GITLITZ, ET AL. v. COMM., Cite as 87 AFTR 2d 2001-417 (531 U.S. 20.docx

GITLITZ, ET AL. v. COMM., Cite as 87 AFTR 2d 2001-417
(531 U.S. 206), Code Sec(s) 108; 1366; 61; 108; 1367, (S Ct),
01/09/2001
David A. GITLITZ, ET AL., PETITIONERS v.
COMMISSIONER of Internal Revenue.
Case Information:
[pg. 2001-417]
Code Sec(s):
108; 1366
Court Name:
U.S. Supreme Court,
Docket No.:
Docket No. 99-1295,
Date Decided:
01/09/2001.
Prior History:
Court of Appeals, (1999, CA10) 84 AFTR 2d 99-5059, 182 F3d
1143, affirming Winn, Philip, et al (1998) TC Memo 1998- 71
[1998 RIA TC Memo ¶98,071], RIA TC Memo ¶98071, 75 CCH
TCM 1840 [1998 RIA TC Memo ¶98,071], withdrawing (1997)
TC Memo 1997-286 [1997 RIA TC Memo ¶97,286], RIA TC
Memo ¶97286, 73 CCH TCM 3167 [1997 RIA TC Memo
¶97,286] (opinions by Cohen, Ch.J.), reversed.
Tax Year(s):
Years 1991, 1992.
Disposition:
Decision for Taxpayers. 531 U.S. 206.
Cites:
HEADNOTE
1. S corp. loss deductions—discharge of indebtedness income—
insolvency exception—“items of income.” For passthrough loss
computation purposes, Supreme Court held that insolvent S

corp.'s Code Sec. 108 -excluded DOI income was “item of
income” subject to passthrough: under statute's plain language,
insolvency merely caused DOI income to be excluded from
gross income, but didn't alter its character. Fact that not all
income items were includible in gross income under Code Sec.
1366(a)(1) and other IRC sections supported conclusion that
exclusion in itself didn't imply recharacterization; lack of
economic outlay in DOI situation wasn't material distinction;
Code Sec. 108(e) , which limited prior judicial insolvency
exception, presumed DOI to always be income; Reg. §1.61-
12(b) said nothing about DOI's passthrough; and whether DOI
income was tax-deferred vs tax-exempt was irrelevant since
Code Sec. 1366(a)(1)(A) encompassed any income item.
Reference(s): ¶ 13,665 ;¶ 1085.04 Code Sec. 108;Code Sec.
1366
2. S corp. loss deductions—increase in stock basis—discharge
of indebtedness income—insolvency exception. For passthrough
loss computation purposes, Supreme Court reversed 10th Cir.'s
decision that NOL reduction preceded rather than followed
passthrough of insolvent S corp.'s Code Sec. 108 excluded DOI
income: Code Sec. 108(b)(4)(A) 's express sequencing
provisions required that tax determination precede attribute
reduction; and passthrough and basis adjustment were necessary
to such determination; so, 10th Cir.'s conclusion that DOI was
absorbed before [pg. 2001-418] passthrough and unavailable for
basis increase was incorrect. Also, Code Sec. 108(d)(7)(A)
didn't abrogate ordinary passthrough rules; and whether
sequencing scheme resulted in “double windfall” was irrelevant
since result was mandated by statute.
Reference(s): ¶ 13,675 ;¶ 1085.02(30) ;¶ 615.116(7) Code Sec.
61;Code Sec. 108;Code Sec. 1367
OPINION
Supreme Court of the United States, Certiorari To the United
States Court of Appeals for the Tenth Circuit.
Judge: THOMAS, Judge:
Shareholders of a corporation taxed under Subchapter S of the

Internal Revenue Code may elect a “pass-through” taxation
system, under which the corporation's profits pass through
directly to its shareholders on a pro rata basis and are reported
on the shareholders' individual tax returns. 26 U.S.C. section
1366(a)(1)(A). To prevent double taxation of distributed
income, shareholders may increase their corporate bases by
certain items of income. Section 1367(a)(1)(A). Corporate
losses and deductions are passed through in a similar manner,
section 1366(a)(1)(A), and the shareholders' bases in the S
corporation's stock and debt are decreased accordingly, sections
1367(a)(2)(B), 1367(b)(2)(A). However, to the extent that such
losses and deductions exceed a shareholder's basis in the S
corporation's stock and debt, the excess is “suspended” until
that basis becomes large enough to permit the deduction.
Sections 1366(d)(1)-(2). In 1991, an insolvent S corporation in
which petitioners David Gitlitz and Philip Winn were
shareholders excluded its entire discharge of indebtedness
amount from gross income. On their tax returns, petitioners
used their pro rata share of the discharge amount to increase
their bases in the corporation's stock on the theory that it was an
“item of income” subject to pass-through. They used their
increased bases to deduct corporate losses and deductions,
including suspended ones from previous years. With the upward
basis adjustments, they were each able to deduct the full amount
of their pro rata share of the corporation's losses. The
Commissioner determined that they could not use the
corporation's discharge of indebtedness to increase their bases
in the stock and denied their loss deductions. The Tax Court
ultimately agreed. In affirming, the Tenth Circuit assumed that
excluded discharge of indebtedness is an item of income subject
to pass-through, but held that the discharge amount first had to
be used to reduce certain tax attributes of the S corporation
under section 108(b) and that only the leftover amount could be
used to increase basis. Because the tax attribute to be reduced
here (the corporation's net operating loss) equaled the
discharged debt amount, that entire amount was absorbed by the

reduction at the corporate level and nothing remained to be
passed through to the shareholders.
Held:
1. The statute's plain language establishes that excluded
discharged debt is an “item of income,” which passes through to
shareholders and increases their bases in an S corporation's
stock. Section 61(a)(12) states that discharge of indebtedness is
included in gross income. And section 108(a) provides only that
the discharge ceases to be included in gross income when the S
corporation is insolvent, not that it ceases to be an item of
income, as the Commissioner contends. Not all items of income
are included in gross income, see section 1366(a)(1), so an
item's mere exclusion from gross income does not imply that the
amount ceases to be an item of income. Moreover, sections 101
through 136 employ the same construction to exclude various
items from gross income, but not even the Commissioner encour
[pg. 2001-419] ages a reading that would exempt all such items
from pass-through. Instead the Commissioner asserts that
discharge of indebtedness is unique because it requires no
economic outlay on the taxpayer's part, but can identify no
statutory language that makes this distinction relevant. On the
contrary, the statute makes clear that section 108(a)'s exclusion
does not alter the character of discharge of indebtedness as an
item of income. Specifically, section 108(e) presumes that such
discharge is always “income,” and that the only question for
section 108 purposes is whether it is includible in gross income.
The Commissioner's contentions that, notwithstanding the
statute's plain language, excluded discharge of indebtedness is
not income and, specifically, that it is not “tax-exempt income”
under section 1366(a)(1)(A) do not alter the conclusion reached
here. Pp. 5-9.
2. Pass-through is performed before the reduction of an S
corporation's tax attributes under section 108(b). The
sequencing question presented here is important. If attribute
reduction is performed before the discharge of indebtedness is
passed through to the shareholders, the shareholders' losses that

exceed basis are treated as the corporation's net operating loss
and are then reduced by the amount of the discharged debt; in
this case no suspended losses would remain that would permit
petitioners to take deductions. However, if it is performed after
the discharged debt income is passed through, then the
shareholders would be able to deduct their losses (up to the
amount of the increase in basis caused by the discharged debt).
Any suspended losses remaining then will be treated as the S
corporation's net operating loss and reduced by the discharged
debt amount. Section 108(b)(4)(A) expressly addresses the
sequencing question, directing that the attribute reductions
“shall be made after the determination of the tax imposed...for
the taxable year of the discharge.” (Emphases added.) In order
to determine the “tax imposed,” a shareholder must adjust his
basis in S corporation stock and pass through all items of
income and loss. Consequently the attribute reduction must be
made after the basis adjustment and pass-through. Petitioners
must pass through the discharged debt, increase corporate bases,
and then deduct their losses, all before any attribute reduction
could occur. Because their basis increase is equal to their
losses, they have no suspended losses remaining and thus have
no net operating losses to reduce. The primary arguments made
in Courts of Appeals against this reading of the sequencing
provision are rejected. Pp. 9-13.
182 F.3d 1143 [84 AFTR 2d 99- 5059], reversed.
Judge: THOMAS, J., delivered the opinion of the Court, in
which REHNQUIST, C.J., and STEVENS, O'CONNOR,
SCALIA, KENNEDY, SOUTER, and GINSBURG, JJ., joined.
BREYER, J., filed a dissenting opinion.
*****
Opinion of the Court
[January 9, 2001]
Justice THOMAS delivered the opinion of the Court.
The Commissioner of Internal Revenue assessed tax
deficiencies against petitioners David and Louise Gitlitz and
Philip and Eleanor Winn because they used nontaxed discharge

of indebtedness to increase their bases in S corporation stock
and to deduct suspended losses. In this case we must answer two
questions. First, we must decide whether the Internal Revenue
Code (Code) permits taxpayers to increase bases in their S
corporation stock by the amount of an S corporation's discharge
of indebtedness excluded from gross income. And, second, if
the Code permits such an increase, we [pg. 2001-420] must
decide whether the increase occurs before or after taxpayers are
required to reduce the S corporation's tax attributes.
I
David Gitlitz and Philip Winn 1 were shareholders of
P.D.W.&A., Inc., a corporation that had elected to be taxed
under subchapter S of the Code, 26 U.S.C. sections 1361-1379
(1994 ed. and Supp. III). Subchapter S allows shareholders of
qualified corporations to elect a “pass-through” taxation system
under which income is subjected to only one level of taxation.
See Bufferd v. Commissioner, 506 U.S. 523, 525 [71 AFTR 2d
93-573] (1993). The corporation's profits pass through directly
to its shareholders on a pro rata basis and are reported on the
shareholders' individual tax returns. See section 1366(a)(1)(A).
2 To prevent double taxation of income upon distribution from
the corporation to the shareholders, section 1367(a)(1)(A)
permits shareholders to increase their corporate bases by items
of income identified in section 1366(a) (1994 ed. and Supp. III).
Corporate losses and deductions are passed through in a similar
manner, see section 1366(a)(1)(A), and the shareholders' bases
in the S corporation's stock and debt are decreased accordingly,
see section 1367(a)(2)(B), 1367(b)(2)(A). However, a
shareholder cannot take corporate losses and deductions into
account on his personal tax return to the extent that such items
exceed his basis in the stock and debt of the S corporation. See
section 1366(d)(1) (Supp. III). If those items exceed the basis,
the excess is “suspended” until the shareholder's basis becomes
large enough to permit the deduction. See sections 1366(d)(1)-
(2) (1994 ed. and Supp. III). In 1991, P.D.W.&A. realized
$2,021,296 of discharged indebtedness. At the time, the

corporation was insolvent in the amount of $2,181,748. Because
it was insolvent even after the discharge of indebtedness was
added to its balance sheet, P.D.W.&A. excluded the entire
discharge of indebtedness amount from gross income under 26
U.S.C. sections 108(a) and 108(d)(7)(A). On their tax returns,
Gitlitz and Winn increased their bases in P.D.W.&A. stock by
their pro rata share (50 percent each) of the amount of the
corporation's discharge of indebtedness. Petitioners' theory was
that the discharge of indebtedness was an “item of income”
subject to pass-through under section 1366(a)(1)(A). They used
their increased bases to deduct on their personal tax returns
corporate losses and deductions, including losses and
deductions from previous years that had been suspended under
section 1366(d). Gitlitz and Winn each had losses (including
suspended losses and operating losses) that totaled $1,010,648.
With the upward basis adjustments of $1,010,648 each, Gitlitz
and Winn were each able to deduct the full amount of their pro
rata share of P.D.W.&A.'s losses. The Commissioner determined
that petitioners could not use P.D.W.&A.'s discharge of
indebtedness to increase their bases in the stock and denied
petitioners' loss deductions. Petitioners petitioned the Tax Court
to review the deficiency determinations. The Tax Court, in its
initial opinion, granted relief to petitioners and held that the
discharge of indebtedness was an “item of income” and
therefore could support a basis increase. See Winn v.
Commissioner, 73 TCM 3167 (1997), paragraph 97,286 RIA
Memo withdrawn and reissued, 75 TCM 1840 (1998), paragraph
98,071 RIA Memo TC. In light of the Tax Court's decision in
Nelson v. Commissioner, 110 T.C. 114 (1998), aff'd, 182 F.3d
1152 [84 AFTR 2d 99-5067] (CA10 [pg. 2001-421] 1999), 3
however, the Tax Court granted the Commissioner's motion for
reconsideration and held that shareholders may not use an S
corporation's untaxed discharge of indebtedness to increase
their bases in corporate stock. See Winn v. Commissioner, 75
TCM 1840 (1998), paragraph 98,071 RIA Memo TC. The Court
of Appeals affirmed. See 182 F.3d 1143 [84 AFTR 2d 99-5059]

(CA10 1999). It assumed that excluded discharge of
indebtedness is an item of income subject to passthrough to
shareholders pursuant to section 1366(a)(1)(A), id., at 1148,
1151, n.7, but held that the discharge of indebtedness amount
first had to be used to reduce certain tax attributes of the S
corporation under section 108(b), and that only the leftover
amount could be used to increase basis. 4 The Court of Appeals
explained that, because the tax attribute to be reduced (in this
case the corporation's net operating loss) was equal to the
amount of discharged debt, the entire amount of discharged debt
was absorbed by the reduction at the corporate level, and
nothing remained of the discharge of indebtedness to be passed
through to the shareholders under section 1366(a)(1)(A). Id., at
1151. Because Courts of Appeals have disagreed on how to treat
discharge of indebtedness of an insolvent S corporation,
compare Gaudiano v. Commissioner, 216 F.3d 524, 535 [86
AFTR 2d 2000-5065] (CA6 2000) (holding that tax attributes
are reduced before excluded discharged debt income is passed
through to shareholders), cert. pending, No. 00-459, Witzel v.
Commissioner, 200 F.3d 496, 498 [85 AFTR 2d 2000- 483]
(CA7 2000) (same), cert. pending, No. 99-1693, and 182 F.3d,
at 1150 (case below), with United States v. Farley, 202 F.3d
198, 206 [85 AFTR 2d 2000-615] (CA3 2000) (holding that
excluded discharged debt income is passed through to
shareholders before tax attributes are reduced), cert. pending,
No. 99-1675; see also Pugh v. Commissioner, 213 F.3d 1324,
1330 [85 AFTR 2d 2000-1986] (CA11 2000) (holding that
excluded discharged debt income is subject to passthrough and
can increase basis), cert. pending, No. 00-242, we granted
certiorari. 529 U.S. 1097 (2000).
II
[1] Before we can reach the issue addressed by the Court of
Appeals — whether the increase in the taxpayers' corporate
bases occurs before or after the taxpayers are required to reduce
the S corporation's tax attributes — we must address the
argument raised by the Commissioner. 5 The Commissioner

argues that the discharge of indebtedness of an insolvent S
corporation is not an “item of income” and thus never passes
through to shareholders. Under a plain reading of the statute, we
reject this argument and conclude that excluded discharged debt
is indeed an “item of income,” which passes through to the
shareholders and increases their bases in the stock of the S
corporation. Section 61(a)(12) states that discharge of
indebtedness generally is included in gross income. Section
108(a)(1) provides an express exception to this general rule:
“Gross income does not include any amount which (but for this
subsection) would be includible in gross income by reason of
the discharge...of indebtedness of the taxpayer if —....”
[pg. 2001-422]
“(B) the discharge occurs when the taxpayer is insolvent.”
The Commissioner contends that this exclusion from gross
income alters the character of the discharge of indebtedness so
that it is no longer an “item of income.” However, the text and
structure of the statute do not support the Commissioner's
theory. Section 108(a) simply does not say that discharge of
indebtedness ceases to be an item of income when the S
corporation is insolvent. Instead it provides only that discharge
of indebtedness ceases to be included in gross income. Not all
items of income are included in gross income, see section
1366(a)(1) (providing that “items of income,” including “tax-
exempt” income, are passed through to shareholders), so mere
exclusion of an amount from gross income does not imply that
the amount ceases to be an item of income. Moreover, sections
101 through 136 employ the same construction to exclude
various items from gross income: “Gross income does not
include....” The consequence of reading this language in the
manner suggested by the Commissioner would be to exempt all
items in these sections from pass-through under section 1366.
However, not even the Commissioner encourages us to reach
this sweeping conclusion. Instead the Commissioner asserts that
discharge of indebtedness is unique among the types of items
excluded from gross income because no economic outlay is

required of the taxpayer receiving discharge of indebtedness.
But the Commissioner is unable to identify language in the
statute that makes this distinction relevant, and we certainly
find none. On the contrary, the statute makes clear that section
108(a)'s exclusion does not alter the character of discharge of
indebtedness as an item of income. Specifically, section
108(e)(1) reads:
“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.”
This provision presumes that discharge of indebtedness is
always “income,” and that the only question for purposes of
section 108 is whether it is includible in gross income. If
discharge of indebtedness of insolvent entities were not actually
“income,” there would be no need to provide an exception to its
inclusion in gross income; quite simply, if discharge of
indebtedness of an insolvent entity were not “income,” it would
necessarily not be included in gross income. Notwithstanding
the plain language of the statute, the Commissioner argues,
generally, that excluded discharge of indebtedness is not income
and, specifically, that it is not “tax-exempt income” under
section 1366(a)(1)(A). 6 First, the Commissioner argues that
section 108 merely codified the “judicial insolvency exception,”
and that, under this exception, discharge of indebtedness of an
insolvent taxpayer was not considered income. The insolvency
exception was a rule that the discharge of indebtedness of an
insolvent taxpayer was not taxable income. See, e.g., Dallas
Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d
95 [13 AFTR 930] (CA5 1934); Astoria Marine Construction
Co. v. Commissioner, 12 T.C. 798 (1949). But the exception has
since been limited by section 108(e). Section 108(e) precludes
us from relying on any understanding of the judicial insolvency
exception that was not codified in section 108. And as ex [pg.
2001-423] plained above, the language and logic of section 108
clearly establish that, although discharge of indebtedness of an
insolvent taxpayer is not included in gross income, it is

nevertheless income. The Commissioner also relies on a
Treasury Regulation to support his theory that no income is
realized from the discharge of the debt of an insolvent:
“Proceedings under Bankruptcy Act.”
“(1) Income is not realized by a taxpayer by virtue of the
discharge, under section 14 of the Bankruptcy Act (11 U.S.C.
32), of his indebtedness as the result of an adjudication in
bankruptcy, or by virtue of an agreement among his creditors
not consummated under any provision of the Bankruptcy Act, if
immediately thereafter the taxpayer's liabilities exceed the
value of his assets.” 26 CFR section 1.61-12(b) (2000).
Even if this regulation could be read (countertextually) to apply
outside the bankruptcy context, it merely states that “[i]ncome
is not realized.” The regulation says nothing about whether
discharge of indebtedness is income subject to pass-through
under section 1366. Second, the Commissioner argues that
excluded discharge of indebtedness is not “tax-exempt” income
under section 1366(a)(1)(A), but rather “tax-deferred” income.
According to the Commissioner, because the taxpayer is
required to reduce tax attributes that could have provided future
tax benefits, the taxpayer will pay taxes on future income that
otherwise would have been absorbed by the forfeited tax
attributes. Implicit in the Commissioner's labeling of such
income as “tax-deferred,” however, is the erroneous assumption
that section 1366(a)(1)(A) does not include “taxdeferred”
income. Section 1366 applies to “items of income.” This section
expressly includes “tax-exempt” income, but this inclusion does
not mean that the statute must therefore exclude “tax-deferred”
income. The section is worded broadly enough to include any
item of income, even tax-deferred income, that “could affect the
liability for tax of any shareholder.” Section 1366(a)(1)(A).
Thus, none of the Commissioner's contentions alters our
conclusion that discharge of indebtedness of an insolvent S
corporation is an item of income for purposes of section
1366(a)(1)(A).
III

[2] Having concluded that excluded discharge of indebtedness is
an “item of income” and is therefore subject to pass-through to
shareholders under section 1366, we must resolve the
sequencing question addressed by the Court of Appeals —
whether pass-through is performed before or after the reduction
of the S corporation's tax attributes under section 108(b).
Section 108(b)(1) provides that “[t]he amount excluded from
gross income under [section 108(a)] shall be applied to reduce
the tax attributes of the taxpayer as provided [in this section].”
Section 108(b)(2) then lists the various tax attributes to be
reduced in the order of reduction. The first tax attribute to be
reduced, and the one at issue in this case, is the net operating
loss. See section 108(b)(2)(A). Section 108(d)(7)(B) specifies
that, for purposes of attribute reduction, the shareholders'
suspended losses for the taxable year of discharge are to be
treated as the S corporation's net operating loss. If tax attribute
reduction is performed before the discharge of indebtedness is
passed through to the shareholders (as the Court of Appeals
held), the shareholders' losses that exceed basis are treated as
the corporation's net operating loss and are then reduced by the
amount of the discharged debt. In this case, no suspended losses
would remain that would permit petitioners [pg. 2001-424] to
take deductions. 7 If, however, attribute reduction is performed
after the discharged debt income is passed through (as
petitioners argue), then the shareholders would be able to
deduct their losses (up to the amount of the increase in basis
caused by the discharged debt). Any suspended losses remaining
then will be treated as the S corporation's net operating loss and
will be reduced by the amount of the discharged debt.
Therefore, the sequence of the steps of pass-through and
attribute reduction determines whether petitioners here were
deficient when they increased their bases by the discharged debt
amount and deducted their losses. The sequencing question is
expressly addressed in the statute. Section 108(b)(4)(A) directs
that the attribute reductions “shall be made after the
determination of the tax imposed by this chapter for the taxable

year of the discharge.” (Emphases added.) See also section
1017(a) (applying the same sequencing when section 108
attribute reduction affects basis of corporate property). In order
to determine the “tax imposed,” an S corporation shareholder
must adjust his basis in his corporate stock and pass through all
items of income and loss. See sections 1366, 1367 (1994 ed. and
Supp III). Consequently, the attribute reduction must be made
after the basis adjustment and pass-through. In the case of
petitioners, they must pass through the discharged debt,
increase corporate bases, and then deduct their losses, all before
any attribute reduction could occur. Because their basis increase
is equal to their losses, petitioners have no suspended losses
remaining. They, therefore, have no net operating losses to
reduce. Although the Commissioner has now abandoned the
reasoning of the Court of Appeals below, 8 we address the
primary arguments made in the Courts of Appeals against
petitioners' reading of the sequencing provision. First, one court
has expressed the concern that, if the discharge of indebtedness
is passed through to the shareholder before the tax attributes are
reduced, then there can never be any discharge of indebtedness
remaining “at [the] corporate level,” section 108(d)(7)(A), by
which to reduce tax attributes. 9 Gaudiano, 216 F.3d, at 533.
This concern presumes that tax attributes can be reduced only if
the discharge of indebtedness itself remains at the corporate
level. The statute, however, does not impose this restriction.
Section 108(b)(1) requires only that the tax attributes be
reduced by “[t]he amount excluded from gross income,”
(emphasis added), and that amount is not altered by [pg. 2001-
425] the mere pass-through of the income to the shareholder.
Second, courts have discussed the policy concern that, if
shareholders were permitted to pass through the discharge of
indebtedness before reducing any tax attributes, the
shareholders would wrongly experience a “double windfall”:
They would be exempted from paying taxes on the full amount
of the discharge of indebtedness, and they would be able to
increase basis and deduct their previously suspended losses.

See, e.g., 182 F.3d, at 1147-1148. Because the Code's plain text
permits the taxpayers here to receive these benefits, we need not
address this policy concern. 10 *** The judgment of the Court
of Appeals, accordingly, is reversed. It Is So Ordered. *****
[January 9, 2000]
Justice BREYER, Dissenting. I agree with the majority's
reasoning with the exception of footnotes 6 and 10. The basic
statutory provision before us is 26 U.S.C. section 108 — the
provision that excludes from the “gross income” of any
“insolvent” taxpayer, income that cancellation of a debt (COD)
would otherwise generate. As the majority acknowledges,
however, ante, at 7, n.6, section 108 contains a subsection that
sets forth a special exception. The exception, entitled “Special
rules for S corporation,” says:
“(A) Certain provisions to be applied at corporate level.”
“In the case of an S corporation, subsections (a), (b), (c), and
(g) shall be applied at the corporate level.” 26 U.S.C. section
108(d)(7)(A).
If one reads this language literally as exclusive, both the COD
exclusion (section 108(a)) and the tax attribute reduction
(section 108(b)) would apply only “at the corporate level.”
Hence the COD income would not flow through to S corporation
shareholders. Consequently, the insolvent S corporation's COD
income would not increase the shareholder's basis and would
not help the shareholder take otherwise unavailable deductions
for suspended losses. The Commissioner argues that we should
read the language in this way as preventing the flow-through of
the corporation's COD income. Brief for United States 27. He
points to the language of a House Committee, which apparently
thought, when Congress passed an amendment to section 108,
that the Commissioner's reading is correct. H. R. Rep. No. 103-
111, pp. 624-625 (1993) (“[T]he exclusion and basis reduction
are both made at the S corporation level (sec. 108(d)(7)). The
shareholders' basis in their stock is not adjusted by the amount
of debt discharge income that is excluded at the corporate
level”). At least one commentator believes the same. See Loebl,

Does the Excluded COD Income of an Insolvent S Corporation
Increase the Basis of the Shareholders' Stock?, 52 U. Fla. L.
Rev. 957, 981-988 (2000). But see Lockhart & Duffy, Tax Court
Rules in Nelson that S Corporation Excluded COD Income Does
Not Increase Shareholder Stock Basis, 25 Wm. Mitchell L. Rev.
287 (1999). The Commissioner finds support for his literal,
exclusive reading of section 108(d)(7)(A)'s language in the fact
that his reading would close a significant tax loophole. That
loophole — preserved by the majority — would grant a solvent
shareholder of an insolvent S corporation a tax [pg. 2001-426]
benefit in the form of permission to take an otherwise
unavailable deduction, thereby sheltering other, unrelated
income from tax. See Witzel v. Commissioner, 200 F.3d 496,
497 [85 AFTR 2d 2000-483] (CA7 2000) (Posner, C.J.) (“It is
hard to understand the rationale for using a tax exemption to
avoid taxation not only on the income covered by the exemption
but also on unrelated income that is not tax exempt”).
Moreover, the benefit often would increase in value as the
amount of COD income increases, a result inconsistent with
congressional intent to impose a “price” (attribute reduction),
see Lipton, Different Courts Adopt Different Approaches to the
Impact of COD Income on S Corporations, 92 J. Tax. 207
(2000), on excluded COD. Further, this deduction-related tax
benefit would have very different tax consequences for
identically situated taxpayers, depending only upon whether a
single debt can be split into segments, each of which is canceled
in a different year. For example, under the majority's
interpretation, a $1 million debt canceled in one year would
permit Taxpayer A to deduct $1 million of suspended losses in
that year, thereby permitting A to shelter $1 million of
unrelated income in that year. But because section 108 reduces
tax attributes after the first year, five annual cancellations of
$200,000 will not create a $1 million shelter. Timing is all
important. The majority acknowledges some of these policy
concerns and confesses ignorance of any “other instance in
which section 108 directly benefits a solvent entity,” but claims

that its reading is mandated by the plain text of section
108(d)(7)(A) and therefore that the Court may disregard the
policy consequences. Ante, at 13, and n.10. It is difficult,
however, to see why we should interpret that language as
treating different solvent shareholders differently, given that the
words “at the corporate level” were added “[i]n order to treat all
shareholders in the same manner.” H.R. Rep. No. 98-432, pt. 2,
p. 1640 (1984). And it is more difficult to see why, given the
fact that the “plain language” admits either interpretation, we
should ignore the policy consequences. See Commissioner v.
Gillette Motor Transport, Inc., 364 U.S. 130, 134-135 [5 AFTR
2d 1770] (1960) (abandoning literal meaning of 26 U.S.C.
section 1221 (1958 ed.) for a reading more consistent with
congressional intent). Accord, Commissioner v. P. G. Lake,
Inc., 356 U.S. 260, 264-267 [1 AFTR 2d 1394] (1958); Corn
Products Refining Co. v. Commissioner, 350 U.S. 46, 51-52 [47
AFTR 1789] (1955); Hort v. Commissioner, 313 U.S. 28, 30-31
[25 AFTR 1207] (1941). The arguments from plain text on both
sides here produce ambiguity, not certainty. And other things
being equal, we should read ambiguous statutes as closing, not
maintaining, tax loopholes. Such is an appropriate
understanding of Congress' likely intent. Here, other things are
equal, for, as far as I am aware, the Commissioner's literal
interpretation of section 108(d)(7)(A) as exclusive would
neither cause any tax-related harm nor create any statutory
anomaly. Petitioners argue that it would create a linguistic
inconsistency, for they point to a Treasury Regulation that says
that the Commissioner will apply hobby loss limitations under
section 183 “at the corporate level in determining” allowable
deductions, while, presumably, nonetheless permitting the
deduction so limited to flow through to the shareholder. Treas.
Reg. section 1.183-1(f), 26 CFR section 1.183-1(f) (2000). But
we are concerned here with the “application” of an exclusion,
not with “determining” the amount of a deduction. Regardless,
the regulation's use of the words “at the corporate level,” like
the three other appearances of the formulation “applied” or

“determined” “at the corporate level” in the Code, occur in
contexts that are so very different from this one that nothing we
say here need affect their interpretation. See 26 U.S.C. section
49(a)(1)(E)(ii)(I) (determining whether financing is recourse
financing); 26 U.S.C. section 264(f)(5)(B) [pg. 2001-427] (1994
ed., Supp. IV) (determining how to allocate interest expense to
portions of insurance policies); 26 U.S.C. section 302(e)(1)(A)
(determining whether a stock distribution shall be treated as a
partial liquidation). If there are other arguments militating in
favor of the majority's interpretation, I have not found them.
The majority, in footnote 6, says that the words “at the
corporate level” in section 108(d)(7)(A) apply to the exclusion
of COD income from corporate income and to “tax attribute
reduction” but do not “suspen[d] the operation of ...ordinary
pass-through rules” because section 108(d)(7)(A) “does not
state or imply that the debt discharge provisions shall apply
only “at the corporate level.”” It is the majority, however, that
should explain why it reads the provision as nonexclusive
(where, as here, its interpretation of the Code results in the
“practical equivalent of [a] double deduction,” Charles Ilfeld
Co. v. Hernandez, 292 U.S. 62, 68 [13 AFTR 881] (1934)). See
United States v. Skelly Oil Co., 394 U.S. 678, 684 [23 AFTR 2d
69-1186] (1969) (requiring “clear declaration of intent by
Congress” in such circumstances). I do not contend that section
108(d)(7)(A) must be read as having exclusive effect, only that,
given the alternative, this interpretation provides the best
reading of section 108 as a whole. And I can find no “clear
declaration of intent by Congress” to support the majority's
contrary conclusion regarding section 108(d)(7)(A)'s effect. It is
that conclusion from which, for the reasons stated, I
respectfully dissent.
1
Each man filed a joint tax return with his wife.
2

Section 1366(a)(1) provides:
“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..., 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....”
3
In Nelson, the Tax Court held that excluded discharge of
indebtedness does not pass through to an S corporation's
shareholders because section 108 is an exception to normal S
corporation pass-through rules. Specifically, the court held that,
because section 108(d)(7)(A) requires that “subsections (a) [and
(b) of section 108] shall be applied at the corporate level” in the
case of an S corporation, it precludes any pass-through of the
discharge of indebtedness to the shareholder level. See Nelson,
110 T.C., at 121-124.
4
Section 108(b)(1) reads: “The amount excluded from gross
income under [section 108(a)(1)] shall be applied to reduce the
tax attributes of the taxpayer....”
5
The Commissioner has altered his arguments throughout the
course of this litigation. According to the Tax Court, during the
first iteration of this case the Commissioner made several
arguments but then settled on a “final” one — that the discharge
of indebtedness of the insolvent S corporation was not an “item
of income,” see 73 TCM 3167 (1997), paragraph 97,286 RIA
Memo TC. In the Court of Appeals, the Commissioner argued
instead that, because any pass-through of excluded discharge of
indebtedness to petitioners took place after any reduction of tax
attributes and by then the income would have been fully

absorbed by the tax attributes, no discharged debt remained to
flow through to petitioners. The Commissioner relegated to a
footnote his argument that discharge of indebtedness is not an
“item of income.” See Brief for Appellee in Nos. 98-9009 and
98-9010 (CA10), p. 33, n.14.
6
The Commissioner also contends, as does the dissent, that
because section 108(d)(7)(A) mandates that the discharged debt
amount be determined and applied to reduce tax attributes “at
the corporate level,” rather than at the shareholder level, the
discharged debt, even if it is some type of income, simply
cannot pass through to shareholders. In other words, the
Commissioner contends that section 108(d)(7)(A) excepts
excluded discharged debt from the general pass-through
provisions for S corporations. However, section 108(d)(7)(A)
merely directs that the exclusion from gross income and the tax
attribute reduction be made at the corporate level. Section
108(d)(7)(A) does not state or imply that the debt discharge
provisions shall apply only “at the corporate level.” The very
purpose of Subchapter S is to tax at the shareholder level, not
the corporate level. Income is determined at the S corporation
level, see section 1363(b), not in order to tax the corporation,
see section 1363(a) (exempting an S corporation from income
tax), but solely to pass through to the S corporation's
shareholders the corporation's income. Thus, the controlling
provision states that, in determining a shareholder's liability,
“there shall be taken into account the shareholder's pro rata
share of the corporation's...items of income (including tax-
exempt income)....” section 1366(a)(1). Nothing in section
108(d)(7)(A) suspends the operation of these ordinary pass-
through rules.
7
Under this scenario, the shareholders' losses would be reduced
by the discharge of indebtedness. However, it is unclear

precisely what would happen to the discharge of indebtedness.
The Court of Appeals below stated that the discharged debt
would be “absorbed” by the reduction to the extent of the net
operating loss and that therefore only the excess excluded
discharged debt would remain to pass through to the
shareholders. 182 F.3d, at 1149. In contrast, another Court of
Appeals suggested, albeit in dictum, that the full amount of the
discharge might still pass through to the shareholder and be
used to increase basis; the discharged debt amount would reduce
the net operating loss but would not be absorbed by it. Witzel v.
Commissioner, 200 F.3d 496, 498 [85 AFTR 2d 2000-483] (CA7
2000). We need not resolve this issue because we conclude that
the discharge of indebtedness passes through before any
attribute reduction takes place.
8
The Commissioner has abandoned his argument related to the
sequencing issue before this Court. This abandonment is
particularly odd given that the sequencing issue predominated
in the Commissioner's argument to the Court of Appeals.
Notwithstanding the Commissioner's attempt at oral argument to
distance himself from the reasoning of the Court of Appeals on
this issue — the Commissioner represented to us that the Court
of Appeals developed its reading of the statute sua sponte, Tr.
of Oral Arg. 22-24, 27 — it is apparent from the
Commissioner's brief in the Court of Appeals that the
Commissioner supplied the very sequencing theory that the
Court of Appeals adopted. Compare, e.g., Brief for Appellee in
Nos. 98-9009 and 98-9010 (CA10), p. 28 (“First, the discharge
of indebtedness income that is excluded under Section 108(a) at
the corporate level is temporarily set aside and has no tax
consequences....Second, PDW & A. computes its tax attributes,
i.e., taxpayers' suspended losses. Third, the excluded discharge
of indebtedness income is applied against and eliminates the
suspended losses. Because the excluded income is applied
against — and offset by — the suspended losses, no item of

income flows through to taxpayers under Section 1366(a), and
no upward basis adjustment is made under Section 1367(a)”
(citations omitted)), with, e.g., 182 F.3d, at 1151 (“PDW & A
first must compute its discharge of indebtedness income and set
this figure aside temporarily. The corporation then must
calculate its net operating loss tax attribute....Finally, the
corporation must apply the excluded discharged debt to reduce
its tax attributes. In this case, the net operating loss tax
attribute fully absorbs the corporation's excluded discharge of
indebtedness income. Thus, there are no items of income to pass
through to Gitlitz and Winn”).
9
Similar to this argument is the contention that, in cases such as
this one in which the shareholders' suspended losses are fully
deducted before attribute reduction could take place, no net
operating loss remains and no attribute reduction can occur,
thus rendering section 108(b) inoperative. However, there will
be other cases in which section 108(b) will be inoperative. In
particular, if a taxpayer has no tax attributes at all, there will be
no reduction. Certainly the statute does not condition the
exclusion under section 108(a) on the ability of the taxpayer to
reduce attributes under section 108(b). Likewise, in the case of
shareholders similarly situated to petitioners in this case, there
is also the possibility that other attributes, see sections
108(b)(2)(B)-(G), could be reduced.
10
The benefit at issue in this case arises in part because section
108(d)(7)(A) permits the exclusion of discharge of indebtedness
income from gross income for an insolvent S corporation even
when the S corporation shareholder is personally solvent. We
are aware of no other instance in which section 108 directly
benefits a solvent entity. However, the result is required by
statute. Between 1982 and 1984, section 108 provided that the
exclusion from gross income and the reduction in tax attributes

occurred at the shareholder level. See Subchapter S Revision
Act of 1982, Pub. L. No. 97-354, section 3(e), 96 Stat. 1689.
This provision, which paralleled the current taxation of
partnerships at the partner level, see 26 U.S.C. section
108(d)(6), prevented solvent shareholders from benefiting as a
result of their S corporation's insolvency. In 1984, however,
Congress amended the Code to provide that section 108 be
applied “at the corporate level.” Tax Reform Act of 1984, Pub.
L. No. 98-369, section 721(b), 98 Stat. 966. It is as a direct
result of this amendment that the solvent petitioners in this case
are able to benefit from section 108's exclusion.
WARD v. U.S., Cite as 48 AFTR 2d 81-5942, Code Sec(s) 1371,
(Ct Cl), 09/23/1981
John S. WARD, PLAINTIFF v. U.S., DEFENDANT.
Case Information:
[pg. 81-5942]
Code Sec(s):
1371
Court Name:
U.S. Court of Claims,
Docket No.:
No. 398-79T,
Date Decided:
09/23/1981
Prior History:
Trial Judge's opinion, 48 AFTR 2d 81-5337, adopted.
Tax Year(s):
Years 1969, 1970 and 1972.
Disposition:
Decision for Govt.
Cites:
48 AFTR 2d 81-5942, 228 Ct Cl 690, 661 F2d 226, 81-2 USTC
P 9674.

HEADNOTE
1. SUBCHAPTER S ELECTION—Eligible corporations—
shareholders. Net operating loss denied taxpayer since his corp.
didn't qualify for Sub S election. Taxpayer's marriage to
nonresident alien under Mexican community property law made
wife half owner of stock and thus disqualified corp. from
making small business election. Taxpayer's Sec. 981 election
only applied to income, not property ownership; even if it had
applied, a 1977 election couldn't retroactively convert corp. to
Sub S corp. for 1972.
Reference(s): 1981 P-H Fed. ¶33,367.5(60); ¶30,911. Code Sec.
1371; Code Sec. 981.
OPINION
Towner Leeper, David Leeper, Attys. for Plaintiff.
Mary M. Abate, Theodore D. Peyser, Donald H. Olson, Attys.,
John F. Murray, Act. Asst. Atty. Gen., for Defendant.
Before DAVIS, NICHOLS and BENNETT, Judges.
Judge: PER CURIAM:
Opinion
This case comes before the court on defendant's motion, filed
August 3, 1981, requesting that the court adopt as the basis for
its judgment in this case the recommended decision of Senior
Trial Judge Mastin G. White, filed June 22, 1981, pursuant to
Rule 134(h), since plaintiff has filed no notice of intention to
except or exceptions thereto and the time for so filing under the
Rules of the court has expired. Upon consideration thereof,
without oral argument, since the court agrees with the
recommended decision, as hereinafter set forth * , it hereby
grants defendant's [pg. 81-5943] motion and adopts the decision
as the basis for its judgment in this case. Accordingly, plaintiff
is not entitled to recover, and the petition is dismissed.
Opinion of Trial Judge
Judge: WHITE, Senior Trial Judge:
The plaintiff, John S. Ward, sues for refunds of income taxes
assessed against and collected from the plaintiff for the calendar
years 1972, 1970, and 1969, in the respective amounts of

$664.80, $3,775.70, and $1,758.44, together with interest on
such amounts.
The plaintiff relies on section 1374 of the Internal Revenue
Code of 1954 (the 1954 Code), which states in subsection (a)
the general rule that "A net operating loss of an electing small
business corporation for any taxable year shall be allowed as a
deduction from gross income of the shareholders of such
corporation *** " (emphasis supplied).
In support of his claim, the plaintiff contends: that he was the
sole stockholder in 1972 of Wheels West, Inc., that this
corporation was a "small business corporation," as that term is
defined in section 1371(a) of the 1954 Code; that Wheels West,
Inc., was also an "electing small business corporation," as that
term defined in section 1371(b) of the 1954 Code, because the
corporation had made an election on February 15, 1972, under
section 1372(a) of the 1954 Code not to be subject, for its
taxable year beginning January 17, 1972, to the taxes imposed
by chapter 1 of the 1954 Code (relating to normal income taxes
and surtaxes); and that Wheels West, Inc., sustained a net
operating loss of $42,047.14 in 1972, resulting in an authorized
deduction from the plaintiff's gross income for 1972 and also in
a net operating loss carryback to the plaintiff's taxable years
1970 and 1969.
The plaintiff's claim for refunds of 1972, 1970, and 1969
income taxes, based upon the grounds previously outlined, was
submitted to, and denied by, the Internal Revenue Service. The
present litigation followed.
[1] The Government's defense against the action is based
principally upon the contention that Wheels West, Inc., did not
qualify as a small business corporation because the plaintiff's
wife, a nonresident alien, was a shareholder in the corporation;
and, therefore, that Wheels West, Inc., was not eligible to make
an election under section 1372(a) of the 1954 Code.
In 1972, section 1371(a) of the 1954 Code (26 U.S.C. §1371(a)
(1970)) defined a "small business corporation" in negative terms
as a domestic corporation which did not—

((1)) have more than 10 shareholders;
((2)) have as a shareholder a person (other than an estate) who
was not an individual;
((3)) have a nonresident alien as a shareholder; and
((4)) have more than one class of stock.
The parties are in agreement that, at all times material to this
case, Guadalupe Perez Ward, the plaintiff's wife, was a
nonresident alien, being a citizen of Mexico and a resident of
Juarez, Mexico. Accordingly, the primary issue to be decided by
the court is whether the plaintiff's wife was or was not a
shareholder in Wheels West, Inc.
Wheels West, Inc., was organized by the plaintiff under the
laws of New Mexico in 1972. Seventy shares of capital stock in
the corporation, having a par value of $100 per share, were
issued in the name of John S. Ward. No other stock was issued
by the corporation. In payment for the shares of stock, the
plaintiff drew a check in the amount of $7,500 on his account
with the Southwest National Bank of El Paso, Texas, the check
being payable to Wheels West, Inc. The plaintiff obtained the
$7,500 by borrowing the money from the profit-sharing plan of
his employer.
On February 15, 1972, the plaintiff executed on behalf of
Wheels West, Inc., a Form 2553, Election by Small Business
Corporation, being an election not to be taxed under chapter 1
of the 1954 Code for the corporation's taxable year beginning
January 17, 1972.
The defendant takes the position, however, that Wheels West,
Inc., was not eligible to make such an election as a small
business corporation because, by virtue of Mexican law, the
shares of stock in Wheels West, Inc., were the community
property of, and were jointly owned by, the plaintiff and his
wife, thus making the latter, a nonresident alien, a shareholder
in the corporation.
The plaintiff is a citizen of the United States, and, as previously
stated, his wife is a citizen of Mexico. The plaintiff and his [pg.
81-5944] wife were married on November 9, 1960, in Juarez,

Mexico. At all times material to this case, the plaintiff and his
wife resided and were domiciled in Juarez.
Some 4 or 5 months before their marriage, the plaintiff and
Guadalupe Perez orally agreed that they would maintain
separate property during the existence of the marriage. This
agreement was made in Juarez. At the time when the marriage
was performed, however, the plaintiff and his wife signed,
before a judge of the Civil Registry in Juarez, the document
comprising the public record of their marriage, and this
marriage record, or contract, expressly provided that the
marriage was to be under the regime of the "sociedad
conyugal," i.e., under the community property system.
Under Mexican law, the parties to a marriage can mutually
agree at the time of the marriage either (1) that there shall be a
separation of property in the marriage, or (2) that the marriage
shall be under the community property system. In order to be
valid, an agreement that there shall be a separation of property
must be incorporated in the public record of the marriage
contract; and in the absence of a specific provision in the public
record of the marriage contract on the subject of the ownership
of property, a marriage is automatically under the community
property system.
An oral agreement between the parties to a marriage that there
shall be a separation of property is ineffective. In view of this,
and as the public record of the marriage contract between the
plaintiff and his wife specifically provided that the marriage
was to be under the regime of the "sociedad conyugal," the
prenuptial oral agreement between the plaintiff and Guadalupe
Perez was ineffective, and their subsequent marriage was under
the community property system.
Under the community property system of Mexico, all the
property acquired by the husband or the wife during the
existence of the marriage is the community property of, and is
owned jointly by, the husband and the wife, except that property
acquired by the husband or the wife, through donation,
inheritance, or "act of fortune" is the personal property of the

acquiring spouse. Accordingly, as the shares of stock in Wheels
West, Inc., which the plaintiff acquired in 1972 were not
acquired through donation, inheritance, or an "act of fortune,"
the stock became the community property of, and was owned
jointly by, the plaintiff and his wife. Hence, the plaintiff's wife,
a nonresident alien as regards the United States, was a
shareholder in Wheels West, Inc.
For that reason, Wheels West, Inc., did not qualify as a "small
business corporation," and its purported 1972 election under
section 1372(a) of the 1954 Code was ineffective.
The plaintiff calls attention to the fact that he and his wife,
acting under the authority of section 981 of the 1954 Code, as
applicable to the year 1972, submitted to the Internal Revenue
Service in March 1977 an election "to have the community
property laws of Mexico inapplicable to the income realized by
either or both of us for the calendar year 1972."
In 1972, section 981 provided that if a citizen of the United
States resided in a foreign country throughout an entire taxable
year, and was married at the close of the taxable year to a
spouse who was a nonresident alien during the entire taxable
year, the citizen-taxpayer and his or her spouse, if they wished
to do so, could elect to have the community property laws of the
foreign country of residence inapplicable for such year and
subsequent years to (1) earned income, (2) trade or business
income, and a partner's distributive share of partnership income,
and (3) any other community income derived from the separate
property of the husband or wife (26 U.S.C. §981 (1970)). 1
It will be noted that under section 981 an election by a
nonresident citizen-taxpayer and his or her nonresident alien
spouse related only to certain types of income which, in absence
of an election, would have constituted community property
under the laws of the foreign country of residence. An election
under section 981 did not have any effect on the ownership of
property by the nonresident citizen-taxpayer and his or her
nonresident alien spouse.
Moreover, the election made by the plaintiff and his wife in

1977 referred only to "the income realized" by them in 1972,
and did not purport to affect the ownership of property.
Even if the plaintiff and his wife had attempted, in their 1977
action, to convert their marriage from the "sociedad conyugal"
to the separate property system (as can be done under Mexican
law if certain formalities are observed), such action could not
have converted Wheels West, Inc., retroactively into an
"electing small business corporation" for its taxable year 1972.
Section 1372(c)(1) provided in 1972 (26 U.S.C. §1372(c)(1)
(1970)) that a small business corporation wishing to relieve
itself for a taxable year of taxation under [pg. 81-5945] chapter
1 of the 1954 Code could make the election only during "the
first month of such taxable year, or at any time during the
month preceding such first month." There was no statutory
provision whereby an enlargement of the 2-month election
period could be obtained. Hence, the eligibility of Wheels West,
Inc., to make an election for its taxable year 1972 depended
entirely on the status of the corporation (with respect to the
citizenship of shareholders, etc.) during the first month of such
taxable year and the preceding month. As of those months, the
plaintiff's wife, a nonresident alien as regards the United States,
was a shareholder in the corporation by virtue of the community
property laws of Mexico; and, consequently Wheels West, Inc.,
did not qualify as a small business corporation and was
ineligible to make an election not to be taxed under chapter 1 of
the 1954 Code. Eligibility could not be conferred retroactively
by any action taken by the plaintiff and his wife, with respect to
the ownership of property, after the termination of the 2-month
election period.
It is my opinion, therefore, that the Internal Revenue Service
did not err in denying the plaintiff's claim of entitlement to
deduct from his gross income the amount of the net operating
loss sustained by Wheels West, Inc., during its taxable year
1972. The petition shoud be dismissed.
Conclusion Of Law
Upon the findings of fact and the foregoing opinion, which are

adopted by the court, the court concludes as a matter of law that
the plaintiff is not entitled to recover; and the petition is
therefore dismissed.
*
Although the court adopted the trial judge's separate findings
of fact, which are set forth in his report, they are not printed
herein since such facts as are necessary to the decision are
contained in his opinion.
1
Section 981 was repealed by section 1012(b)(2) of Public Law
94-455 (90 Stat. 1614).
Internal Revenue Code
§ 1363 Effect of election on corporation.
(a) General rule.
(1) In general.
For purposes of this title, the term “S corporation” means, with
respect to any taxable year, a small business corporation for
which an election under section 1362(a) is in effect for such
year.
(2) C corporation.
For purposes of this title, the term “C corporation” means, with
respect to any taxable year, a corporation which is not an S
corporation for such year.
(b) Small business corporation.
(1) In general.
For purposes of this subchapter, the term “small business
corporation” means a domestic corporation which is not an
ineligible corporation and which does not—
(A) have more than 100 shareholders,
(B) have as a shareholder a person (other than an estate, a trust

described in subsection (c)(2) , or an organization described in
subsection (c)(6) ) who is not an individual,
(C) have a nonresident alien as a shareholder, and
(D) have more than 1 class of stock.
(2) Ineligible corporation defined.
For purposes of paragraph (1) , the term “ineligible
corporation” means any corporation which is—
(A) a financial institution which uses the reserve method of
accounting for bad debts described in section 585 ,
(B) an insurance company subject to tax under subchapter L,
(C) a corporation to which an election under section 936
applies, or
(D) a DISC or former DISC.
(3) Treatment of certain wholly owned subsidiaries.
(A) In general. Except as provided in regulations prescribed by
the Secretary, for purposes of this title—
(i) a corporation which is a qualified subchapter S subsidiary
shall not be treated as a separate corporation, and
(ii) 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.
(B) Qualified subchapter S subsidiary. For purposes of this
paragraph , the term “qualified subchapter S subsidiary” means
any domestic corporation which is not an ineligible corporation
(as defined in paragraph (2) ), if—
(i) 100 percent of the stock of such corporation is held by the S
corporation, and
(ii) the S corporation elects to treat such corporation as a
qualified subchapter S subsidiary.
(C) Treatment of terminations of qualified subchapter S
subsidiary status.
(i) In general. For purposes of this title, if any corporation
which was a qualified subchapter S subsidiary ceases to meet
the requirements of subparagraph (B) , such corporation shall be
treated as a new corporation acquiring all of its assets (and

assuming all of its liabilities) immediately before such cessation
from the S corporation in exchange for its stock.
(ii) Termination by reason of sale of stock. If the failure to
meet the requirements of subparagraph (B) is by reason of the
sale of stock of a corporation which is a qualified subchapter S
subsidiary, the sale of such stock shall be treated as if—
(I) the sale were a sale of an undivided interest in the assets of
such corporation (based on the percentage of the corporation's
stock sold), and
(II) the sale were followed by an acquisition by such
corporation of all of its assets (and the assumption by such
corporation of all of its liabilities) in a transaction to which
section 351 applies.
(D) Election after termination. If a corporation's status as a
qualified subchapter S subsidiary terminates, such corporation
(and any successor corporation) shall not be eligible to make—
(i) an election under subparagraph (B)(ii) to be treated as a
qualified subchapter S subsidiary, or
(ii) an election under section 1362(a) to be treated as an S
corporation,
before its 5th taxable year which begins after the 1st taxable
year for which such termination was effective, unless the
Secretary consents to such election.
(E) Information returns. Except to the extent provided by the
Secretary, this paragraph shall not apply to part III of
subchapter A of chapter 61 (relating to information returns).
(c) Special rules for applying subsection (b) .
(1) Members of a family treated as 1 shareholder.
(A) In general. For purposes of subsection (b)(1)(A), there
shall be treated as one shareholder—
(i) a husband and wife (and their estates), and
(ii) all members of a family (and their estates).
(B) Members of a family. For purposes of this paragraph—
(i) In general. The term “members of a family” means a
common ancestor, any lineal descendant of such common
ancestor, and any spouse or former spouse of such common

ancestor or any such lineal descendant.
(ii) Common ancestor. An individual shall not be considered to
be a common ancestor if, on the applicable date, the individual
is more than 6 generations removed from the youngest
generation of shareholders who would (but for this
subparagraph ) be members of the family. For purposes of the
preceding sentence, a spouse (or former spouse) shall be treated
as being of the same generation as the individual to whom such
spouse is (or was) married.
(iii) Applicable date. The term “applicable date” means the
latest of—
(I) the date the election under section 1362(a) is made,
(II) the earliest date that an individual described in clause (i)
holds stock in the S corporation, or
(III) October 22, 2004.
(C) Effect of adoption, etc. Any legally adopted child of an
individual, any child who is lawfully placed with an individual
for legal adoption by the individual, and any eligible foster
child of an individual (within the meaning of section
152(f)(1)(C) ), shall be treated as a child of such individual by
blood.
(2) Certain trusts permitted as shareholders.
(A) In general. For purposes of subsection (b)(1)(B) , the
following trusts may be shareholders:
(i) A trust all of which is treated (under subpart E of part I of
subchapter J of this chapter) as owned by an individual who is a
citizen or resident of the United States.
(ii) A trust which was described in clause (i) immediately
before the death of the deemed owner and which continues in
existence after such death, but only for the 2-year period
beginning on the day of the deemed owner's death.
(iii) A trust with respect to stock transferred to it pursuant to
the terms of a will, but only for the 2-year period beginning on
the day on which such stock is transferred to it.
(iv) A trust created primarily to exercise the voting power of
stock transferred to it.

(v) An electing small business trust.
(vi) In the case of a corporation which is a bank (as defined in
section 581 ) or a depository institution holding company (as
defined in section 3(w)(1) of the Federal Deposit Insurance Act
(12 U.S.C. 1813(w)(1)), a trust which constitutes an individual
retirement account under section 408(a) , including one
designated as a Roth IRA under section 408A , but only to the
extent of the stock held by such trust in such bank or company
as of the date of the enactment of this clause.
This subparagraph shall not apply to any foreign trust.
(B) Treatment as shareholders.—For purposes of subsection
(b)(1) —
(i) In the case of a trust described in clause (i) of subparagraph
(A) , the deemed owner shall be treated as the shareholder.
(ii) In the case of a trust described in clause (ii) of
subparagraph (A) , the estate of the deemed owner shall be
treated as the shareholder.
(iii) In the case of a trust described in clause (iii) of
subparagraph (A) , the estate of the testator shall be treated as
the shareholder.
(iv) In the case of a trust described in clause (iv) of
subparagraph (A) , each beneficiary of the trust shall be treated
as a shareholder.
(v) In the case of a trust described in clause (v) of
subparagraph (A) , each potential current beneficiary of such
trust shall be treated as a shareholder; except that, if for any
period there is no potential current beneficiary of such trust,
such trust shall be treated as the shareholder during such period.
(vi) In the case of a trust described in clause (vi) of
subparagraph (A) , the individual for whose benefit the trust
was created shall be treated as a shareholder.
(3) Estate of individual in bankruptcy may be shareholder.
For purposes of subsection (b)(1)(B) , the term “estate” includes
the estate of an individual in a case under title 11 of the United
States Code.
(4) Differences in common stock voting rights disregarded.

For purposes of subsection (b)(1)(D) , a corporation shall not be
treated as having more than 1 class of stock solely because there
are differences in voting rights among the shares of common
stock.
(5) Straight debt safe harbor.
(A) In general. For purposes of subsection (b)(1)(D) , straight
debt shall not be treated as a second class of stock.
(B) Straight debt defined. For purposes of this paragraph , the
term “straight debt” means any written unconditional promise to
pay on demand or on a specified date a sum certain in money
if—
(i) the interest rate (and interest payment dates) are not
contingent on profits, the borrower's discretion, or similar
factors,
(ii) there is no convertibility (directly or indirectly) into stock,
and
(iii) the creditor is an individual (other than a nonresident
alien), an estate, a trust described in paragraph (2) , or a person
which is actively and regularly engaged in the business of
lending money.
(C) Regulations. The Secretary shall prescribe such regulations
as may be necessary or appropriate to provide for the proper
treatment of straight debt under this subchapter and for the
coordination of such treatment with other provisions of this
title.
(6) Certain exempt organizations permitted as shareholders.
For purposes of subsection (b)(1)(B) , an organization which
is—
(A) described in section 401(a) or 501(c)(3) , and
(B) exempt from taxation under section 501(a) ,
may be a shareholder in an S corporation.
(d) Special rule for qualified subchapter S trust.
(1) In general.
In the case of a qualified subchapter S trust with respect to
which a beneficiary makes an election under paragraph (2) —
(A) such trust shall be treated as a trust described in subsection

(c)(2)(A)(i) ,
(B) for purposes of section 678(a) , the beneficiary of such
trust shall be treated as the owner of that portion of the trust
which consists of stock in an S corporation with respect to
which the election under paragraph (2) is made, and
(C) for purposes of applying sections 465 and 469 to the
beneficiary of the trust, the disposition of the S corporation
stock by the trust shall be treated as a disposition by such
beneficiary.
(2) Election.
(A) In general. A beneficiary of a qualified subchapter S trust
(or his legal representative) may elect to have this subsection
apply.
(B) Manner and time of election.
(i) Separate election with respect to each corporation. An
election under this paragraph shall be made separately with
respect to each corporation the stock of which is held by the
trust.
(ii) Elections with respect to successive income beneficiaries.
If there is an election under this paragraph with respect to any
beneficiary, an election under this paragraph shall be treated as
made by each successive beneficiary unless such beneficiary
affirmatively refuses to consent to such election.
(iii) Time, manner, and form of election. Any election, or
refusal, under this paragraph shall be made in such manner and
form, and at such time, as the Secretary may prescribe.
(C) Election irrevocable. An election under this paragraph ,
once made, may be revoked only with the consent of the
Secretary.
(D) Grace period. An election under this paragraph shall be
effective up to 15 days and 2 months before the date of the
election.
(3) Qualified subchapter S trust.
For purposes of this subsection , the term “qualified subchapter
S trust” means a trust—
(A) the terms of which require that—

(i) during the life of the current income beneficiary, there shall
be only 1 income beneficiary of the trust,
(ii) any corpus distributed during the life of the current income
beneficiary may be distributed only to such beneficiary,
(iii) the income interest of the current income beneficiary in
the trust shall terminate on the earlier of such beneficiary's
death or the termination of the trust, and
(iv) upon the termination of the trust during the life of the
current income beneficiary, the trust shall distribute all of its
assets to such beneficiary, and
(B) all of the income (within the meaning of section 643(b) ) of
which is distributed (or required to be distributed) currently to 1
individual who is a citizen or resident of the United States.
A substantially separate and independent share of a trust within
the meaning of section 663(c) shall be treated as a separate trust
for purposes of this subsection and subsection (c) .
(4) Trust ceasing to be qualified.
(A) Failure to meet requirements of paragraph (3)(A) . If a
qualified subchapter S trust ceases to meet any requirement of
paragraph (3)(A) , the provisions of this subsection shall not
apply to such trust as of the date it ceases to meet such
requirement.
(B) Failure to meet requirements of paragraph (3)(B) . If any
qualified subchapter S trust ceases to meet any requirement of
paragraph (3)(B) but continues to meet the requirements of
paragraph (3)(A) , the provisions of this subsection shall not
apply to such trust as of the first day of the first taxable year
beginning after the first taxable year for which it failed to meet
the requirements of paragraph (3)(B) .
(e) Electing small business trust defined.
(1) Electing small business trust.
For purposes of this section —
(A) In general. Except as provided in subparagraph (B) , the
term “electing small business trust” means any trust if—
(i) such trust does not have as a beneficiary any person other
than (I) an individual, (II) an estate, (III) an organization

described in paragraph (2) , (3) ,(4) , or (5) of section 170(c) ,
or (IV) an organization described in section 170(c)(1) which
holds a contingent interest in such trust and is not a potential
current beneficiary,
(ii) no interest in such trust was acquired by purchase, and
(iii) an election under this subsection applies to such trust.
(B) Certain trusts not eligible. The term “electing small
business trust” shall not include—
(i) any qualified subchapter S trust (as defined insubsection
(d)(3) ) if an election under subsection (d)(2) applies to any
corporation the stock of which is held by such trust,
(ii) any trust exempt from tax under this subtitle, and
(iii) any charitable remainder annuity trust or charitable
remainder unitrust (as defined in section 664(d) ).
(C) Purchase. For purposes of subparagraph (A) , the term
“purchase” means any acquisition if the basis of the property
acquired is determined under section 1012 .
(2) Potential current beneficiary.
For purposes of this section , the term “potential current
beneficiary” means, with respect to any period, any person who
at any time during such period is entitled to, or at the discretion
of any person may receive, a distribution from the principal or
income of the trust (determined without regard to any power of
appointment to the extent such power remains unexercised at
the end of such period). If a trust disposes of all of the stock
which it holds in a S corporation, then, with respect to such
corporation, the term “potential current beneficiary” does not
include any person who first met the requirements of the
preceding sentence during the 1-year period ending on the date
of such disposition.
(3) Election.
An election under this subsection shall be made by the trustee.
Any such election shall apply to the taxable year of the trust for
which made and all subsequent taxable years of such trust
unless revoked with the consent of the Secretary.
(4) Cross reference.

For special treatment of electing small business trusts, see
section 641(c).
(f) Restricted bank director stock.
(1) In general.
Restricted bank director stock shall not be taken into account as
outstanding stock of the S corporation in applying this
subchapter (other than section 1368(f)).
(2) Restricted bank director stock.
For purposes of this subsection, the term “restricted bank
director stock” means stock in a bank (as defined in section
581) or a depository institution holding company (as defined in
section 3(w)(1) of the Federal Deposit Insurance Act (12 U.S.C.
1813(w)(1)), if such stock—
(A) is required to be held by an individual under applicable
Federal or State law in order to permit such individual to serve
as a director, and
(B) is subject to an agreement with such bank or company (or a
corporation which controls (within the meaning of section
368(c)) such bank or company) pursuant to which the holder is
required to sell back such stock (at the same price as the
individual acquired such stock) upon ceasing to hold the office
of director.
(3) Cross reference.
For treatment of certain distributions with respect to restricted
bank director stock, see section 1368(f).
(g) Special rule for bank required to change from the reserve
method of accounting on becoming S corporation.
In the case of a bank which changes from the reserve method of
accounting for bad debts described in section 585 or 593 for its
first taxable year for which an election under section 1362(a) is
in effect, the bank may elect to take into account any
adjustments under section 481 by reason of such change for the
taxable year immediately preceding such first taxable year.
§ 1362 Election; revocation; termination.
(a) Election.

(1) In general.
Except as provided in subsection (g) , a small business
corporation may elect, in accordance with the provisions of this
section, to be an S corporation.
(2) All shareholders must consent to election.
An election under this subsection shall be valid only if all
persons who are shareholders in such corporation on the day on
which such election is made consent to such election.
(b) When made.
(1) In general.
An election under subsection (a) may be made by a small
business corporation for any taxable year—
(A) at any time during the preceding taxable year, or
(B) at any time during the taxable year and on or before the
15th day of the 3d month of the taxable year.
(2) Certain elections made during 1st 2 1/2 months treated as
made for next taxable year.
If—
(A) an election under subsection (a) is made for any taxable
year during such year and on or before the 15th day of the 3d
month of such year, but
(B) either—
(i) on 1 or more days in such taxable year before the day on
which the election was made the corporation did not meet the
requirements of subsection (b) of section 1361 , or
(ii) 1 or more of the persons who held stock in the corporation
during such taxable year and before the election was made did
not consent to the election,
then such election shall be treated as made for the following
taxable year.
(3) Election made after 1st 2 1/2 months treated as made for
following taxable year.
If—
(A) a small business corporation makes an election under
subsection (a) for any taxable year, and
(B) such election is made after the 15th day of the 3d month of

the taxable year and on or before the 15th day of the 3rd month
of the following taxable year,
then such election shall be treated as made for the following
taxable year.
(4) Taxable years of 2 1/2 months or less.
For purposes of this subsection , an election for a taxable year
made not later than 2 months and 15 days after the first day of
the taxable year shall be treated as timely made during such
year.
(5) Authority to treat late elections, etc., as timely.
If—
(A) an election under subsection (a) is made for any taxable
year (determined without regard to paragraph (3) ), after the
date prescribed by this subsection for making such election for
such taxable year or no such election is made for any taxable
year, and
(B) the Secretary determines that there was reasonable cause
for the failure to timely make such election,
the Secretary may treat such an election as timely made for such
taxable year (and paragraph (3) shall not apply).
(c) Years for which effective.
An election under subsection (a) shall be effective for the
taxable year of the corporation for which it is made and for all
succeeding taxable years of the corporation, until such election
is terminated under subsection (d) .
(d) Termination.
(1) By revocation.
(A) In general. An election under subsection (a) may be
terminated by revocation.
(B) More than one-half of shares must consent to revocation.
An election may be revoked only if shareholders holding more
than one-half of the shares of stock of the corporation on the
day on which the revocation is made consent to the revocation.
(C) When effective. Except as provided in subparagraph (D) —
(i) a revocation made during the taxable year and on or before
the 15th day of the 3d month thereof shall be effective on the

1st day of such taxable year, and
(ii) a revocation made during the taxable year but after such
15th day shall be effective on the 1st day of the following
taxable year.
(D) Revocation may specify prospective date. If the revocation
specifies a date for revocation which is on or after the day on
which the revocation is made, the revocation shall be effective
on and after the date so specified.
(2) By corporation ceasing to be small business corporation.
(A) In general. An election under subsection (a) shall be
terminated whenever (at any time on or after the 1st day of the
1st taxable year for which the corporation is an S corporation)
such corporation ceases to be a small business corporation.
(B) When effective. Any termination under this paragraph shall
be effective on and after the date of cessation.
(3) Where passive investment income exceeds 25 percent of
gross receipts for 3 consecutive taxable years and corporation
has accumulated earnings and profits.
(A) Termination.
(i) In general. An election under subsection (a) shall be
terminated whenever the corporation—
(I) has accumulated earnings and profits at the close of each of
3 consecutive taxable years, and
(II) has gross receipts for each of such taxable years more than
25 percent of which are passive investment income.
(ii) When effective. Any termination under this paragraph shall
be effective on and after the first day of the first taxable year
beginning after the third consecutive taxable year referred to in
clause (i) .
(iii) Years taken into account. A prior taxable year shall not be
taken into account under clause (i) unless—
(I) such taxable year began after December 31, 1981, and
(II) the corporation was an S corporation for such taxable year.
(B) Gross receipts from the sales of certain assets. For
purposes of this paragraph—
(i) in the case of dispositions of capital assets (other than stock

and securities), gross receipts from such dispositions shall be
taken into account only to the extent of the capital gain net
income therefrom, and
(ii) in the case of sales or exchanges of stock or securities,
gross receipts shall be taken into account only to the extent of
the gains therefrom.
(C) Passive investment income defined.
(i) In general. Except as otherwise provided in this
subparagraph, the term “passive investment income” means
gross receipts derived from royalties, rents, dividends, interest,
and annuities.
(ii) Exception for interest on notes from sales of inventory. The
term “passive investment income” shall not include interest on
any obligation acquired in the ordinary course of the
corporation's trade or business from its sale of property
described in section 1221(a)(1).
(iii) Treatment of certain lending or finance companies. If the S
corporation meets the requirements of section 542(c)(6) for the
taxable year, the term “passive investment income” shall not
include gross receipts for the taxable year which are derived
directly from the active and regular conduct of a lending or
finance business (as defined in section 542(d)(1)).
(iv) Treatment of certain dividends. If an S corporation holds
stock in a C corporation meeting the requirements of section
1504(a)(2) , the term “passive investment income” shall not
include dividends from such C corporation to the extent such
dividends are attributable to the earnings and profits of such C
corporation derived from the active conduct of a trade or
business.
(v) Exception for banks, etc. In the case of a bank (as defined
in section 581 ) or a depository institution holding company (as
defined in section 3(w)(1) of the Federal Deposit Insurance Act
(12 U.S.C. 1813(w)(1)), the term “passive investment income”
shall not include—
(I) interest income earned by such bank or company, or
(II) dividends on assets required to be held by such bank or

company, including stock in the Federal Reserve Bank, the
Federal Home Loan Bank, or the Federal Agricultural Mortgage
Bank or participation certificates issued by a Federal
Intermediate Credit Bank.
(e) Treatment of S termination year.
(1) In general.
In the case of an S termination year, for purposes of this title—
(A) S short year. The portion of such year ending before the 1st
day for which the termination is effective shall be treated as a
short taxable year for which the corporation is an S corporation.
(B) C short year. The portion of such year beginning on such
1st day shall be treated as a short taxable year for which the
corporation is a C corporation.
(2) Pro rata allocation.
Except as provided in paragraph (3) and subparagraphs (C) and
(D) of paragraph (6) , the determination of which items are to
be taken into account for each of the short taxable years
referred to in paragraph (1) shall be made—
(A) first by determining for the S termination year—
(i) the amount of each of the items of income, loss, deduction,
or credit described in section 1366(a)(1)(A) , and
(ii) the amount of the nonseparately computed income or loss,
and
(B) then by assigning an equal portion of each amount
determined under subparagraph (A) to each day of the S
termination year.
(3) Election to have items assigned to each short taxable year
under normal tax accounting rules.
(A) In general. A corporation may elect to have paragraph (2)
not apply.
(B) Shareholders must consent to election. An election under
this subsection shall be valid only if all persons who are
shareholders in the corporation at any time during the S short
year and all persons who are shareholders in the corporation on
the first day of the C short year consent to such election.
(4) S termination year.

For purposes of this subsection , the term “S termination year”
means any taxable year of a corporation (determined without
regard to this subsection ) in which a termination of an election
made under subsection (a) takes effect (other than on the 1st
day thereof).
(5) Tax for C short year determined on annualized basis.
(A) In general. The taxable income for the short year described
in subparagraph (B) of paragraph (1) shall be placed on an
annual basis by multiplying the taxable income for such short
year by the number of days in the S termination year and by
dividing the result by the number of days in the short year. The
tax shall be the same part of the tax computed on the annual
basis as the number of days in such short year is of the number
of days in the S termination year.
(B) Section 443(d)(2) to apply. Subsection (d) of section 443
shall apply to the short taxable year described in subparagraph
(B) of paragraph (1) .
(6) Other special rules.
For purposes of this title—
(A) Short years treated as 1 year for carryover purposes. The
short taxable year described in subparagraph (A) of paragraph
(1) shall not be taken into account for purposes of determining
the number of taxable years to which any item may be carried
back or carried forward by the corporation.
(B) Due date for S year. The due date for filing the return for
the short taxable year described in subparagraph (A) of
paragraph (1) shall be the same as the due date for filing the
return for the short taxable year described in subparagraph (B)
of paragraph (1) (including extensions thereof).
(C) Paragraph (2) not to apply to items resulting from section
338 . Paragraph (2) shall not apply with respect to any item
resulting from the application of section 338 .
(D) Pro rata allocation for S termination year not to apply if
50-percent change in ownership. Paragraph (2) shall not apply
to an S termination year if there is a sale or exchange of 50
percent or more of the stock in such corporation during such

year.
(f) Inadvertent invalid elections or terminations.
If—
(1) an election under subsection (a)or section 1361(b)(3)(B)(ii)
by any corporation—
(A) was not effective for the taxable year for which made
(determined without regard to subsection (b)(2) ) by reason of a
failure to meet the requirements of section 1361(b) or to obtain
shareholder consents, or
(B) was terminated under paragraph (2) or (3) of subsection (d)
or section 1361(b)(3)(C),
(2) the Secretary determines that the circumstances resulting in
such ineffectiveness or termination were inadvertent,
(3) no later than a reasonable period of time after discovery of
the circumstances resulting in such ineffectiveness or
termination, steps were taken—
(A) so that the corporation for which the election was made or
the termination occurred is a small business corporation or a
qualified subchapter S subsidiary, as the case may be, or
(B) to acquire the required shareholder consents, and
(4) the corporation for which the election was made or the
termination occurred, and each person who was a shareholder in
such corporation at any time during the period specified
pursuant to this subsection , agrees to make such adjustments
(consistent with the treatment of such corporation as an S
corporation or a qualified subchapter S subsidiary, as the case
may be) as may be required by the Secretary with respect to
such period,
then, notwithstanding the circumstances resulting in such
ineffectiveness or termination, such corporation shall be treated
as an S corporation or a qualified subchapter S subsidiary, as
the case may be during the period specified by the Secretary.
(g) Election after termination.
If a small business corporation has made an election under
subsection (a) and if such election has been terminated under
subsection (d) , such corporation (and any successor

corporation) shall not be eligible to make an election under
subsection (a) for any taxable year before its 5th taxable year
which begins after the 1st taxable year for which such
termination is effective, unless the Secretary consents to such
election.
§ 1363 Effect of election on corporation.
(a) General rule.
Except as otherwise provided in this subchapter, an S
corporation shall not be subject to the taxes imposed by this
chapter.
(b) Computation of corporation's taxable income.
The taxable income of an S corporation shall be computed in the
same manner as in the case of an individual, except that—
(1) the items described in section 1366(a)(1)(A) shall be
separately stated,
(2) the deductions referred to in section 703(a)(2) shall not be
allowed to the corporation,
(3) section 248 shall apply, and
(4) section 291 shall apply if the S corporation (or any
predecessor) was a C corporation for any of the 3 immediately
preceding taxable years.
(c) Elections of the S corporation.
(1) In general.
Except as provided in paragraph (2) , any election affecting the
computation of items derived from an S corporation shall be
made by the corporation.
(2) Exceptions.
In the case of an S corporation, elections under the following
provisions shall be made by each shareholder separately—
(A) section 617 (relating to deduction and recapture of certain
mining exploration expenditures), and
(B) section 901 (relating to taxes of foreign countries and
possessions of the United States).
(d) Recapture of LIFO benefits.
(1) In general.

If—
(A) an S corporation was a C corporation for the last taxable
year before the first taxable year for which the election under
section 1362(a) was effective, and
(B) the corporation inventoried goods under the LIFO method
for such last taxable year,
the LIFO recapture amount shall be included in the gross
income of the corporation for such last taxable year (and
appropriate adjustments to the basis of inventory shall be made
to take into account the amount included in gross income under
this paragraph ).
(2) Additional tax payable in installments.
(A) In general. Any increase in the tax imposed by this chapter
by reason of this subsection shall be payable in 4 equal
installments.
(B) Date for payment of installments. The first installment
under subparagraph (A) shall be paid on or before the due date
(determined without regard to extensions) for the return of the
tax imposed by this chapter for the last taxable year for which
the corporation was a C corporation and the 3 succeeding
installments shall be paid on or before the due date (as so
determined) for the corporation's return for the 3 succeeding
taxable years.
(C) No interest for period of extension. Notwithstanding
section 6601(b) , for purposes of section 6601 , the date
prescribed for the payment of each installment under this
paragraph shall be determined under this paragraph .
(3) LIFO recapture amount.
For purposes of this subsection , the term “LIFO recapture
amount” means the amount (if any) by which—
(A) the inventory amount of the inventory asset under the first-
in, first-out method authorized by section 471 , exceeds
(B) the inventory amount of such assets under the LIFO
method.
For purposes of the preceding sentence, inventory amounts shall
be determined as of the close of the last taxable year referred to

in paragraph (1) .
(4) Other definitions.
For purposes of this subsection —
(A) LIFO method. The term “LIFO method” means the method
authorized by section 472 .
(B) Inventory assets. The term “inventory assets” means stock
in trade of the corporation, or other property of a kind which
would properly be included in the inventory of the corporation
if on hand at the close of the taxable year.
(C) Method of determining inventory amount. The inventory
amount of assets under a method authorized by section 471 shall
be determined—
(i) if the corporation uses the retail method of valuing
inventories under section 472 , by using such method, or
(ii) if clause (i) does not apply, by using cost or market,
whichever is lower.
(D) Not treated as member of affiliated group. Except as
provided in regulations, the corporation referred to in paragraph
(1) shall not be treated as a member of an affiliated group with
respect to the amount included in gross income under paragraph
(1) .
(5) Special rule.
Sections 1367(a)(2)(D) and 1371(c)(1) shall not apply with
respect to any increase in the tax imposed by reason of this
subsection.
Tax Court & Board of Tax Appeals Memorandum Decisions
T. H. Campbell & Bros., Inc, TC Memo 1975-149. , Code Sec(s)
1372.
T. H. CAMPBELL & BROS., INC.
Case Information:
[pg. 75-679]
Code Sec(s):
1372

Docket:
Docket No. 5195-72.
Date Issued:
05/19/1975
Judge:
Opinion by HALL,J.
Tax Year(s):
Years 1970, 1971.
Disposition:
Deficiencies redetermined.
Cites:
TC Memo 1975-149, PH TCM P 75149, 34 CCH TCM 695.
HEADNOTE
1. SUBCHAPTER S ELECTION—Election—time for election.
Subchapter S treatment denied clothing store that had invalidly
filed for qualification on two separate occasions. First election
attempt was filed too late into existing tax year. Second election
attempt was prematurely filed for intended subsequent tax year.
No matter that IRS had mistakenly marked second election
attempt as valid: estoppel wouldn't preclude IRS from
correcting mistake in law.
Reference(s): 1975 P-H Fed. ¶33,397; Code Sec. 1372.
Syllabus
Official Report
Counsel
Edward M. Dooley, for the petitioner.
Christopher D. Rhodes, for the respondent.
MEMORANDUM FINDINGS OF
FACT AND OPINION
HALL, Judge:
Respondent determined the following deficiencies:
Taxable Year Ended Deficiency
January 31, 1970 ................. $18,072.54
January 31, 1971 ................. 15,118.80
The only issues for decision are whether on each of two
separate occasions petitioner (a corporation) complied with the

filing requirements to qualify for tax treatment under the
subchapter S provisions of the Internal Revenue Code.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
T. H. Campbell & Bros., Inc., petitioner, is a Kentucky
corporation whose principal place of business was Middlesboro,
Kentucky when it filed its petition. It was incorporated on
February 1, 1965. The business was operated as a partnership
prior to incorporation, and consisted of a retail clothing store
both before and after incorporation. The clothing store's
operations were uninterrupted by the incorporation.
Upon incorporation petitioner's shareholders elected to be taxed
under subchapter S. They mailed Form 2553 (Election by Small
Business Corporation) on March 1, 1965, the election to be
effective February 1, 1965. The form was enclosed in an
envelope postmarked March 1, 1965. Form 2553 was received
by the district director at Louisville on March 3, 1965. In a
letter dated March 16, 1965, respondent's Louisville office
advised petitioner that Form 2553 which had been filed March
1, 1965, was not timely, and therefore the corporation had to
file returns as though no election had been made. Thereafter,
petitioner filed standard federal corporate income tax returns,
Forms 1120, for the taxable years ended January 31, 1966, 1967
and 1968.
On November 18, 1968 petitioner again submitted Form 2553,
said election to be effective February 1, 1969. The Form 2553
was received by the district director on November 20, 1968.
However, it is stamped "ACCEPTED DEC 13 1968" and it is
also stamped in the upper right hand corner with an
identification number and the date January 2, 1969. Respondent
determined that this election was premature and hence
ineffective, and assessed deficiencies against petitioner for the
years ended January 31, 1970 and 1971.
OPINION
Section 1372(a) 1 provides that a small business corporation
may elect not to be subject to Federal income taxes with certain

exceptions not here material. Section 1372(c)(1) dictates that
the election for sub-chapter S treatment must be made " *** for
any taxable year at any time during the first month of such
taxable year, or at any time during the month preceding such
first month." The election is made by filing Form 2553 with
respondent. Section[pg. 75-680] 1.1372-2, Income Tax Regs.
Once a valid election has been made, it remains in effect for
succeeding taxable years unless the election is terminated.
Section 1372(d). Section 1372(a) speaks in terms of "months."
If the first day of the first month of the taxable year is on the
first day of a month, the election must be filed during that
month or the preceding month, regardless of the number of days
in each month. Regulation section 1.1372-2(b)(1) expands upon
the statute, noting that where a new corporation's taxable year
begins after the first day of a calendar month, a " *** 'month'
means the period commencing with the beginning of the first
day of the taxable year and ending with the close of the day
preceding the numerically corresponding day of the succeeding
calendar month *** " and that the first month of the taxable
year of a new corporation begins when " *** the corporation has
shareholders or acquires assets or begins doing business,
whichever is the first to occur."
Petitioner claims that it timely executed and filed on two
separate occasions Form 2553, thereby complying with the
requirements of section 1372(c)(1). Petitioner makes two
arguments. First, petitioner contends that its election filed
March 1, 1965 was valid, and that said election remained in
effect through the years at issue even though it filed corporate
income tax returns for those years rather than subchapter S
returns. Second, petitioner contends that even if the first
election were invalid, the election filed in November 1968 for
the taxable year beginning February 1, 1969 was valid, and
respondent is estopped to contest its validity because of his acts
indicating acceptance. Respondent disagrees, arguing that the
earlier election was not timely and is therefore invalid, that the
later election was filed prematurely and therefore is invalid, and

that he is not estopped to contest the validity of the latter
election where his apparent acceptance was the result of a
mistake of law. We agree with respondent.
We commence our analysis with the earlier attempted election.
Petitioner had been operating as a partnership prior to
incorporation on February 1, 1965. It was engaged in the retail
clothing store business. Petitioner filed required Form 2553 on
March 1, 1965 seeking to benefit from the subchapter S
provisions of the Code. Had those been the only facts before us
it would have been axiomatic that petitioner filed its election
one day late. The final date for filing would have been the last
day of February 1965, assuming the first day of the first month
of petitioner's taxable year was February 1, 1965.
But petitioner asserts that the corporation did not begin doing
business until February 2, 1965, and therefore it could file Form
2553 through March 1, 1965. See Reg. 1.1372-2(b)(1), Income
Tax Regs. Petitioner has the burden of proof (Rule 142, Rules
of Practice and Procedure, United States Tax Court) and it has
failed to sustain its contention that the corporation's first
taxable year for election purposes did not begin until February
2, 1965. Petitioner failed to introduce any evidence to show that
the corporation did not have shareholders or assets as of
February 1, 1965, the day of incorporation. Further, George
Campbell, petitioner's executive vice president, testified that
the clothing store did not discontinue operations immediately
prior to the period of incorporation. Without other convincing
evidence, we can only conclude that the corporation was doing
business on February 1, 1965. See Nick A. Artukovich, 61 T.C.
100, 106, fn. 8 (1973).
While petitioner filed the election only one day late, we noted
on an earlier occasion that " *** section *** 1372(c)(1) *** [is]
both demanding and explicit. There is no provision for leniency
with respect to the filing of elections under subchapter S. ***
[W]hatever the equities or the harsh results, we do not feel that
we can grant an extension of time where Congress has
specifically set the time for the making of the election required

GITLITZ, ET AL. v. COMM., Cite as 87 AFTR 2d 2001-417 (531 U.S. 20.docx

GITLITZ, ET AL. v. COMM., Cite as 87 AFTR 2d 2001-417 (531 U.S. 20.docx

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GITLITZ, ET AL. v. COMM., Cite as 87 AFTR 2d 2001-417 (531 U.S. 20.docx