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00-242

In the Supreme Court of the United States

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

v.

JAMES H. PUGH, JR. AND ALEXIS PUGH

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

PETITION FOR A WRIT OF CERTIORARI

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
EDWARD T. PERELMUTER
PAULA K. SPECK
Attorneys
Department of Justice
Washington, D.C. 20530-0001
(202) 514-2217

 

 

QUESTION PRESENTED

Respondent James D. Pugh, Jr. was a shareholder in an insolvent subchapter S corporation. During 1990, 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 expressly "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 respondent as the shareholder of the Subchapter S corporation, thereby increasing his basis in its stock under 26 U.S.C. 1367(a)(1)(A), and thereby allowing him to report a larger tax loss than he otherwise could have reported after the stock of the corporation became worthless.

 

 

In the Supreme Court of the United States

 

No. 00-242

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

v.

JAMES H. PUGH, JR. AND ALEXIS PUGH

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

PETITION FOR A WRIT OF CERTIORARI

The Solicitor General, on behalf of the United States of America, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Eleventh Circuit in this case.

OPINIONS BELOW

The opinion of the court of appeals (App., infra, 1a-17a) is reported at 213 F.3d 1324. The opinion of the Tax Court (App., infra, 18a-23a) is unofficially reported at 77 T.C.M. (CCH) 1367.

JURISDICTION

The judgment of the court of appeals was entered on June 5, 2000. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1).

STATUTORY PROVISIONS INVOLVED

The relevant provisions of Sections 108, 1366 and 1367 of the Internal Revenue Code, 26 U.S.C. 108, 1366, 1367, are set forth in the Appendix, infra, 24a-31a.

STATEMENT

1. a. In 1990, respondent James H. Pugh, Jr. owned 97 percent of the stock of Epoch Capital Corporation (ECC), a corporation that had elected to be taxed under the provisions of Subchapter S of the Internal Revenue Code, 26 U.S.C. 1361-1379.1 App., infra, 2a. As this Court explained 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."

In 1990, while ECC was insolvent, its creditors forgave $661,357 of its debt. App., infra, 2a. This amount would have represented "[i]ncome from discharge of indebtedness" 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 specifies that discharge of indebtedness is not an item of income for an insolvent corporation, respondent argues 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 treatment of shareholders of a Subchapter S corporation. 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 earnings 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.

c. ECC was liquidated in 1990, and its common stock became worthless during that year. App., infra, 2a. Section 165(a), (b) and (g) of the Code permit a loss deduction to be taken in the year that a security becomes worthless. 26 U.S.C. 165(a), (b) and (g). Under Section 1001(a) of the Code, the loss is computed as the excess of the shareholder's adjusted basis of the stock over the amount realized.

On January 1, 1990, respondent's basis in his ECC stock was $694,659. His distributive share of ECC's ordinary losses for 1990 was $199,857. App., infra, 2a n.2. On his income tax return for 1990, respondent decreased his basis in ECC by the amount of these losses. Ibid. He also reported an ordinary loss of $100,000 on his ECC stock in 1990 under Section 1244 of the Code, which permits up to $100,000 that would ordinarily be treated as a capital loss on certain stock to be treated as an ordinary loss, and he decreased his basis in his ECC stock pro tanto under Section 1244(d)(1)(A). Ibid. Taking these adjustments into account, respondent's basis in his stock was $394,802 at the end of 1990. Ibid.

Respondent then treated his pro rata share of the debt forgiven to ECC ($612,245) as an item of "income" passing through to him under Section 1366(a)(1)(A) that increased his basis in the stock under Section 1367(a)(1)(A), even though, for the reasons described above, Section 108(a) of the Code expressly states that this is "not" an item of income. App., infra, 2a. Respondent therefore calculated the loss deductions attributable to the worthlessness of the stock by using an adjusted basis that was augmented by his share of the amount of the forgiven debt. Ibid.

Upon audit, the Commissioner of Internal Revenue determined that respondent was not entitled to increase his stock basis by the discharge of indebtedness that was "not" an item of income under Section 108 of the Code. The Commissioner therefore disallowed the portion of the deductions claimed by respondent that was inflated by the upward basis adjustment and asserted income tax deficiencies against respondent. App., infra, 3a.

2. Respondent filed a petition in Tax Court to contest the deficiencies. The Tax Court held that the discharge of the indebtedness of the Subchapter S corporation did not increase respondent's basis in the stock of that corporation. App., infra, 18a-23a. The court followed its reviewed decision in Nelson v. Commissioner, 110 T.C. 114 (1998), aff'd, 182 F.3d 1152 (10th Cir. 1999), in which the Tax Court unanimously concluded that a discharged debt that is excluded from a Subchapter S corporation's gross income because of its insolvency does not constitute an item of "income" that would increase a shareholder's stock basis in the corporation. App., infra, 21a.

3. The Eleventh Circuit reversed. App., infra, 1a-17a. The court "acknowledge[d] the justice of the Comissioner's position" but concluded that the plain meaning of Sections 1366(a)(1)(A) and 1367(a)(1)(A) of the Code "clearly requires" that an amount excluded from an insolvent Subchapter S corporation's gross income under Section 108 passes through the corporation to its shareholder and increases his basis in the stock of the corporation. App., infra, 16a. The court noted that in Gitlitz v. Commissioner, 182 F.3d 1143 (1999), cert. granted, 120 S. Ct. 1830 (2000), the Tenth Circuit held that the amount of the discharge of indebtedness of an insolvent Subchapter S corporation does not pass through to its shareholders as an item of "income" under Section 1366 or increase their basis in the stock of the corporation under Section 1367. App., infra, 9a-11a. The Eleventh Circuit distinguished Gitlitz on the ground that the taxpayers in that case were seeking to use the discharge of the corporation's indebtedness to obtain upward basis adjustments that would allow them to deduct corporate losses that were otherwise nondeductible under Section 1366(d)(1) of the Code. Id. at 10a.2 The court nonetheless acknowledged that the Tenth Circuit in Gitlitz had described examples in its opinion in that case that indicated that an amount excluded from an S corporation's gross income does not pass through to its shareholders even when the shareholders are not seeking deductions for otherwise nondeductible corporate losses. Id. at 11a n.10 (citing Gitlitz v. Commissioner, 182 F.3d at 1150 n.6). The Eleventh Circuit also noted that, in a companion case to Gitlitz, the Tenth Circuit affirmed a Tax Court decision that denied an upward basis adjustment from the discharge of indebtedness of an insolvent Subchapter S corporation for a shareholder who did not have losses that were nondeductible under Section 1366(d)(1). App., infra, 11a n.10 (citing Nelson v. Commissioner, 182 F.3d 1152 (10th Cir. 1999)).

REASONS FOR GRANTING THE PETITION

This case presents the same question that is presented in Gitlitz v. Commissioner, cert. granted, No. 99-1295 (May 1, 2000), which is set for argument in this Court on October 2, 2000. The petition in this case should therefore be held and disposed of as appropriate in light of the Court's disposition of the Gitlitz case.

CONCLUSION

The petition for a writ of certiorari should be held and disposed of as appropriate in light of the Court's disposition of Gitlitz v. Commissioner, No. 99-1295.

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
EDWARD T. PERELMUTER
PAULA K. SPECK
Attorneys

AUGUST 2000

 

1 Alexis Pugh is a party to this proceeding solely by virtue of having filed joint income tax returns with her husband for the years in suit. As a result, we refer to Mr. Pugh as respondent.

2 Section 1366(d)(1) provides that the aggregate amount of corporate losses and deductions that may be taken into account by a shareholder of an S corporation (under Section 1366(a)(1)(A)) shall not exceed the shareholder's adjusted basis in the stock of the corporation and the shareholder's adjusted basis in any debt owed to him by the corporation. Corporate losses that are not deductible under Section 1366(d)(1) are carried forward into future years (and are therefore referred to as "suspended" losses), but may be deducted in future years only if the shareholder acquires additional basis in the corporation. 26 U.S.C. 1366(d)(2).

 

APPENDIX A

 

UNITED STATES COURT OF APPEALS
FOR THE ELEVENTH CIRCUIT

No. 99-12646

T.C. Docket No. 27237-96

JAMES H. PUGH, JR. AND ALEXIS PUGH, PETITIONERS

v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

[Filed: 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 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 WL 66131 (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

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 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, 37 S.Ct. 192, 61 L.Ed. 442 (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.

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.

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, 111 S.Ct. 1512, 113 L.Ed.2d 608 (1991); United States v. Kirby Lumber Co., 284 U.S. 1, 52 S.Ct. 4, 76 L.Ed. 131 (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 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). 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 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, at 7018.

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. at 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 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. --, 120 S.Ct. 1830, 146 L.Ed.2d 774, 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 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

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 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 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 cir- cuits 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.

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 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 subsidiary's COD income because parent had not "paid for" it (see 103 T.C. 398, 409, 1994 WL 466342 (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, 104 S.Ct. 756, 78 L.Ed.2d 549 (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

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

 

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 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. --, 120 S.Ct. 1830, 146 L.Ed.2d 774, 68 U.S.L.W. 3497 (May 1, 2000) (No. 99-1295). See Nelson v. Commissioner, 182 F.3d 1152 (10th Cir. 1999).

4 See 26 U.S.C. §§ 165(b), 1001(a), 1011.

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. --, 120 S.Ct. 1830, 146 L.Ed.2d 774, 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 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).

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.

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).

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).

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, 111 S.Ct. 1512, 113 L.Ed.2d 608 (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 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).

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 See Farley, 202 F.3d at 212 n. 10.

 

APPENDIX B

UNITED STATES TAX COURT

No. 27237-96

T.C. Memo. 1999-38

JAMES H. PUGH, JR., AND ALEXIS C. PUGH, PETITIONERS

v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

[Filed: Feb. 8, 1999]

MEMORANDUM OPINION

COHEN, Chief J.:

Respondent determined deficiencies in petitioners' Federal income tax of $83,181 and $76,723 and penalties under section 6662(c) of $16,636 and $15,432 for the taxable years 1990 and 1991, respectively. After concessions, the issues for decision are:

(1) Whether petitioner James H. Pugh, Jr. (petitioner), may increase his basis in stock of an S corporation by the amount of discharge of indebtedness income (also referred to as cancellation of debt (COD) income) excluded from gross income under section 108(a), and (2) whether petitioners are liable for the accuracy-related penalties for negligence or disregard of rules or regulations for 1990 and 1991. Respondent has conceded that portion of the penalty for each year that relates to the first issue to be decided in this case. Unless otherwise indicated, all section references are to the Internal Revenue Code as in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

This case was submitted fully stipulated pursuant to Rule 122. The stipulated facts are incorporated herein by this reference. Petitioners resided in Orlando, Florida, at the time they filed the petition.

Background

The first issue in this case concerns petitioner's interest in Epoch Capital Corporation (ECC). ECC was incorporated in the State of Florida on December 10, 1987. ECC had properly elected to be treated as an S corporation pursuant to section 1362 prior to 1990, and such election was effective for ECC's taxable year ended December 31, 1990.

ECC realized COD income during 1990 in the amount of $661,357. ECC was liquidated in 1990. Articles of Dissolution were filed with the State of Florida on December 18, 1990. Petitioner did not receive any distributions from ECC upon liquidation. Petitioner's ECC common stock became worthless during 1990.

In completing its 1990 Form 1120S, U.S. Income Tax Return for an S Corporation, ECC properly excluded the COD income from its income pursuant to section 108. On petitioner's Schedule K-1 (Form 1120S), Shareholder's Share of Income, Credits, Deductions, Etc., ECC separately stated the COD income and reported petitioner's pro rata share in the amount of $612,245. Petitioner increased his basis in his ECC stock in 1990 by the $612,245. Petitioner's basis in his ECC stock on December 31, 1990, taking into account all adjustments other than that for ECC's COD income, was $394,802. On petitioners' 1990 Federal income tax return, they reported a capital loss with respect to the ECC stock commensurate with petitioner's reported basis in the stock. On their 1991 return, petitioners carried forward and reported capital losses from 1990. Coopers & Lybrand, a certified public accounting firm, prepared petitioners' tax returns for 1990 and 1991 and ECC's return for 1990.

Respondent disallowed the inclusion of the COD income in petitioner's basis in his ECC stock and reduced Mr. Pugh's loss accordingly. Respondent also determined increases in petitioners' income in the amounts of $60,077 and $5,763 for 1990 and 1991, respectively, for gain on the sale of stock in Epoch Management, Inc., which sale petitioners failed to report on their returns. Petitioners have conceded the latter adjustments. Respondent determined accuracy-related penalties for 1990 and 1991, having determined that the underpayments of tax were "due to negligence or intentional disregard of rules and regulations."

Discussion

Inclusion of COD Income in Basis

Petitioners argue that petitioner was correct in increasing the basis in his ECC stock by his share of the COD income. In Nelson v. Commissioner, 110 T.C. 114 (1998), we held 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). Petitioners do not distinguish this case from Nelson v. Commissioner, supra. They ask us to overrule a recent Court-reviewed opinion, as being decided incorrectly. We decline to do so. Accordingly, we hold that petitioner may not increase the basis in his ECC stock by his share of the COD income.

Accuracy-related Penalties

Section 6662(a) imposes an accuracy-related penalty of 20 percent on any portion of an underpayment of tax that is attributable to items set forth in section 6662(b). Included in those items is negligence or disregard of rules or regulations. Sec. 6662(b)(1). Section 6662(c) provides that for purposes of section 6662, "the term 'negligence' includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term 'disregard' includes any careless, reckless, or intentional disregard."

The accuracy-related penalty will not be imposed with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with re-spect to such portion. Sec. 6664(c)(1). The determination of whether a taxpayer acted with reasonable cause and in good faith depends upon the facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The most important factor is the extent of the taxpayer's effort to determine the taxpayer's proper tax liability. Id.

Respondent determined that petitioners' underpayments of tax were due to negligence or intentional disregard of rules or regulations. Respondent since has conceded the portions of the penalties related to the COD issue. The remaining portions of the penalties relate to the income conceded by petitioners; i.e., the gain on the sale of stock in Epoch Management, Inc.

Petitioners argue that they were not negligent, but merely mistaken, in their reporting position with respect to the Epoch Management, Inc. stock. They state in their brief that they concluded they could recover all of their basis before reporting any gain. They also allege that their failure to include the gain was inadvertent, in view of the amounts of the adjustment resulting from this omission ($60,077 and $5,763 for 1990 and 1991, respectively) as compared to the total income reported ($778,781 and $1,215,732, respectively).

Petitioners have supplied us with no evidence with respect to the Epoch Management, Inc., stock transaction or with respect to their decision that the gain on the sale of the stock was not includable in income. Petitioners have the burden of proof on this issue. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933). The fact that this case was submitted fully stipulated does not alter the burden of proof. Rule 122(b); Alumax Inc. v. Commissioner, 109 T.C. 133, 160 (1997), affd. __ F.3d __ (11th Cir., Jan. 21, 1999). Petitioners have failed to establish that they were not negligent with respect to the underpayments stemming from the omission of the gain from the sale of the Epoch Management, Inc., stock. Therefore, we hold that they are liable for the portions of the accuracy-related penalties related to that gain.

 

In keeping with the parties' concessions and our holdings as set forth above,

Decision will be entered under Rule 155.

 

 

APPENDIX C

STATUTORY APPENDIX

Internal Revenue Code of 1986 (26 U.S.C.) (1991):

§ 108. Income from discharge of indebtedness

(a) Exclusion from gross income

(1) In general

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-

(A) the discharge occurs in a title 11 case,

(B) the discharge occurs when the taxpayer is

insolvent, or

(C) the indebtedness discharged is qualified farm indebtedness.

* * * * *

(3) Insolvency exclusion limited to amount of insolvency.

In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.

(b) Reduction of tax attributes

(1) In general

The amount excluded from gross income under paragraph (A), (B), or (C) of subsection (a)(1) shall be applied to reduce the tax attributes of the taxpayer as provided in paragraph (2).

(2) Tax attributes affected; order of reduction. Except as provided in paragraph (5), the reduction referred to in paragraph (1) shall be made in the following tax attributes in the following order:

(A) NOL

Any net operating loss for the taxable year of the discharge, and any net operating loss carryover to such taxable year.

(B) General business credit

Any carryover to or from the taxable year of a discharge of an amount for purposes of determining the amount allowable as a credit under section 38 (relating to general business credit).

(C) Capital loss carryovers

Any net capital loss for the taxable year of the discharge, and any capital loss carryover to such taxable year under section 1212.

(D) Basis reduction

(i) In general

The basis of the property of the taxpayer.

(ii) Cross reference

For provisions making the reduction described in clause (i), see section 1017.

(E) Foreign tax credit carryovers

Any carryover to or from the taxable year of the discharge for purposes of determining the amount of the credit allowable under section 27.

(3) Amount of reduction

(A) In general

Except as provided in subparagraph (B), the reductions described in paragraph (2) shall be one dollar for each dollar excluded by subsection (a).

(B) Credit carryover reduction

The reductions described in subparagraphs (B) and (E) of paragraph (2) shall be 33 1/3 cents for each dollar excluded by subsection (a).

(4) Ordering rules

(A) Reductions made after determination of tax for year

The reductions described in paragraph (2) shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge.

(B) Reductions under subparagraph (A) or (C) of paragraph (2)

The reductions described in subparagraphs (B) and (E) of paragraph (2) (as the case may be) shall be made first in the loss for the taxable year of the discharge and then in the carryovers to such taxable year in the order of the taxable years from which such carryover arose.

* * * * *

(5) Election to apply reduction first against depreciable property

(A) In general

The taxpayer may elect to apply any portion of the reduction referred to in paragraph (1) to the reduction under section 1017 of the basis of the depreciable property of the taxpayer.

* * * * *

(d) Meaning of terms; special rules relating to subsections (a), (b) and (g)

* * * * *

(2) Insolvent

For purposes of this section, the term "insolvent" means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer's assets and liabilities immediately before the discharge.

* * * * *

(6) Subsections (a), (b), and (g) to be applied at partner level

In the case of a partnership, subsections (a), (b), and (g) shall be applied at the partner level.

(7) Special rules for S corporation

(A) Subsections (a), (b), and (g) to be applied at corporate level

In the case of an S corporation, subsections (a), (b), and (g) shall be applied at the corporate level.

(B) Reduction in carryover of disallowed losses and deductions

In the case of an S corporation, for purposes of subparagraph (A) of subsection (b)(2), any loss or deduction for the taxable year of the discharge under section 1366(d)(1) shall be treated as a net operating loss for such taxable year.

(C) Coordination with basis adjustments under section 1367(b)(2)

For purposes of subsection (e)(6), a shareholder's adjusted basis in indebtedness of an S corporation shall be determined without regard to any adjustments made under section 1367(b)(2).

* * * * *

(e) General rules for discharge of indebtedness (including discharges not in Title 11 cases or insolvency)

For purposes of this title

 

(1) No other insolvency exception

Except as otherwise provided in this section, there shall be no insolvency exception from the general rule that gross income includes income from the discharge of indebtedness.

* * * * *

§ 1366. Pass-thru of items to shareholders

(a) Determination of shareholder's tax liability

(1) In general

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 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, and

(B) nonseparately computed income or loss.

For purposes of the preceding sentence, the items referred to in subparagraph (A) shall include amounts described in paragraph (4) or (6) of section 702(a).

* * * * *

(b) Character passed thru

The character of any item included in a shareholder's prorata share under paragraph (1) of subsection (a) 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.

(c) Gross income of a shareholder

In any case where it is necessary to determine the gross income of a shareholder for purposes of this title, such gross income shall include the shareholder's pro rata share of the gross income of the corporation.

(d) Special rules for losses and deductions

(1) Cannot exceed shareholder's basis in stock and debt

The aggregate amount of losses and deductions taken into account by a shareholder under subsection (a) for any taxable year shall not exceed the sum of-

(A) the adjusted basis of the shareholder's stock in the S corporation (determined with regard to paragraph (1) of section 1367(a) for the taxable year and

(B) the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder (determined without regard to any adjustment under paragraph (2) of section 1367(b) for the taxable year).

(2) Indefinite carryover of disallowed losses and deductions.

Any loss or deduction which is disallowed for any taxable year by reason of paragraph (1) shall be treated as incurred by the corporation in the succeeding taxable year with respect to that shareholder.

* * * * *

§ 1367. Adjustments to Basis of Stock of Shareholders, etc

(a) General rule

(1) Increases in basis

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),

(B) any nonseparately computed income determined under subparagraph (B) of section 1366(a)(1), and

(C) the excess of the deductions for depletion over the basis of the property subject to depletion.

(2) Decreases in basis

The basis of each shareholder's stock in an S corporation shall be decreased for any period (but not below zero) by the sum of the following items determined with respect to the shareholder for such period:

(A) distributions by the corporation which were not includible in the income of the shareholder by reason of section 1368,

(B) the items of loss and deduction described in subparagraph (A) of section 1366(a)(1),

(C) any nonseparately computed loss determined under subparagraph (B) of section 1366(a)(1) * * * [.]

* * * * *