Gitlitz v. Commissioner
The Supreme Court ruled that shareholders of an insolvent S corporation can increase their stock basis by the amount of the corporation's canceled debt, even though that debt was excluded from the corporation's taxable income, and that this basis increase happens before any of the corporation's tax attributes are reduced.
The result lets shareholders in this position both avoid tax on the canceled debt and use the resulting higher stock basis to deduct previously blocked losses -- a combination the dissent called an unwarranted double tax benefit, but which the majority found required by the statute's plain text.
“so mere exclusion of an amount from gross income does not imply that the amount ceases to be an item of income”
The Court's core reason for treating tax-free canceled debt as income that still passes through to shareholders.
How it got here: The Tax Court ruled against the shareholders on reconsideration, the Tenth Circuit affirmed, and the shareholders asked the Supreme Court to resolve a split among circuit courts.
The Case in Depth
What happened
Two men each owned half of a small corporation that had elected special "pass-through" tax status. In 1991 the corporation had over $2 million of debt canceled while it was deeply insolvent, so it paid no tax on that canceled debt. The two shareholders then used that canceled-debt amount to raise their stock basis and deduct millions in losses that had previously been blocked because their basis was too low.
The question before the Court
When an insolvent S corporation has debt canceled and doesn't have to pay tax on it, can its shareholders still use that canceled debt to boost their stock basis and unlock old suspended losses?
Why it matters
Shareholders of financially troubled S corporations that have debt forgiven can now count that forgiven debt toward their stock basis, letting them deduct losses that had been stuck on the sidelines. Accountants and tax planners restructuring failing small businesses gain a clearer, more taxpayer-favorable roadmap, while the government loses the ability to collect tax on that benefit.
What changes now
This is a final merits ruling that resolves a split among several federal appeals courts over how to handle canceled debt in insolvent S corporations. The lower court's judgment against the shareholders is reversed, meaning they may keep their loss deductions. Other similarly situated S corporation shareholders and the IRS now have a settled, nationwide rule to follow, though Congress remains free to amend the statute if it disagrees with the outcome.
What this does not decide
The Court did not resolve exactly what happens to any canceled-debt amount left over after shareholders use it to raise their basis and deduct losses -- for example, whether leftover amounts get 'absorbed' by the corporation's tax attributes or simply reduce them without disappearing. It also did not address whether the outcome creates an unfair tax loophole, since it found the statute's text controlling regardless of that policy concern.
Concurrences and dissents
Dissent — Justice Breyer
“The arguments from plain text on both sides here produce ambiguity, not certainty.”Breyer's central objection that the majority treated a genuinely ambiguous statute as clear-cut.
Justice Breyer agreed with most of the majority's reasoning but objected to two footnotes addressing whether a special rule sends the whole canceled-debt process -- including the pass-through -- to the corporate level only, keeping it from ever reaching shareholders. He argued the statutory text is genuinely ambiguous on this point, and that ambiguous tax statutes should be read to close loopholes rather than hand solvent shareholders an unintended windfall from their company's insolvency.
How the Court got there
The legal reasoning, step by step
- The Court first asked whether canceled debt that is excluded from a corporation's taxable income still counts as an 'item of income' that flows through to shareholders under the pass-through statute. It held that being excluded from taxable income is not the same as ceasing to be income at all -- the statute already treats some income, like tax-exempt income, as passing through without being taxed.
- The Court read a companion provision stating that canceled debt is always presumed to be income unless a specific exception applies, which confirmed that excluding it from taxable income does not strip it of its status as income for pass-through purposes.
- The Court rejected the government's argument that a special rule requiring certain calculations to be done 'at the corporate level' blocks the income from passing through to shareholders at all, finding nothing in that rule's text suspending the ordinary pass-through system.
- Having decided canceled debt does pass through, the Court turned to timing: whether shareholders raise their basis and deduct losses before or after the corporation's tax attributes (like its net operating loss) are reduced to offset the tax-free benefit.
- The Court found that a separate provision expressly requires attribute reduction to happen only after the tax owed for the year is calculated, and calculating that tax requires first passing the canceled debt through and adjusting shareholder basis. So the basis increase and loss deductions had to happen before, not after, the corporation's tax attributes were reduced.
- Applying that sequence, the shareholders' basis increase used up their suspended losses entirely, leaving no losses left over to be treated as the corporation's net operating loss, so there was nothing left to reduce at the corporate level.