                       T.C. Memo. 1997-286



                     UNITED STATES TAX COURT



          PHILIP D. AND ELEANOR G. WINN, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

         DAVID A. AND LOUISE A. GITLITZ, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 5358-96, 5359-96.       Filed June 24, 1997.



     Darrell D. Hallett, Larry N. Johnson, Robert J. Chicoine,

and John M. Colvin, for petitioners.

     Keith G. Medleau, for respondent.



                       MEMORANDUM OPINION

     COHEN, Chief Judge:   Respondent determined a deficiency of

$242,555 in Philip D. and Eleanor G. Winn's (the Winns) 1992

Federal income tax and a deficiency of $251,192 in David A. and
                                - 2 -

Louise A. Gitlitz's (the Gitlitzes) 1991 Federal income tax.     The

issue for decision is whether Philip D. Winn (Winn) and David A.

Gitlitz (Gitlitz) are entitled to claimed S corporation losses of

approximately $1 million, which in turn depends upon whether Winn

and Gitlitz may increase their respective adjusted bases in the

S corporation stock by their pro rata allocation of discharge of

indebtedness income.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     These matters are before the Court on respondent's motions

for summary judgment filed January 31, 1997, and on petitioners'

cross-motions for partial summary judgment filed March 25, 1997.

Background

     At the time their respective petitions were filed, all

petitioners resided in Colorado.

     Winn and Gitlitz were shareholders in P.D.W. & A., Inc.

(PDW&A), a Colorado corporation.    In 1991, PDW&A had an election

in effect to be taxed as a subchapter S corporation.      Effective

January 1, 1992, PDW&A revoked its S corporation election.

     PDW&A was a partner in Parker Properties Joint Venture

(Parker).    Parker realized $4,154,891 in discharge of

indebtedness income in 1991.    PDW&A's distributive share of

Parker's discharge of indebtedness income in 1991 was $2,021,296.
                               - 3 -

At the time that Parker realized the discharge of indebtedness

income, PDW&A was insolvent to the extent of $2,181,748.

     Winn increased his basis in his PDW&A stock by the amount of

his pro rata share ($1,010,648) of the discharge of indebtedness

income.   Winn did not claim a loss on the Winns' 1991 Federal

income tax return because Winn believed that the passive activity

loss limitations prevented him from doing so.   On the Winns' 1992

Federal income tax return, Winn claimed losses from PDW&A that

were carried over from 1991 totaling $1,010,648.

     Gitlitz increased his basis in his PDW&A stock by the amount

of his pro rata share ($1,010,648) of the discharge of

indebtedness income.   Gitlitz claimed losses from PDW&A totaling

$1,010,648 on the Gitlitzes' 1991 Federal income tax return.

Absent the basis increase, the deductibility of these losses

would have been suspended under section 1366(d).

     Respondent disallowed the losses claimed by Winn and Gitlitz

on the premise Winn and Gitlitz lacked sufficient basis in their

PDW&A stock.

Discussion

     Under Rule 121, a summary adjudication may be made "if the

pleadings, answers to interrogatories, depositions, admissions,

and any other acceptable materials, together with the affidavits,

if any, show that there is no genuine issue as to any material

fact and that a decision may be rendered as a matter of law."

Rule 121(b).   The parties agree that whether discharge of
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indebtedness income increases a taxpayer's basis in his

S corporation stock may be decided as a matter of law.

     Section 1367(a)(1) provides:



               (1) Increases in basis.--The basis of each
          shareholder’s stock in an S corporation shall be
          increased for any period by the sum of the
          following items determined with respect to that
          shareholder for such period:

                   (A) the items of income described in
               subparagraph (A) of section 1366(a)(l),

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

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

Section 1366(a)(1) provides:

               (1) In general.--In determining the tax under
          this chapter of a shareholder for the
          shareholder’s taxable year in which the taxable
          year of the S corporation ends (or for the final
          taxable year of a shareholder who dies before the
          end of the corporation’s taxable year), there
          shall be taken into account the shareholder’s pro
          rata share of the corporation’s--

                   (A) items of income (including tax-exempt
               income), loss, deduction, or credit the
               separate treatment of which could affect the
               liability for tax of any shareholder, and

                   (B) nonseparately computed income or
               loss.

          For purposes of the preceding sentence, the items
          referred to in subparagraph (A) shall include
          amounts described in paragraph (4) or (6) of
          section 702(a).
                               - 5 -

The shareholder’s basis, once computed, limits the amount of

losses and deductions that may be taken into account by a

shareholder for the taxable year.   Sec. 1366(d).

     In memoranda filed with the Court prior to the hearing on

these matters, several arguments were set forth in support of

respondent's motions, including the argument that discharge of

indebtedness income was “deferred” and not “tax-exempt income”

under section 1366(a).   (Respondent did not argue that section

1367(b)(1) precluded an increase in basis with respect to income

from discharge of indebtedness, presumably because, to the extent

at issue here, such income was not required to be included on

petitioners’ returns.)   At the hearing on these matters, however,

respondent abandoned those prior arguments and argued the

following position:

           If the Court were to hold that excluded COD
     [cancellation (discharge) of indebtedness] is an item
     of income under Code section 1366, then you would have
     to find that it flows through to the taxpayers and they
     increase their basis. Respondent's position is that
     it's not an item of income and never flows through
     * * *

We deal here solely with respondent’s “final” position.

     Respondent's position is based on section 1.61-12(a), Income

Tax Regs., which states in part:    "The discharge of indebtedness,

in whole or in part, may result in the realization of income",

and on section 1.61-12(b), Income Tax Regs., which states in

part:   "Income is not realized by a taxpayer * * * by virtue of

an agreement among his creditors not consummated under any
                                 - 6 -

provision of the Bankruptcy Act, if immediately thereafter, the

taxpayer's liabilities exceed the value of his assets."

     Section 1.61-12(b), Income Tax Regs., adopted by T.D. 6272,

1957-2 C.B. 18, 31, restates the pre-section 108 judicially

created insolvency exception.    See, e.g., Estate of Delman v.

Commissioner, 73 T.C. 15, 32 (1979).     Section 108 codified the

insolvency exception as an exclusion from gross income.

Bankruptcy Tax Act of 1980, Pub. L. 96-589, sec. 2, 94 Stat.

3389.   Section 108(e)(1) provides that "there shall be no

insolvency exception from the general rule that gross income

includes income from the discharge of indebtedness", except as

provided in section 108.   Thus, section 108, not section 1.61-

12(b), Income Tax Regs., controls in these cases.

     Respondent would have us treat differently the operation of

sections 61(a)(12) and 108 and, for example, sections 61(a)(4)

and 103 (relating to interest) or sections 61(a)(10) and 101

(relating to insurance).   Respondent argues that, as an

illustration, death benefits are first realized under section

61(a)(10) and then certain death benefits are excluded, i.e., not

recognized, by section 101.   Respondent argues that no such

realization occurs in the case of discharge of indebtedness.

     Section 61 requires that certain amounts be included in

income, i.e., items of income.    Specifically, section 61(a)(12)

requires that income from discharge of indebtedness be included

in gross income.   Absent any exclusionary provision, items of
                                 - 7 -

income are included in gross income.     Sec. 61(a).   Sections 101

through 135 exclude specific items of income from gross income.

Discharge of indebtedness income to the extent of insolvency is

one of the items of income so excluded.     Sec. 108(a)(1)(A), (3).

     Based on the foregoing, we hold that discharge of

indebtedness is an "item of income" for purposes of determining a

shareholder's basis in S corporation stock by its inclusion in

the definition of gross income under section 61(a)(12).

     On the basis of the record, respondent’s motions for summary

judgment will be denied, and petitioners’ cross-motions for

partial summary judgment will be granted.

     To reflect the foregoing,

                                                Appropriate orders

                                           will be issued.
