Gitlitz v. Commissioner

Background

David and Louise Gitlitz and Philip and Eleanor Winn were shareholders of P. D. W. & A., an S corporation that had its debts canceled while insolvent. The IRS assessed additional tax because the shareholders increased their stock bases by their shares of the canceled debt (which the corporation excluded from gross income) and then used that increase to deduct suspended losses on their personal returns. The lower Tax Court and the Tenth Circuit had ruled against the shareholders, creating a split among Courts of Appeals.

Reasoning

The Court asked two questions: whether a canceled debt excluded under Section 108 stops being an "item of income," and whether any pass-through to shareholders occurs before corporate tax-attribute reductions. The majority (Justice Thomas) read the tax code to say that exclusion from gross income does not change the character of the canceled debt as an item of income. The Court held that excluded canceled debt does pass through under the S corporation rules to increase shareholder basis, and that statutory sequencing requires shareholders to adjust basis and take deductions before any attribute reductions.

Real world impact

As a result, shareholders of insolvent S corporations (including solvent individual shareholders) can increase their stock basis with the excluded canceled debt and claim previously suspended losses to offset personal income. The decision resolves conflicting Court of Appeals rulings and will affect S corporation taxation nationwide. The opinion also acknowledged that this outcome can produce substantial tax benefits for shareholders and may create differing results depending on timing of debt cancellation.

Dissents or concurrances

Justice Breyer dissented in part, arguing that a provision saying the rule be "applied at the corporate level" could be read to prevent any flow-through, and he warned that allowing pass-through first may preserve a tax advantage Congress likely intended to limit.