The opinion
PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
______
No. 13-2247
______
R BALL FOR R BALL III BY APPT
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17593)
_____________
R BALL CHILDREN TRUST 9/9/1969
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17594)
_____________
ETHEL BALL FOR R BALL III APT 2/9/1967
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17595)
_____________
ETHEL BALL FOR A L BALL AS APPT
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17596)
_____________
R BALL JR. CHILDRENTRUST 1/29/1970
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17597)
_____________
R BALL JR. F/B/O R BALL III 12/22/1976
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17598)
_____________
R BALL FOR A L BALL BY APPT
v.
2
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17599)
_____________
R BALL CHILDREN TRUST 1/24/1973
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17600)
_____________
RUSSELL BALL JR SEC FIRST 9/9/1967
v.
COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 11-17601)
_____________
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 JR. CHILDRENTRUST 1/29/1970; R BALL JR.
F/B/O R BALL III 12/22/1976; R BALL FOR A L BALL BY
APPT; R BALL CHILDREN TRUST 1/24/1973; RUSSELL
BALL JR SEC FIRST 9/9/1967,
Appellants
______
3
On Appeal from the United States Tax Court
(Tax Court Nos. 17593-11, 17594-11, 17595-11, 17596-11,
17597-11, 17598-11,
17599-11, 17600-11, 17601-11)
Tax Court Judge: Honorable Kathleen Kerrigan
______
Argued: December 17, 2013
Before: JORDAN, VANASKIE, and VAN ANTWERPEN,
Circuit Judges.
(Filed: February 12, 2014)
Nancy Winkelman, Esq. [ARGUED]
Timothy K. Lewis, Esq.
Schnader Harrison Segal & Lewis LLP
1600 Market Street, Suite 3600
Philadelphia, PA 19103
Attorneys for Appellants
Francesca Ugolini, Esq. [ARGUED]
Richard Farber, Esq.
Kathryn Keneally, Esq.
United States Department of Justice, Tax Division
P.O. Box 502
Washington, D.C. 20044
Attorneys for Appellee
______
OPINION OF THE COURT
______
4
VAN ANTWERPEN, Circuit Judge.
I. INTRODUCTION
An S corporation (“S Corp.”) is a small business
corporation that is permitted to have its corporate income,
losses, deductions, and credits attributed to its shareholders.
This appeal arises out of nine consolidated cases before the
United States Tax Court regarding the tax implications of an
S Corp.’s election to treat its subsidiary as a “qualified
subchapter S subsidiary” (“Qsub”) under Internal Revenue
Code § 1361.1 Specifically, the parties disagree as to whether
the Qsub election and subsequent sale of the S Corp. parent
creates an “item of income” under § 1366(a)(1)(A)2 thereby
1
26 U.S.C. § 1361. All statutory citations refer to the Internal
Revenue Code unless otherwise noted.
2
The relevant portion stating:
In determining the tax under this chapter of a
shareholder for the shareholder’s taxable year in
which the taxable year of the S corporation ends
(or for the final taxable year of a shareholder who
dies, or of a trust or estate which terminates,
before the end of the corporation’s taxable year),
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 . . . .
5
requiring the parties who held stock in the parent S Corp. to
adjust their bases in stock under § 1367(a)(1)(A).3 For
reasons which follow, we affirm the decision of the Tax
Court, finding an increase in stock bases and declared losses
to be improper.
II. FACTS
In June 1997, ten trusts for the benefit of the Ball
family (“Trusts”)4 acquired direct ownership of all shares of
26 U.S.C. § 1366(a)(1)(A).
3
“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) . . . .” Id. § 1367(a)(1)(A).
4
The named Trusts are nine of ten total trusts: 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 Jr. F/B/O R. Ball III 12/22/1976; R. Ball for A.
L. Ball By Appt.; R Ball Jr. Children Trust 1/29/1970; R. Ball
For Children Trust 1/24/1973; Russell Ball Jr. Sec. First
9/9/1967. The tenth trust has a related case stayed in the
United States District Court for the Eastern District of
Pennsylvania pending this appeal. See R. Ball, Jr. For A. L.
Ball Trust, December 22, 1976 v. United States, 2:12-cv-921
(E.D. Pa. Feb. 22, 2012). For purposes of this appeal, the term
“Trusts” will include the tenth trust, though not a party,
except that, in section V of this opinion, our use of the term
generally refers only to the nine Appellants.
6
American Insurance Service, Inc. (“AIS”)5 with an aggregate
basis in AIS stock totaling $5,612,555. In 1999, the Trusts
formed Wind River Investment Corporation (“Wind River”),
a Delaware corporation. The Trusts then contributed their
shares in AIS in exchange for all of the shares of Wind River.
This resulted in Wind River owning all of the shares of AIS.
Effective June 4, 1999, Wind River designated itself a
subchapter S Corporation. On February 28, 2003, Wind River
elected to treat AIS as a Qsub under § 1361(b)(3).6 Prior to
the Qsub election, the Trusts’ aggregate adjusted basis in the
Wind River stock was $15,246,099. Following the Qsub
election, the Trusts increased their bases in the Wind River
stock from $15,246,099 to a new basis of $242,481,544.7
5
AIS is a Pennsylvania corporation. Although it became a
subsidiary of Wind River, AIS was also the parent company
of a group of insurance-affiliated corporations. Prior to
acquiring direct ownership of all AIS shares, the Trusts had
previously indirectly owned shares in AIS.
6
26 U.S.C. § 1361(b)(3). A Qsub is a wholly owned
subsidiary of a parent S Corp., and as such, “all assets,
liabilities, and items of income, deduction, and credit of a
qualified subchapter S subsidiary shall be treated as assets,
liabilities, and such items (as the case may be) of the S
corporation.” Id. § (b)(3)(A)(ii).
7
The fair market value of AIS’s assets at the time it was
absorbed by Wind River was $232,848,000 and by
subtracting the prior aggregate basis of AIS stock of
$5,612,555, an increase of $227,235,445 results. When this
increase is added to the prior basis of $15,246,099, a new
basis of $242,481,544 is arrived at for Wind River. This basis
increase and its tax consequences are the subject of this
appeal.
7
Following the Qsub election and stock basis
adjustments, the Trusts sold their interests in Wind River to a
third party, Fox Paine, on September 5, 2003. After
transaction costs, this sale yielded $230,111,857 in cash and
securities in exchange for all of the Wind River stock.8 Even
though they had received $230,111,857 from the sale, the
Trusts claimed a loss in the amount of $12,247,229.9 This was
calculated as the difference between the amount actually
received for the sale and the new basis in the Wind River
stock. The Trusts shareholders’ 2003 tax returns were filed
citing the aforementioned capital loss.
The Internal Revenue Service (“IRS”) determined the
Trusts should not have increased their bases in the Wind
River stock to $242,481,544 following the Qsub election. The
IRS determined instead that a capital gain of approximately
$214 million had been realized from the sale of Wind River to
Fox Paine. This resulted in a cumulative tax deficiency of
$33,747,858 for the nine trusts that have filed appeals in this
case. Deficiency notices were sent to the Trusts on May 18
and 19, 2011, stating “the Qsub election and the resulting
8
The amount received individually by the Trusts was divided
based on percentage of ownership.
9
The figures stated for the new basis, sale proceeds, and tax
loss are totals for all ten trusts. As mentioned above, only
nine trusts are parties to this suit and, accordingly, the actual
figures for the new basis and stock sale proceeds are
somewhat less, being approximately $240,080,978 for the
new basis and $227,833,750 for the sale proceeds.
Subtracting one from the other yields the loss of $12,247,228.
8
deemed I.R.C. § 332[10] liquidation did not give rise to an item
of income under I.R.C. § 1366(a)(1)(A); therefore, [the
Trusts] could not increase the basis of their [Wind River]
stock under I.R.C. [§] 1367(a)(1)(A).” (Appendix (“App.”) at
A373.) The Trusts filed petitions with the United States Tax
Court seeking a redetermination of deficiencies under the
jurisdiction of §§ 6213(a) and 7442. The cases were
consolidated and submitted for decision on stipulated facts,
under Tax Court Rule 122,11 as R. Ball for R. Ball III By
Appt., et al. v. Commissioner, 105 T.C.M. (CCH) 1257, 2013
WL 452722 (2013). As previously noted, the Tax Court found
the increase in stock basis and declared loss to be improper.
III. TAX COURT PROCEEDINGS
The main issue before the Tax Court and now on
appeal is whether or not a Qsub election creates an “item of
income” for the parent corporation under § 1366(a)(1)(A).
The Trusts relied on their assertion that the election “resulted
in a gain derived from dealings in property and, therefore,
10
26 U.S.C. § 332. § 332 governs the liquidation of a wholly-
owned subsidiary into its parent corporation. “(a) General
rule.--No gain or loss shall be recognized on the receipt by a
corporation of property distributed in complete liquidation of
another corporation.” Id.
11
“Any case not requiring a trial for the submission of
evidence (as, for example, where sufficient facts have been
admitted [or] stipulated . . .) may be submitted at any time
after joinder of issue (see Rule 38) by motion of the parties
filed with the Court.” T.C. Rule 122(a).
9
created an item of income under § 61(a).”12 R. Ball, 2013 WL
452722, at *4. If the election resulted in an “item of income,”
the new higher bases and resulting tax losses are proper. If it
did not result in an “item of income,” the increase in stock
bases and declared tax losses are improper.
More specifically, before the Tax Court, the Trusts
argued that the deemed liquidation of AIS was, under § 331, a
sale or exchange of property creating a realized gain to Wind
River. They further claimed that gains from dealings in
property are expressly included in gross income under §
61(a). They then contended that, although § 332 provides for
the nonrecognition of that gain, it was still “an item of income
(including tax exempt income)” under § 1366(a)(1)(A), which
passed through to them and increased their bases in Wind
River stock under § 1367(a)(1)(A). To support their position,
the Trusts raised several contentions to the Commissioner’s
deficiency finding: (1) their bases were properly adjusted
pursuant to § 1367(a)(1)(A), (2) the losses were properly
claimed from the sale of Wind River, and (3) “the Qsub
election resulted in an item of income pursuant to [§]
1366(a)(1)(A).” See R. Ball, 2013 WL 452722, at *4. Lastly,
the Trusts cited United States v. Farley13 and Gitlitz v.
Commissioner,14 arguing that the “realized” liquidation gain
under §§ 331 and 61(a)(3), allowed an increase in basis, but
12
The relevant sections state: “[e]xcept as otherwise provided
in this subtitle, gross income means all income from whatever
source derived, including (but not limited to) the following
items: . . . (3) Gains derived from dealings in property. . . .”
26 U.S.C. § 61(a)(3).
13
202 F.3d 198 (3d Cir. 2000).
14
531 U.S. 206 (2001).
10
that gain is not taxable under the non-recognition provision of
§ 332(a). The Commissioner responded to the Trusts’
arguments by asserting that the Qsub election did not create
an “item of income (including tax exempt income)” under §
1366(a)(1)(A).
The Tax Court rejected the Trusts’ arguments, relying
on the differences between “realization” and “recognition” of
income in determining what constitutes an “item of income”
under § 1366 as it relates to §§ 1367, 331, 332, and 61(a). R.
Ball, 2013 WL 452772, at *4-5 (2013). The Tax Court held
that gain from a Qsub election is “realized” and calculated
under § 1001,15 yet it is not “recognized” due to the non-
recognition provision of § 332. Id. (“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.”). Furthermore, the Court found,
under § 1366, that when a gain is unrecognized, it “does not
rise to the level of income” and is not an “item of income for
tax purposes.”16 Id. at *7. Finally, the Court distinguished
Gitlitz and Farley and determined that “neither case is
squarely on point.” R. Ball, 2013 WL 452722, at *8. The
Court reasoned that Gitlitz and Farley only established that
the nature of “discharge of indebtedness” as income is not
affected by an exclusion elsewhere in the Code. See id. Here,
15
“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.” §
1001(b).
16
In addition the Tax Court found no cases in which a Qsub
election created an item of income for the parent S Corp. R.
Ball, 2013 WL 452722, at *4.
11
however, “realized gain from the Qsub election was never
included explicitly in gross income and was never excluded
from gross income.” Id. Therefore, the Tax Court determined
Gitlitz and Farley were unpersuasive in qualifying the Qsub
election as an “item of income” under § 1366. 17 Id.
In sum, the Court held that “unrecognized gain
resulting from the Qsub election did not create an item of
income or tax exempt income pursuant to
section1366(a)(1)(A).” Id. at *10. Accordingly, the Trusts
were found deficient for improperly adjusting their bases in
Wind River stock following the Qsub election and this appeal
followed. Id..
IV. JURISDICTION
Section 7482(a) provides exclusive jurisdiction by this
Court over decisions before the United States Tax Court. Our
review of the Tax Court’s construction of the Internal
Revenue Code is plenary. Nat’l Starch & Chem. Corp. v.
Comm’r, 918 F.2d 426, 428 (3d Cir. 1990).
V. DISCUSSION
A. Items of Income
As previously noted, the main issue before us is
whether or not the Qsub election created an “item of income.”
17
The Court also noted that the cases have since been
overridden by Congressional action amending 26 U.S.C. §
108(d)(7)(A). Id. at *8; see also Job Creation and Worker
Assistance Act of 2002, Pub.L. No. 107-147, 116 Stat. at 40.
12
An “item of income” is required for a shareholder of an S
Corp. to increase the basis in his or her of the S Corp.. See §
1366(a)(1)(A).18 Despite use of the term “item of income” in
§ 1366, it is not defined in the Internal Revenue Code and the
Treasury regulations provide only guidance.19 See 26 C.F.R. §
18
“To prevent double taxation of income upon distribution
from the corporation to the shareholders, § 1367(a)(1)(A)
permits shareholders to increase their corporate bases by
items of income identified in § 1366(a).” Gitlitz, 531 U.S. at
209.
19
The separately stated items [of income] of the S
corporation include, but are not limited to, the following
items—
(i) The corporation’s combined net amount of
gains and losses from sales or exchanges of capital
assets . . .
(ii) The corporation’s combined net amount of
gains and losses from sales or exchanges of
property . . .
(iii) Charitable contributions . . .
(vi) Each of the corporation’s separate items of
gains and losses from wagering transactions
(section 165(d)); soil and water conservation
expenditures (section 175); deduction under an
election to expense certain depreciable business
expenses (section 179); medical, dental, etc.,
expenses (section 213) . . .
....
(vii) Any of the corporation’s items of portfolio
income or loss, and expenses related thereto . . .
13
1.1366-1(a)(2); see also Comm’r v. Glenshaw Glass Co., 348
U.S. 426 (1955). “Gross income,” however, is defined. It is
governed by § 61, and includes “[g]ains derived from
dealings in property,” as well as “[i]ncome from discharge of
indebtedness.”20 Id. § 61(a)(3), (12). Further, the Supreme
Court has defined “gross income” as “accessions to wealth,
clearly realized, and over which the taxpayers have complete
dominion.” Glenshaw Glass, 348 U.S. at 431. Gains derived
from the property obtained by electing and liquidating the
Qsub are claimed by the Trusts to be “items of income” for
(viii) The corporation’s tax-exempt income. For
purposes of subchapter S, tax-exempt income is
income that is permanently excludible from gross
income in all circumstances in which the
applicable provision of the Internal Revenue Code
applies . . . .
26 C.F.R. § 1.1366-1(a)(2).
20
Other gross income measurements are:
Compensation for services, including fees,
commissions, fringe benefits, and similar items;
Gross income derived from business; Interest;
Rents; Royalties; Dividends; Alimony and
separate maintenance payments; Annuities;
Income from life insurance and endowment
contracts; Pensions; Income from discharge of
indebtedness; Distributive share of partnership
gross income; Income in respect of a decedent; and
Income from an interest in an estate or trust.
26 U.S.C. § 61(a).
14
the purpose of § 1366. Fundamentally, the Trusts claim
there was a gain from liquidation (§ 61(a)), that gain was
“realized” (§ 331) and calculated (§ 1001), and thus is an
“item of income” (§ 1366). (Appellant Br. at 17.) The Trusts
summarily dismiss the effect of non-recognition on whether a
gain is income; however, this premise is undermined by
regulations corresponding to § 61(a).21 Under the § 61(a)
Treasury Regulations, gains from the sale or exchange of
property, including those derived under § 331, are not
“recognized,” and thus “not included in or deducted from
gross income at the time the transaction occurs.”22 26 C.F.R.
§ 1.61-6(b)(1).
While “item of income” is a broad and undefined term,
it is not one without limits. § 61(a) provides a “broad
definition of ‘gross income,’” that is “sweeping [in] scope,”
unless “excepted by another provision in the tax code.”
Comm’r v. Schleier, 515 U.S. 323, 328-29 (1995). The
Supreme Court concluded that “income” requires an
21
The Trusts state, “[i]n sum, that realized gain is not
recognized does not alter the fact that the realized gain is
income . . . .” (Appellant Br. at 18.)
22
Appellants assert that the quoted language from 26 C.F.R.
1.61 -6(b)(1) only addresses issues of timing, namely that
realized but unrecognized gain is not taken into account when
the transaction occurs. They support that assertion with
examples of income defined under subsections of § 61(a) but
then subject to nonrecognition treatment elsewhere. Those
examples are distinguishable from the gains at issue here
because the examples of income are expressly provided for
under § 61(a) and are not analogous to the unique treatment
of Qsub liquidations under the Code.
15
“accession to wealth.” Glenshaw Glass, 348 U.S. at 431. The
Qsub election did not add wealth, it merely changed the tax
treatment of the income flowing from the Qsub. This
reformation by liquidation did not provide an “accession to
wealth” for the corporation and therefore could not create
“income” for the Trusts.
B. Realization and Recognition of Gains
The Internal Revenue Code
defers the tax consequences of a gain or loss in
property value until the taxpayer ‘realizes’ the gain
or loss. The realization requirement is implicit in §
1001(a) of the Code, which defines ‘[t]he gain [or
loss] from the sale or other disposition of property’
as the difference between ‘the amount realized’
from the sale or disposition of the property and its
‘adjusted basis.’
Cottage Sav. Ass’n v. Comm’r, 499 U.S. 554, 559 (1991)
(quoting 26 U.S.C. § 1001(a-b)). “To realize a gain or loss in
the value of property, the taxpayer must engage in a ‘sale or
other disposition of [the] property.’” Id. (quoting § 1001(a)).
The Commissioner and the Trusts differ as to whether
“realizing” a gain is enough to create an “item of income”
under § 1366, or whether this section requires the gain to be
“recognized.” The Tax Court concluded that “nonrecognition
provisions prevent realized gain from being included in a
taxpayer’s gross income.” R. Ball, 2013 WL 452722, at *5.
The Trusts contend that the Tax Court “confused the concepts
of realization and recognition.” (Appellants’ Opening Br. at
14.) They argue that the Tax Court reached the
16
“unprecedented conclusion that because ‘no gain was
recognized, . . . the unrecognized gain did not create an item
of income under § 61(a)(3),’ or § 1355(a)(1)(A).” (Id. at 15
(quoting App. at 24.) The Trusts assert that the “crux of the
Tax Court’s error” is its determination that “unrecognized
gain does not rise to the level of income.” (Id.) They argue
that the Code cannot be parsed to create some realized gain
that is income and some realized gain that, by virtue of
nonrecognition, is not. According to the Trusts, realized gain
is always income, a categorization that does not change if that
realized gain is then unrecognized.
Inherent in this conflict is which statutory provision,
§§ 331 or 332, applies to the liquidation of AIS via Qsub
election. Section 331, governing “gain or loss to shareholders
in corporate liquidations,” states “[a]mounts 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.” The payment via liquidation is realized and
calculated by adding “any money received plus the fair
market value of the property (other than money) received.” 26
U.S.C. § 1001(b). At this point, the Trusts argue that the
realized gain becomes an “item of income” by way of §
61(a)(3) and the Supreme Court’s holding in Gitlitz. Id. §
61(a)(3) (“[G]ross income means all income from whatever
source derived, including . . . [g]ains derived from dealings in
property . . . .”); 531 U.S. at 213. The Trusts argue § 331
applies to “realize” the gain. The Trusts claim the gain is
defined in § 61(a) and that it is then calculated under §
1001(a). The Trusts deem § 332’s non-recognition provision
to apply only after realization under § 331, without effect on
whether the gain is an “item of income.” 26 U.S.C. § 331.
The Trusts position is that this realized but unrecognized gain
17
is considered an “item of income” and they are permitted to
increase their bases in their Wind River stock.
In contrast, the Commissioner claims the gain must
first be “recognized” to qualify as an “item of income,” and
the gain in this case is not recognized due to § 332’s non-
recognition provision. Section 332 governs “complete
liquidations of subsidiaries.” Id. § 332 (emphasis added). An
S Corp. may elect Qsub status for its subsidiary if “(1) the [S
Corp.] parent holds 100 percent of the subsidiary’s stock, (2)
the subsidiary is otherwise eligible to qualify as an [S Corp.]
on its own, but for the fact that it has a corporate shareholder,
and (3) the [S Corp.] parent makes the appropriate election . .
. .” In re Majestic Star Casino, LLC, 716 F.3d 736, 743 n.6
(2013) After a Qsub election, for tax purposes, “the
subsidiary is deemed to have liquidated into the parent under
I.R.C. §§ 332 and 337.” 26 C.F.R. § 1.1361-4 (2012). Thus,
“[a] Qsub does not even exist for federal tax purposes.”
Majestic Star Casino, 716 F.3d at 759. Section 332 then states
“[n]o gain or loss shall be recognized on the receipt by a
corporation of property distributed in complete liquidation of
another corporation.” 26 U.S.C. § 332(a) (emphasis added);
see also § 337(a) (“No gain or loss shall be recognized to the
liquidating corporation on the distribution to the 80-percent
distributee of any property in a complete liquidation to which
section 332 applies.”).
18
The Treasury Regulations further distinguish between
§§ 331 and 332.23 “Section 332 applies only to those cases in
which the recipient corporation receives at least partial
payment for the stock which it owns in the liquidating
corporation.”24 26 C.F.R. § 1.332-2(b).
23
The relevant distinguishing language states:
Under the general rule prescribed by section 331
for the treatment of distributions in liquidation of a
corporation, amounts received by one corporation
in complete liquidation of another corporation are
treated as in full payment in exchange for stock in
such other corporation, and gain or loss from the
receipt of such amounts is to be determined as
provided in section 1001. Section 332 excepts
from the general rule property received, under
certain specifically described circumstances, by
one corporation as a distribution in complete
liquidation of the stock of another corporation and
provides for the nonrecognition of gain or loss in
those cases which meet the statutory requirements.
26 C.F.R. § 1.332-1.
24
The regulations further state:
The nonrecognition of gain or loss is limited to the
receipt of such property by a corporation which is
the actual owner of stock (in the liquidating
corporation) possessing at least 80 percent of the
total combined voting power of all classes of stock
entitled to vote and the owner of at least 80
percent of the total number of shares of all other
19
Ultimately, the Tax Court rejected the Trusts’
arguments under § 331, specifically noting that § 332, which
governs the liquidation of a subsidiary of which the parent
corporation owns eighty percent or more, applies here, not §
331, which governs “all other liquidations.” R. Ball, 2013
WL 452722, at *6. The Court held that a liquidation cannot
be governed by both § 331 and § 332, thereby foreclosing the
Trusts’ argument that the gain was first realized under § 331
and then subject to nonrecognition treatment under § 332.
The Tax Court is correct. The Trusts fail to address the
fact that § 332, by its plain text, applies to a special set of
liquidations that are treated under a different statutory scheme
and do not create “items of income.” Under the Internal
Revenue Code, a Qsub election results in a § 332 liquidation.
See 26 C.F.R. § 1.1361-4 (providing that a Qsub election is a
classes of stock (except nonvoting stock which is
limited and preferred as to dividends). The
recipient corporation must have been the owner of
the specified amount of such stock on the date of
the adoption of the plan of liquidation and have
continued so to be at all times until the receipt of
the property. If the recipient corporation does not
continue qualified with respect to the ownership of
stock of the liquidating corporation and if the
failure to continue qualified occurs at any time
prior to the completion of the transfer of all the
property, the provisions for the nonrecognition of
gain or loss do not apply to any distribution
received under the plan.
26 C.F.R. § 1.332-2(a).
20
deemed liquidation into the parent corporation); 26 U.S.C. §
332 (covering the complete liquidation of a wholly owned
subsidiary). Section 332 applies to the liquidation of a
“controlled subsidiary” into its parent. Boris I. Bittker &
James S. Eustice, Federal Income Taxation of Corporations
& Shareholders ¶ 10.20 (7th ed. 2006). A Qsub is a wholly
owned subsidiary under § 1361(b)(3)(B)(i) (“[one hundred]
percent of the stock of such corporation is held by the S
corporation.”).
The Trusts argue that § 332(d) (“Recognition of gain
on liquidation of certain holding companies”) provides that
“subsection (a) and section 331 shall not apply to such
distribution.” 26 U.S.C § 332(d)(1)(A). This, according to
them, is proof that the sections are not mutually exclusive,
because, if they were, there would be no need for the
exception. That subsection, however, does not affect the
analysis of a Qsub liquidation at issue here. Instead, it
focuses on “distribution[s] to foreign corporation in complete
liquidation of an applicable holding company.” Id. It is not
incongruous to say that a Qsub liquidation, governed by §
1361, is only covered by § 332 but that other liquidations,
covered by other sections of the Code, may be covered by
both § 332 and § 331. Rather, the complexities of
intersecting provisions should be maintained. The tax treatise
cited by both parties states that § 332 is an “important
exception” to the general rule provided in § 331. Bittker &
Eustice ¶ 10.20. As such, a liquidation is either governed by
the general rule in § 331, or it is covered by the exception in §
332. As the Tax Court correctly held, “[a] liquidation cannot
be governed by both.” R. Ball, 2013 WL 452722, at *6.
C. Gitlitz and Farley
21
The Trusts contend, however, regardless of “whether
or not Sections 331 and 332 are viewed as separate corporate
liquidation schemes does not alter the result.” (Appellants’
Opening Br. at 42.) Rather, the results of Gitlitz and Farley
and the treatment of gains as income under § 61(a) are
dispositive.
The Trusts rely on the holdings of Gitlitz and Farley,
allowing a discharge of indebtedness to pass through to
shareholders as an “item of income,” as justification for their
own “items of income” argument.25 Specifically, the Trusts
argue that an “item of income” may be defined as gross
income under one provision of the Code, yet not recognized
under another provision, and still remain an “item of income”
for the purpose of § 1366. In Gitlitz, petitioners were
shareholders of an insolvent S corporation, which realized
over two million dollars of discharge of indebtedness income
in 1991. 531 U.S. at 208. Even after the discharge of
indebtedness income, the S Corp. was still insolvent and so
the entire discharge of indebtedness was excluded from gross
income under §§ 108(a) and 108(d)(7)(A). Id. at 209-10. On
their tax returns, the Gitlitz petitioners increased their bases in
the S corp.’s stock by their pro rata share of the discharge of
indebtedness income under the theory that the discharge of
indebtedness income was an “item of income” that was
passed through to the taxpayers under § 1366(a)(1)(A). Id. at
210. The petitioners in Gitlitz then used the increased bases
to deduct their total losses. Id. The Supreme Court agreed,
finding “[that] section [1366] is worded broadly enough to
include any item of income, even tax-deferred income, that
25
The Trusts state “[t]his case falls squarely within Gitlitz
and Farley.” (Reply Brief at 9.)
22
‘could affect the liability for tax of any shareholder.’” Id. at
216 (quoting § 1366(a)(1)(A)).
This Circuit in Farley issued a similar, and even more
expanded, holding. 202 F.3d at 206.
We hold that because the controlling statutes
clearly provide that tax attribute reduction takes
place after income has passed through the S
corporation to its shareholders (pass through being
a necessary prerequisite to “determin[ing] the tax
imposed by this chapter for the taxable year of
discharge”), in the case of an insolvent S
corporation, discharge of indebtedness income that
is excluded from gross income by section 108(a),
passes through to the shareholders, increases the
shareholder's basis in their S corporation stock,
thus allowing the shareholders to take deductions
for S corporation losses suspended under section
1366(d)(1).
Id. The Supreme Court in Gitlitz acknowledged that all “items
of income” need not qualify as gross income and the
indebtedness in Gitlitz still was “income” as included under §
61(a)(12). Id. at 213. In contrast to Gitlitz, a similar inclusion
under § 61(a) is not present in the “gain” in the appeal before
us. See Nathel v. Comm’r, 615 F.3d 83, 91 (2d Cir. 2010)
(“The argument ignores the crucial difference between Gitlitz
and this case: Gitlitz addressed payments that explicitly were
included in gross income under § 61(a).”). Rather, the “gain”
under § 61(a) is not recognized nor is it income, and thus it
cannot be an “item of income.”
23
The Tax Court noted that any conclusion other than a
holding that “unrecognized gain from a Qsub election does
not constitute an item of income or tax-exempt income under
§ 1366(a)(1)(A),” would lead to “absurd results” and “open
the door to a myriad of abusive transactions.” R. Ball, 2013
WL 452722, at *9-10. The Supreme Court in Gitlitz,
however, refused to address this policy argument when the
text of the Code was clear. Gitlitz, 531 U.S. at 220 (“Because
the Code’s plain text permits the taxpayers here to receive
these benefits, we need not address this policy concern.”).
Although statutory text cannot be read in a way that creates
an absurdity, the payment of some taxes and not others is not
an absurdity, but rather a policy choice rightly left to
Congress. Id. Indeed, Congress, subsequent to Gitlitz, made
changes to the statute at issue in that case to prevent further
uses of the tax code loophole.26
26
See supra note 17. “As a general matter, the Committee
believes 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.” H.R. Rep.
No. 107-251, at 52 (2002). Congress provides a further
illustration of why the change, similar to issues presented on
appeal.
24
Interconnecting these regulations demonstrates that the
gain is not recognized and under the definition of the
Supreme Court is not income, and therefore if not income,
cannot be deemed an “item of income” under § 1366. In sum,
the S Corp. shareholders could not increase their bases under
§ 1367. The Trusts fail to cite any authority for the
alternative.
For the foregoing reasons, we will affirm the Order of
the Tax Court.
To illustrate these rules, assume that a sole
shareholder of an S corporation has zero basis in
its stock of the corporation. The S corporation
borrows $100 from a third party and loses the
entire $100. Because the shareholder has no basis
in its stock, the $100 loss is “suspended” at the
corporate level. If the $100 debt is forgiven when
the corporation is in bankruptcy or is insolvent, the
$100 income from the discharge of indebtedness is
excluded from income, and the $100 “suspended”
loss should be eliminated in order to achieve a tax
result that is consistent with the economics of the
transactions in that the shareholder has no
economic gain or loss from these transactions.
Id.
25