................................................... 

2, 15 

§ 1367(a)(1)(A) ........................................................... 

3, 4, 12, 15 

§ 1367(a)(2) .............................................................................. 

3 

§ 1367(a)(2)(A) ...................................................................... 

3, 15 

§ 1367(a)(2)(B) ........................................................................ 

3 

§ 1368(b)(2) .......................................................................... 

15, 16 

§ 1502 ....................................................................................... 

18 

§ 7482(b)(1)(A) ........................................................................ 

8 

Subchapter S Revision Act of 1982, Pub. L. No. 97-354, 

§ 3(e), 96 Stat. 1689 ................................................................ 

11 

Tax Reform Act of 1984, Pub. L. No. 98-369, Subtit. B, 

98 Stat. 966: 

§ 721(b), 98 Stat. 966 ......................................................... 

11 

§ 721(y), 98 Stat. 972 ......................................................... 
11 

Treas. Reg. (26 C.F.R.) (1999): 
§ 1.1366-1(a)(2)(viii) ............................................................... 
15 

§ 1.1366-5 ................................................................................. 
15 

Miscellaneous: 

1 B. Bittker & L. Lokken, Federal Taxation of In- 
come, Estates and Gifts: 
(2d ed. 1989) ....................................................................... 

10 
(3d ed. 1999) ....................................................................... 
11 

64 Fed. Reg. 71,643 (1999) ................................................... 
15 

H.R. Rep. No. 432, 98th Cong., 1st Sess. (1984) .................. 
11 

H.R. Rep. No. 833, 96th Cong., 2d Sess. (1980) ................... 
17 

S. Rep. No. 1035, 96th Cong., 2d Sess. (1980) .................. 
10, 13 

14, 17 

VI 

In the Supreme Court of the United States 

No. 99-1295 

DAVID A. AND LOUISE A. GITLITZ, ET AL., PETITIONERS 

v. 

COMMISSIONER OF INTERNAL REVENUE 

ON PETITION FOR A WRIT OF CERTIORARI 
TO THE UNITED STATES COURT OF APPEALS 
FOR THE TENTH CIRCUIT 

BRIEF FOR THE RESPONDENT 

OPINIONS BELOW 

The opinion of the court of appeals (Pet. App. 1-20) is 
reported at 182 F.3d 1143. The initial opinion of the 
Tax Court (Pet. App. 25-31) is unofficially reported at 
73 T.C.M. (CCH) 3167. The opinion of the Tax Court on 
reconsideration (Pet. App. 21-24), which withdrew and 
replaced the initial opinion, is unofficially reported at 75 
T.C.M. (CCH) 1840. 

JURISDICTION 

The judgment of the court of appeals was entered on 
July 6, 1999. A petition for rehearing was denied on 
November 3, 1999 (Pet. App. 32-33). The petition for a 
writ of certiorari was filed on February 1, 2000. The 
jurisdiction of this Court is invoked under 28 U.S.C. 
1254(1). 

(1) 

2 

STATEMENT 

1. a. During the 1991 taxable year, petitioners David 
A. Gitlitz and Philip D. Winn each owned a 50% interest 
in P.D.W. & A., Inc. (PDW&A), a Colorado corporation 
that elected to be taxed for that year under the pro- 
visions of Subchapter S of the Internal Revenue Code, 
26 U.S.C. 1361-1379. Pet. App. 2-3. As this Court ex- 
plained in Bufferd v. Commissioner, 506 U.S. 523, 525 
(1993), Subchapter S of the Code implements “a pass- 
through system under which corporate income, losses, 
deductions, and credits are attributed to individual 
shareholders in a manner akin to the tax treatment of 
partnerships.” 
The Subchapter S corporation was a partner in a 
partnership that was discharged from $4,154,891 in 
debt during 1991. Pet. App. 3. The corporation’s share 
of this income was $2,021,296, and this amount would 
have represented “[i]ncome from discharge of indebted- 
ness” to the corporation (26 U.S.C. 61(a)(12)) except 
that, at the time of the discharge, the corporation was 
insolvent. Because the corporation was insolvent, this 
amount was expressly excluded from income under 
Section 108 of the Code, which specifies that “[g]ross 
income does not include any amount which * * * 
would be includible in gross income by reason of the 
discharge * * * of indebtedness of the taxpayer if 

* * * the discharge occurs when the taxpayer is 
insolvent.” 26 U.S.C. 108(a)(1)(B). 

b. Although Section 108 of the Code thus specifies 
that discharge of indebtness is not an item of income for 
an insolvent corporation, petitioners claim that it should 
nonetheless be treated as if it were an item of income 
for purposes of Sections 1366 and 1367 of the Code. 
Those provisions determine various aspects of the tax 

3 

treatment of shareholders of a subchapter S corpora- 
tion. In particular, they specify that “items of income 
(including tax-exempt income), loss, deduction, or 
credit” pass through to the shareholders (26 U.S.C. 
1366(a)(1)(A)), that the “items of income” that pass 
through to the shareholders increase the shareholders’ 
basis in the stock of the Subchapter S corporation (26 
U.S.C. 1367(a)(1)(A)), that the losses and deductions 
that pass through reduce the shareholders’ stock basis 
(26 U.S.C. 1367(a)(2)(B)), and that distributions of earn- 
ings or assets of the corporation to the shareholders 
reduce their basis in the stock (26 U.S.C. 1367(a)(2)(A)). 
The basic concepts reflected in these provisions are: 
(i) that the income earned (or loss incurred) at the 
corporate level is treated as if it were earned (or lost) at 
the individual level; and (ii) that basis adjustments are 
made to avoid a double tax on those earnings or a 
double benefit from those losses. 

A shareholder may deduct losses only to the extent 
that he has not previously recovered (through prior 
deductions) his basis in the stock. 26 U.S.C. 1366(d)(2). 
In this case, petitioners had previously deducted losses 
representing their entire basis in the corporate stock. 
Pet. App. 3-4. At the time the indebtedness of the Sub- 
chapter S corporation was discharged in 1991, peti- 
tioners would thus be allowed further deductions from 
continuing corporate losses only if their basis were 
somehow increased.1 

1 Petitioners had exhausted their basis in the corporate stock 
by deductions taken in prior years. See Pet. App. 3; 26 U.S.C. 
1367(a)(2). The losses of the corporation incurred prior to 1991, 
which petitioners had been unable to deduct because they had 
exhausted their basis, are described as “suspended” losses and are 
carried into future years; they may be deducted in future years 

4 

Petitioners assert that the additional basis that they 
need in order to take further deductions from prior 
corporate losses can be found in the discharge of in- 
debtedness “income” of the corporation in 1991. They 
assert that this discharge of indebtedness is an “item[] 
of income” (26 U.S.C. 1366(a)(1)(A)) which increases 
their basis in the corporate stock (under 26 U.S.C. 
1367(a)(1)(A)) even though, for the reasons described 
above, Section 108(a) of the Code expressly states that 
this item is “not” an item of income. They thus claimed 
additional deductions in an amount equivalent to their 
allocable share of the discharged debt of $2,021,296. 
Pet. App. 3. 

Upon audit, the Commissioner determined that peti- 
tioners were not entitled to increase their stock basis 
by their reported pro rata shares of the discharge of 
indebtedness that was “not” an item of income under 
Section 108 of the Code. The Commissioner therefore 
disallowed the deductions claimed by petitioners and 
asserted a deficiency of $251,192 against petitioner 
Gitlitz and of $242,555 against petitioner Winn. Pet. 
App. 64-66, 81-83. 

2. Petitioners filed separate petitions in Tax Court 
which were consolidated for disposition. On cross- 
motions for summary judgment, the Tax Court initially 
ruled in favor of petitioners. Pet. App. 25-31. The court 
stated (id. at 29-30) that, because income from the 
discharge of indebtedness is an item of income in the 
general definition of gross income (26 U.S.C. 61(a)(12)), 
it qualifies as an “item[] of income” for which an upward 
basis adjustment is appropriate under 26 U.S.C. 

only if the shareholder acquires a basis in the stock to apply 
against them. 26 U.S.C. 1366(d)(2). 

5 

1366(a)(1)(A) even though, due to the insolvency of the 
debtor, it is excluded from income under Section 108(a). 

The Commissioner moved for reconsideration. While 
that motion was pending, the entire Tax Court held in a 
reviewed decision that a discharged debt that is 
excluded from a Subchapter S corporation’s gross in- 
come because of its insolvency does not constitute an 
item of “income” that would increase the shareholder’s 
basis in the corporate stock (and thereby allow deduc- 
tions of losses after that basis has been exhausted by 
prior deductions). Nelson v. Commissioner, 110 T.C. 
114 (1998), aff ’d, 182 F.3d 1152 (10th Cir. 1999). 
Relying on its decision in Nelson, the Tax Court then 
granted the motion for reconsideration in this case and 
entered judgment in favor of the Commissioner. Pet. 
App. 21-24. 

3. The Tenth Circuit affirmed. Pet. App. 1-20.2 The 
court of appeals emphasized that petitioners’ proposed 
interpretation of the Code would accomplish an 
inappropriate double tax benefit for taxpayers: it would 
permit the insolvent Subchapter S corporation to avoid 
tax on an item that is “not” treated as an item of income 
under Section 108(a); at the same time, it would allow 
the shareholders to reduce their gross income from 
other sources by treating this same item as if it were an 
item of “income,” thereby increasing their basis in the 
corporate stock and permitting deductions otherwise 
barred by the prior exhaustion of their basis (Pet. App. 

10). The court noted that this Court has emphasized 

2 The taxpayer in Nelson v. Commissioner also appealed the 
Tax Court’s decision in that case to the Tenth Circuit. The court of 
appeals affirmed the Tax Court’s decision on the authority of its 
opinion in this case. Nelson v. Commissioner, 182 F.3d 1152 
(1999). The taxpayer in Nelson did not file a petition for a writ of 
certiorari. 

6 

that the Internal Revenue Code “should not be inter- 
preted to allow [taxpayers] the practical equivalent of 
[a] double deduction absent a clear declaration of intent 
by Congress.” Ibid. (quoting United States v. Skelly 
Oil Co., 394 U.S. 678, 684 (1969)). The court concluded 
that “only if taxpayers’ theory is unequivocally sup- 
ported by the statutory text may we adopt it here” 
(Pet. App. 10) and that petitioners did not meet that 
burden. 

The court noted that a discharge of indebtedness 
does “not” constitute an item of income under Section 
108(a) if “the debt is * * * discharged in a bankruptcy 
proceeding or at a time when the taxpayer is insolvent” 
(Pet. App. 9) and that this characterization of the item 
is necessarily made and “applied at the corporate level” 
(id. at 11). The court explained that petitioners’ effort 
nonetheless to treat it as an “item[ ] of income” under 
Section 1366 ignores “the ‘price’ Congress imposed 
upon entities whose discharge[] [of indebtedness] 
income is excluded under § 108.” Pet. App. 13. That 
“price” is set forth in the provisions of Section 108(b), 
which requires the insolvent corporation to reduce 
various “tax attributes” (such as carried over credits or 
losses) “that could otherwise yield future tax benefits.” 
Id. at 9. In deciding in Section 108 to “not” treat a dis- 
charge of debts owed by an insolvent as “income,” 
Congress did not mean to provide additional tax bene- 
fits to the corporate shareholders in the manner pro- 
posed by petitioners; instead, Congress determined in 
Section 108(b) to reduce the preexisting tax carry- 
forwards available to the corporation that might yield 
“future tax benefits.” Pet. App. 9. The court concluded 
that petitioners’ interpretation of these statutes “would 
negate the effect of the tax attribution scheme and 

7 

would give [petitioners] an unwarranted windfall.” Id. 
at 16. 

DISCUSSION 

In Section 108 of the Internal Revenue Code, 
Congress specified that the discharge of a debt owed by 
an insolvent corporation does “not” constitute income to 
that corporation. The Tenth Circuit correctly held in 
this case that shareholders of an insolvent Subchapter S 
corporation may not treat the amount that is thus 
expressly “not” income as if it were an “item of income” 
which, under Section 1366, would increase the 
shareholders’ basis in the corporate stock and allow the 
deduction of otherwise nondeductible losses. The deci- 
sion in this case is supported by the recent decision of 
the Seventh Circuit in Witzel v. Commissioner, 200 
F.3d 496 (2000). But see note 7, infra. Both of these 
decisions, however, directly conflict with the decision of 
the Third Circuit in United States v. Farley, 202 F.3d 
198 (2000) (Pet. App. 92-124), which expressly declined 
to follow the decision in this case. See id. at 108-109 

n.4.3 
This direct and acknowledged conflict among the 
courts of appeals warrants review by this Court. The 
issue that has divided these courts has substantial 
administrative importance and is frequently the subject 
of audits and litigation. In addition to the three circuits 
that have already issued conflicting decisions, the same 
question presented in this case is already pending 
in three other circuits. See Friedman v. Commis- 
sioner, 75 T.C.M. (CCH) 2383 (1998), on appeal, No. 98- 
2378 (6th Cir.); Gaudiano v. Commissioner, 76 T.C.M. 

3 We intend to file a petition for a writ of certiorari in United 
States v. Farley, supra, suggesting that that case be held pending 
the Court’s disposition of this case. 

8 

(CCH) 858 (1998), on appeal, No. 99-1294 (6th Cir.); 
Pugh v. Commissioner, 77 T.C.M. (CCH) 1367 (1999), 
on appeal, No. 99-12646 (11th Cir.); Hogue v. United 
States, 2000-1 U.S. Tax Cas. (CCH) ¶ 50,149 (D. Ore. 
Jan. 3, 2000), on appeal, No. 00-35208 (9th Cir.); Eberle 

v. Commissioner, 78 T.C.M. (CCH) 366 (1999), on 
appeal, No. 00-70159 (9th Cir.). In addition, more than 
30 other cases raising this same issue are currently 
pending in Tax Court or in refund suits in federal dis- 
trict courts. These cases are appealable to the various 
circuits located throughout the Nation in which these 
taxpayers reside. See 26 U.S.C. 7482(b)(1)(A). 

Unless this clear and acknowledged conflict among 
the circuits is resolved by this Court, the taxation of 
shareholders of Subchapter S corporations will vary 
due to geographical happenstance, depending solely 
upon the circuit in which the taxpayer happens to 
reside. Review of this recurring issue by this Court is 
needed to avoid continuing uncertainty and inconsistent 
application of the revenue laws, and we therefore do not 
oppose the granting of the petition for a writ of 
certiorari in this case. 

1. Under Section 108(a)(1)(B) of the Code, the dis- 
charge of a debt owed by an insolvent taxpayer is “not” 
included in gross income to the extent of the insolvency. 
26 U.S.C. 108(a)(1)(B), (d)(3).4 As the result, that item 
is not treated as an “item of income” for any purpose, 
including for the basis adjustment purposes of Section 
1366. Instead of treating and taxing this as an “item of 
income,” the Code directs the taxpayer to use this 
excluded item to reduce (or eliminate) certain favorable 

4 Section 108 provides the same treatment for the discharge of 
a debt in a bankruptcy case and for the discharge of “qualified farm 
indebtedness.” 26 U.S.C. 108(a)(1)(A), (C). 

9 

“tax attributes” that the taxpayer could otherwise 
employ to reduce its taxable income in future years. 
26 U.S.C. 108(b)(1)-(2).5 Any debt discharge amount 
remaining after application against these favorable tax 
attributes is then to be “disregarded, i.e., does not 
result in income or have other tax consequences.” 

5 Under Section 108(b)(1), “[t]he amount excluded from gross 
income under * * * subsection (a)(1) shall be applied to reduce 
the tax attributes of the taxpayer as provided in paragraph (2).” 
26 U.S.C. 108(b)(1). Section 108(d)(7)(A) prescribes that, in the 
case of discharge of indebtedness by an S corporation, Sections 
108(a) and (b) “shall be applied at the corporate level.” 26 U.S.C. 
108(d)(7)(A). 

Under Section 108(b)(2), the amount excluded under Section 
108(a)(1) is generally applied to reduce the following tax attributes 
in the following order: (i) any net operating loss for the taxable 
year of the discharge and any net operating loss carryover to the 
taxable year of the discharge, (ii) a general business credit, (iii) 
capital loss carryovers, (iv) the basis of property of the taxpayer 
and (v) foreign credit tax carryovers. 26 U.S.C. 108(b)(2)(A)-(G). 
The reductions are dollar for dollar for net operating losses, capital 
loss carryovers and basis reduction, and 33.33 cents for each dollar 
excluded under Section 108(a) for the general business credit and 
foreign tax credit carryovers. 26 U.S.C. 108(b)(3)(A)-(B). Section 
108(d)(7)(B) defines an S corporation “net operating loss” for 
purposes of Section 108(b)(2)(A) as “any loss or deduction which is 
disallowed for the taxable year of the discharge under section 
1366(d)(1) * * *.” 26 U.S.C. 108(d)(7)(B). 

Under Section 108(b)(5), “[t]he taxpayer may elect to apply any 
portion of the reduction referred to in [Section 108(b)(1)] to the 
reduction under section 1017 of the basis of the depreciable prop- 
erty of the taxpayer.” Section 1017(a) provides that if a portion of 
the amount excluded under Section 108(a) is applied to reduce the 
taxpayer’s basis in depreciable property, “such portion shall be 
applied in reduction of the basis of any property held by the 
taxpayer at the beginning of the taxable year following the taxable 
year in which the discharge occurs.” 26 U.S.C. 1017(a)(2). 

10 

S. Rep. No. 1035, 96th Cong., 2d Sess. 2 (1980) 
(emphasis added). 

By thus using the amount of debt discharge excluded 
from treatment as “income” by the taxpayer’s insol- 
vency to reduce certain favorable tax attributes of the 
corporation, Congress sought to employ Section 108 as 
a tax-deferral, rather than tax-forgiveness, mechanism: 
the taxpayer avoids immediate payment of tax from the 
debt discharge, but pays increased taxes in future years 
as a result of the discharge. See S. Rep. No. 1035, 
supra, at 10 (“the rules of the bill are intended to carry 
out the Congressional intent of deferring, but eventu- 
ally collecting within a reasonable period, tax on ordi- 
nary income realized from debt discharge”). In United 
States v. Centennial Savings Bank, 499 U.S. 573, 580 
(1991), this Court similarly noted that the effect of the 
exclusion for the discharge of qualified business 
indebtedness under former Section 108(a)(1)(C) “is not 
genuinely to exempt such income from taxation, but 
rather to defer the payment of the tax by reducing the 
taxpayer’s annual depreciation deductions or by 
increasing the size of taxable gains upon ultimate 
disposition of the reduced-basis property.”6 

6 In United States v. Kirby Lumber Co., 284 U.S. 1 (1931), this 
Court held that a taxpayer realizes taxable income from the dis- 
charge of indebtedness. Other courts concluded, however, that the 
holding in Kirby Lumber did not apply to a taxpayer that was 
insolvent at the time its debts were discharged and remained 
insolvent after the discharge occurred. See, e.g., Dallas Transfer 
& Terminal Warehouse Co. v. Commissioner, 70 F.2d 95, 96 (5th 
Cir. 1934); Astoria Marine Construction Co. v. Commissioner, 
12 T.C. 798, 801 (1949) (collecting cases). Under these decisions, 
the discharge of indebtedness did not represent taxable income for 
the insolvent taxpayer and had no effect on any of the taxpayer’s 
tax attributes. 1 B. Bittker & L. Lokken, Federal Taxation of 
Income, Estates and Gifts ¶ 6.4.6, at 6-58 n.97 (2d ed. 1989). A 

11 

2. a. Section 1366(d)(1) limits the aggregate amount 
of an S corporation’s losses taken into account by a 
shareholder (under Section 1366(a)) to the sum of the 
shareholder’s adjusted basis in the stock of the corpora- 
tion plus his adjusted basis in any corporate debt owed 
to the shareholder. Losses that may not be deducted 
by the shareholder for this reason are described as 
“suspended” losses; they may be carried forward 

variety of statutory provisions have been enacted, however, to 
require offsetting adjustments of favorable tax attributes to reflect 
an insolvent’s discharge of indebtedness. 

The current statutory scheme was first enacted as part of the 
Bankruptcy Tax Act of 1980, Pub. L. No. 96-589, § 2, 94 Stat. 3389. 
See 1 B. Bittker & L. Lokken, Federal Taxation of Income, 
Estates and Gifts ¶ 7.6.3, at 7-58 (3d ed. 1999). The original pro- 
visions of Section 108 enacted in 1980, however, did not refer to S 
corporations. In the Subchapter S Revision Act of 1982, Pub. L. 
No. 97-354, § 3(e), 96 Stat. 1689, however, Congress amended 
Section 108(d)(6) to provide that, in the case of S corporations, the 
exclusion from gross income and the reduction in tax attributes 
were to occur at the shareholder, rather than corporate, level. Con- 
gress reversed itself on that issue, however, in 1984 by enacting 
Section 108(d)(7), which provides that, in the case of S corpora- 
tions, the exclusion and the attribute reduction are to take place at 
the corporate level, and that any (shareholder) loss disallowed for 
the year of the discharge under Section 1366(d)(1) is to be treated 
as a net operating loss for that year. Tax Reform Act of 1984, Pub. 
L. No. 98-369, § 721(b), 98 Stat. 966. The purpose of the 1984 
amendment is “to treat all shareholders in the same manner” (H.R. 
Rep. No. 432, 98th Cong., 1st Sess. 334 (1984)), and Congress envi- 
sioned that “the exclusion of income arising from discharge of 
indebtedness and the corresponding reductions in attributes (in- 
cluding losses which are not allowed by reason of any shareholder’s 
basis limitation) are made at the corporate level” (ibid.). Because 
the 1984 amendment “t[ook] effect as if included in the Subchapter 
S Revision Act of 1982” (§ 721(y)(1), 98 Stat. 972), the 1982 pro- 
visions that would have made the exclusion and attribute reduction 
operative at the shareholder level were never effective. 

12 

indefinitely and deducted in any subsequent year in 
which the shareholder increases his basis in the cor- 
poration’s stock or debt. 26 U.S.C. 1366(d)(2). 

A shareholder’s basis in stock of the corporation is 
increased by his pro rata share of the “items of income 
(including tax-exempt income)” of the corporation. 
26 U.S.C. 1366(a)(1)(A); see 26 U.S.C. 1367(a)(1)(A). 
Petitioners claim that the debt discharge, which is “not” 
income under Section 108(a), is nonetheless an “item of 
income” of the corporation which increases his basis and 
allows him to take deductions for losses “suspended” in 
a prior year because he had previously exhausted his 
basis by taking other loss deductions. 

The court of appeals correctly rejected that claim, not 
only because it conflicts with the plain language of 
these provisions but also because it would inappropri- 
ately provide petitioners with the “windfall” of a double 
tax benefit in a context where Congress plainly sought 
to limit the benefit, not double it. Pet. App. 10. 

Petitioners seek to characterize an item as “income” 
when Congress has instead specified that it is “not” 
income. Moreover, petitioners do so in an effort to 
double the benefit of the exclusion of this item from 
income, for they would use it to increase their ability to 
take additional, unrelated deductions. But Congress 
instead carefully specified in Section 108(b) that the 
benefit of the characterization of this item as “not” 
income is to be diminished, rather than amplified, by 
requiring the corporation to make compensating reduc- 
tions in its favorable tax attributes. See pages 8-9, 
supra. Petitioners’ contentions thus conflict with both 
the text and the obvious spirit of these provisions. 

b. In ruling in the taxpayer’s favor on this issue in 
United States v. Farley, supra, the Third Circuit did 
not dispute that the taxpayer’s position would result in 

13 

“an apparent ‘double tax benefit’ for S corporation 
shareholders.” Pet. App. 117. That court also acknowl- 
edged that there was strong evidence that the position 
argued by the taxpayer “may not have been the result 
intended by Congress.” Id. at 124 n.10. That court 
nonetheless concluded that “the clear and unambiguous 
language” of Section 1366 required it to rule in the 
taxpayer’s favor because, under that provision, “all 
income, tax-exempt or otherwise, passes through to the 
shareholders of an S corporation” and thereby “in- 
creases the shareholders’ basis in their S corporation 
stock” (Pet. App. 118, 124). 

In so holding, however, the Third Circuit failed to 
take into account (i) that the plain language of Section 
108(a) states that the discharge of indebtedness of an 
insolvent corporation is “not” income (26 U.S.C. 
108(a)(1)(B)); (ii) that Section 108(b) requires that item 
to be applied to reduce the favorable tax attributes of 
the corporation (26 U.S.C. 108(b)); and (iii) that any 
remaining balance of that item is then to be “disre- 
garded” and is not to be treated as “result[ing] in in- 
come or hav[ing] other tax consequences.” S. Rep. No. 
1035, supra, at 2.7 

7 Section 108(d)(7)(A) provides that, in cases involving insol- 
vent Subchapter S corporations, the amount excluded from the 
corporation’s gross income reduces the corporation’s tax attrib- 
utes at the corporate level. Those attributes include the corpora- 
tion’s net operating loss for the taxable year of the discharge. 
26 U.S.C. 108(b)(2)(A). Section 108(d)(7)(B) provides that an 
insolvent S corporation’s net operating loss for the taxable year of 
the discharge includes its shareholders’ suspended losses for that 
year under Section 1366(d)(1). Under these provisions, the amount 
excluded from the corporation’s gross income under Section 108 
remains at the corporate level in order to be available to reduce or 
eliminate the shareholders’ suspended losses; it does not pass 

14 

c. The Third Circuit also erred (Pet. App. 111 n.5, 
117) in equating the amount excluded under Section 108 
with “tax-exempt income,” which is encompassed with- 
in the items that may pass through to a shareholder and 
increase the basis of his stock under 26 U.S.C. 
1366(a)(1). Although “[t]here is no definition of ‘tax 
exempt’ for purposes of section 1366,” the term inher- 
ently signifies an item that is “exempt on a permanent 
basis.” Nelson v. Commissioner, 110 T.C. at 125. Thus, 
items of “tax exempt income” include items such as 
state and local bond interest and life insurance 
proceeds, which not only are “not” income in the year 
received (26 U.S.C. 101, 103) but which are not accom- 
panied with the offsetting reductions in tax attributes 
that make debt discharge income “subject to taxation in 
the future.” 110 T.C. at 125. As this Court explained in 
Centennial Savings Bank, because of the offsetting 
adjustments of tax attributes required for debt dis- 
charge items under Section 108, the result of the 

through to the shareholders to enable them to deduct those losses. 
Witzel, 200 F.3d at 497. 

In Witzel, the Seventh Circuit agreed with the Tenth Circuit in 
this case that the amount excluded under Section 108 remains at 
the corporate level and eliminates suspended shareholder losses 
for the taxable year of the discharge at that level. 200 F.3d at 497; 
see note 5, supra. The Seventh Circuit went on, however, in dicta, 
to state that the amount excluded from the corporation’s gross in- 
come increased the shareholder’s stock basis after eliminating his 
extant suspended losses. 200 F.3d at 497-498. That conclusion is 
incorrect. As the language of these provisions indicates, and as the 
legislative history expressly states, any amount remaining after 
application against the suspended losses “is disregarded, i.e., does 
not result in income or have other tax consequences.” S. Rep. No. 
1035, supra, at 2. 

15 

statute “is not genuinely to exempt such income from 
taxation * * * .” 499 U.S. at 580.8 

When permanently tax exempt items such as state 
and local bond interest (26 U.S.C. 103) and life insur- 
ance proceeds (26 U.S.C. 101) are received by a Sub- 
chapter S corporation and passed through to its share- 
holders under Section 1366(a)(1)(A) as “items of income 
(including tax-exempt income),” the shareholders re- 
ceive an upward basis adjustment (under Section 
1367(a)(1)(A)) that is offset by a corresponding down- 
ward basis adjustment (under Section 1367(a)(2)(A)) 
when such income is distributed to the shareholder. 26 
U.S.C. 1367(a)(2)(A). As the Tenth Circuit stated in 
this case (Pet. App. 8-9), the temporary basis increase 
of such “tax-exempt” items is necessary to preserve the 
tax-exempt character of the income at the shareholder 
level. In the absence of that basis increase, the 

8 On December 21, 1999, the Treasury Department promul- 
gated Treas. Reg. § 1.1366-1(a)(2)(viii), which specifies that income 
excluded under Section 108 is not tax-exempt income for purposes 
of Subchapter S, including the basis adjustment rules of Sections 
1366 and 1367. 64 Fed. Reg. 71,643 (1999). The regulation is 
effective for taxable years beginning on or after August 18, 1998. 
Treas. Reg. § 1.1366-5. 

This new regulation will not resolve the conflict that has devel- 
oped among the courts of appeals. In ruling against the Commis- 
sioner’s position in Farley, although the Third Circuit suggested 
(incorrectly) that its position was supported by the reference to 
“tax-exempt income” in Section 1366(a)(1)(A), the court ultimately 
concluded that “the nature of discharge of indebtedness income has 
little relevance” to this case for “[t]he statute is clear-–all income, 
tax-exempt or otherwise, passes through to the shareholders of an 
S corporation pursuant to § 1366(a)(1)(A).” Pet. App. 118. The 
court concluded that discharge of indebtedness is an “item[] of 
income” for purposes of Section 1366(a)(1) regardless whether it is 
viewed as a tax-exempt or tax-deferred item. Pet. App. 118. 

16 

shareholder would be subject to tax upon the distribu- 
tion of the “tax-exempt” items under Section 1368(b)(2) 
of the Code, which specifies that any distribution that 
exceeds a shareholder’s adjusted basis in stock is 
treated as gain from the sale or exchange of property. 
26 U.S.C. 1368(b)(2). By contrast, when debt is dis- 
charged, there is no distribution in cash or in kind to 
the debtor Subchapter S corporation, let alone the 
shareholder. An upward basis adjustment in this 
context would simply defeat the plain mandate of Con- 
gress that the discharge of indebtedness by an insol- 
vent corporation is “not” to be treated as “income” 
under the Code. 26 U.S.C. 108(a)(1)(B). 

d. Petitioners err in claiming that the “plain lan- 
guage” of Section 108(b)(4)(A) of the Code supports 
their position in this case (Pet. 13-24). Although the 
Tenth Circuit discussed that provision at some length in 
its opinion (Pet. App. 14-16), that statute has no bearing 
on the proper disposition of this case. 

Section 108(b)(4)(A) provides a rule with respect to 
the timing of the attribute reductions mandated by 
Section 108(b)(1)-(2). The statute provides that those 
reductions “shall be made after the determination of the 
tax imposed * * * for the taxable year of the dis- 
charge.” 26 U.S.C. 108(b)(4)(A). In practice, this means 
that the amount excluded under Section 108 is not 
taken into account by the insolvent taxpayer, and 
results in no reduction of its attributes, until after the 
tax for the year of the discharge is computed.9 

9 If the taxpayer elects under Section 108(b)(5) first to reduce 
its basis in depreciable property in lieu of reducing the attributes 
in the order prescribed by Section 108(b)(2) (see note 5, supra), the 
basis reduction takes effect under Section 1017 on the first day of 
the taxable year following the year of the discharge. The timing of 
the basis reduction in the event of this election was chosen “[i]n 

17 

The requirement that the reduction in tax attributes 
under Section 108(b) “shall be made after the deter- 
mination of the tax imposed by this chapter for the 
taxable year of the discharge” (26 U.S.C. 108(b)(4)(A)) 
applies at the corporate level, not to petitioners as 
shareholders of the corporation. 26 U.S.C. 108(d)(7)(A). 
By the express terms of the statute, nothing in Section 
108(b) addresses the question whether petitioners may 
take an amount that is “not” income under Section 
108(a) and treat it as an “item[] of income” for the 
entirely different purposes of Section 1366. Certainly, 
nothing in Section 108(b)(4)(A) can plausibly be said to 
be intended to place any taxpayer in a better position 
than he would have been in had the discharge of 
indebtedness never occurred. As the Tenth Circuit 
observed in this case, “[t]o embrace [petitioners’] posi- 
tion is to effectively eliminate the ‘price’ Congress 
imposed upon entities whose discharged debt income is 
excluded under § 108” (Pet. App. 13). 

3. Petitioners’ contention that they “seek equal 
treatment with other insolvent taxpayers” (Pet. 24) is 
without merit. The court of appeals properly noted that 
petitioners are in fact seeking a “windfall”; they are 
seeking to transmute Section 108 into a double tax 
benefit that would not be available to any taxpayer 
except a shareholder of an insolvent subchapter S 
corporation (Pet. App. 10). 

Petitioners also err in claiming (Pet. 25) that the 
“Tenth Circuit has unfairly denied any benefit flowing 
from the § 108(a) exclusion; it might as well have been 
taxable income.” Petitioners have benefitted from Sec- 

order to avoid interaction between basis reduction and reduction of 
other attributes * * * .” H.R. Rep. No. 833, 96th Cong., 2d Sess. 
11 (1980); S. Rep. No. 1035, supra, at 14. 

18 

tion 108 because they did not pay any tax, and recog- 
nized no “income,” on the occasion of discharge of 
indebtedness of the insolvent subchapter S corporation. 
The decision in this case merely denies petitioners the 
double tax benefit that they erroneously seek. 

10 

CONCLUSION 

The petition for certiorari should be granted. 

Respectfully submitted. 

SETH P. WAXMAN 

Solicitor General 

PAULA M. JUNGHANS 

Acting Assistant Attorney 

General 

LAWRENCE G. WALLACE 

Deputy Solicitor General 

KENT L. JONES 

Assistant to the Solicitor 

General 

TERESA E. MCLAUGHLIN 
EDWARD T. PERELMUTER 

Attorneys 

MARCH 2000 

10 Petitioners erroneously assert (Pet. 7) that the decision in this 
case conflicts with the decision in CSI Hydrostatic Testers v. 
Commissioner, 103 T.C. 398 (1994), aff ’d per curiam, 62 F.3d 136 
(5th Cir. 1995). As the Tenth Circuit correctly explained (Pet. 
App. 19-20), the decision in CSI did not involve Subchapter S cor- 
porations and has no relevance to this case. Instead, that case 
concerned whether the amount excluded under Section 108 is 
includable in a Subchapter C corporation’s subsidiary’s earnings 
and profits for purposes of the consolidated return regulations 
rules concerning investment basis adjustment under Section 1502. 
That case involves entirely different statutory provisions and fur- 
nishes no support for the proposition advocated by petitioners in 
this case. 

19