                              T.C. Memo. 2013-39



                        UNITED STATES TAX COURT



          R BALL FOR R BALL III BY APPT, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 17593-11, 17594-11,           Filed February 6, 2013.
                  17595-11, 17596-11,
                  17597-11, 17598-11,
                  17599-11, 17600-11,
                  17601-11.



      Dennis Lawrence Stein, for petitioners.

      Paul L. Darcy, for respondent.



      1
       Cases of the following petitioners are consolidated herewith: R Ball
Children Trust 9/9/1969, docket No. 17594-11; Ethel Ball For R Ball III Apt
2/9/1967, docket No. 17595-11; Ethel Ball For A L Ball As Appt, docket No.
17596-11; R Ball Jr. Children Trust 1/29/1970, docket No. 17597-11; R Ball Jr
F/B/O R Ball III 12/22/1976, docket No. 17598-11; R Ball For A L Ball By Appt,
docket No. 17599-11; R Ball Children Trust 1/24/1973, docket No. 17600-11; and
Russell Ball Jr Sec First 9/9/1967, docket No. 17601-11.
                                         -2-

[*2]                           MEMORANDUM OPINION


       KERRIGAN, Judge: In these consolidated cases respondent determined the

following deficiencies and revised deficiencies2 with respect to petitioners’ Federal

income tax for tax year 2003:

             Petitioner            Deficiency        Revised deficiency
       R Ball for R Ball
       III by Appt                 $5,919,407           $5,924,028
       R Ball Children
        Trust 9/9/1969              5,374,764             5,378,663
       Ethel Ball For R Ball
       III Apt 2/9/1967             4,438,105             4,441,316
       Ethel Ball For A L
        Ball As Appt                4,439,848             4,441,316
       R Ball Jr. Children
        Trust 1/29/1970             3,402,808             3,251,740
       R Ball Jr F/B/O R
        Ball III 12/22/1976           545,775               337,445
       R Ball For A L
        Ball By Appt                5,919,744             5,924,028

       R Ball For Children          1,839,276             1,840,593
        Trust 1/24/1973



       2
        The parties stipulated that each statutory notice contained one or more errors
that resulted in an incorrect deficiency computation. If respondent prevails,
petitioners will be liable for the revised statutory deficiencies.
                                           -3-

      [*3]
       Russell Ball Jr Sec            2,207,131             2,208,729
        First 9/9/1967


      Unless otherwise indicated, all section references are to the Internal Revenue

Code (Code) in effect for the year in issue, and all Rule references are to the Tax

Court Rules of Practice and Procedure. We round all monetary amounts to the

nearest dollar and all percentage points to the second decimal place.

      After concessions the issue remaining for our consideration is whether

petitioners properly increased their adjusted bases in shares of an S corporation

pursuant to sections 1366 and 1367 after the S corporation made a qualified

subchapter S subsidiary election (Qsub election) pursuant to section 1361, which

resulted in a deemed section 332 liquidation of a subsidiary.

                                      Background

      These consolidated cases were submitted fully stipulated under Rule 122.

The stipulated facts are incorporated in our findings by this reference. Petitioners,

electing small business trusts,3 had legal residence in Pennsylvania when they filed


      3
        Sec. 1361(e)(1)(A) defines electing small business trusts as 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 para. (2), (3), (4), or (5) of sec. 170(c),
or (IV) an organization described in sec. 170(c)(1) which holds a contingent interest
                                                                             (continued...)
                                           -4-

[*4] their petitions. In June 1997 petitioners and a 10th shareholder not party to this

consolidated action (10th shareholder) directly owned 100% of American Insurance

Service, Inc. (AIS). Petitioners and the 10th shareholder had an aggregate adjusted

basis of $5,612,555 in their shares of AIS.

       In 1999 petitioners and the 10th shareholder organized Wind River

Investment Corp. (WRIC). Petitioners and the 10th shareholder contributed 100%

of their shares of AIS to WRIC in exchange for 100% of the stock in WRIC,

resulting in a tax-deferred incorporation under section 351. After the completed

transaction petitioners and the 10th shareholder directly owned 100% of WRIC, and

WRIC directly owned 100% of AIS. During the 2003 taxable year ended

September 4, 2003, petitioners owned 99.01% of WRIC. Individually, petitioners

owned the following percentages of WRIC:




       3
        (...continued)
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 sec. 1361(e) applies to such
trust. Electing small business trusts are subject to further restrictions. See sec.
1361(e)(1)(B), (2). The parties do not dispute that petitioners are valid electing
small business trusts.
                                           -5-

                           [*5]                       WRIC
                         Petitioner              percent ownership
                   R Ball for R Ball III
                    by Appt                           17.38
                   R Ball Children Trust
                    9/9/1969                          15.78
                   Ethel Ball For R Ball
                    III Apt 2/9/1967                  13.03
                   Ethel Ball For A L
                    Ball As Appt                      13.03
                   R Ball Jr. Children
                    Trust 1/29/1970                    9.54
                   R Ball Jr F/B/O R
                    Ball III 12/22/1976                0.99
                   R Ball For A L Ball
                    By Appt                           17.38
                   R Ball Children Trust
                    1/24/1973                          5.40
                   Russell Ball Jr Sec
                    First 9/9/1967                     6.48


      Effective June 4, 1999, WRIC elected to be taxed as an S corporation.4 From

June 4, 1999, through September 4, 2003, WRIC continued to own 100% of AIS.

During WRIC’s taxable year ended September 4, 2003, WRIC made a Qsub


      4
       Small business electing trusts like petitioners are permitted to hold shares of
an S corporation. Sec. 1361(c)(2)(A)(v); see sec. 1361(b)(1)(B). The parties do not
dispute that petitioners were valid S corporation shareholders.
                                        -6-

[*6] election pursuant to section 1361(b)(3)(B) with respect to AIS, effective

February 28, 2003. After the election WRIC treated AIS as a qualified subchapter

S subsidiary (Qsub). Petitioners claimed that the Qsub election produced an item of

income pursuant to section 1366(a)(1)(A) and adjusted their bases accordingly

pursuant to section 1367(a)(1)(A). Petitioners had the following adjusted bases in

their WRIC stock before the Qsub election, and petitioners claimed the following

adjusted bases in their WRIC stock after the Qsub election:
                                        -7-

               [*7]                                       Claimed adjusted
                                  Adjusted basis          basis after Qsub
             Petitioner         before Qsub election          election
      R Ball for R Ball III
       by Appt                      $2,649,773              $42,143,293
      R Ball Children Trust
       9/9/1969                     2,405,834                38,263,589
      Ethel Ball For R Ball
       III Apt 2/9/1967             1,986,567                31,595,345
      Ethel Ball For A L
       Ball As Appt                 1,986,567                31,595,345
      R Ball Jr. Children
       Trust 1/29/1970              1,454,478                23,132,739
      R Ball Jr F/B/O R
      Ball III 12/22/1976             150,936                 2,400,567
      R Ball For A L Ball
       By Appt                      2,649,773                42,143,293
      R Ball Children Trust
       1/24/1973                      823,289                13,094,003
      Russell Ball Jr Sec
       First 9/9/1967                 987,947                15,712,804


      On September 5, 2003, petitioners and the 10th shareholder sold all of their

WRIC shares to an unaffiliated third party. Collectively, petitioners and the 10th

shareholder received $230,111,857. Less transaction costs, petitioners received

individually the following amounts from the sale of WRIC:
                                           -8-

                       [*8] Petitioner           Amount received
                   R Ball for R Ball III
                    by Appt                       $39,993,441
                   R Ball Children Trust
                    9/9/1969                       36,311,651
                   Ethel Ball For R Ball
                   III Apt 2/9/1967                29,983,575
                   Ethel Ball For A L
                    Ball As Appt                   29,983,575
                   R Ball Jr. Children
                    Trust 1/29/1970                21,952,671
                   R Ball Jr F/B/O R
                   Ball III 12/22/1976              2,278,107
                   R Ball For A L Ball
                    By Appt                        39,993,441
                   R Ball Children Trust
                    1/24/1973                      12,426,040
                   Russell Ball Jr Sec
                    First 9/9/1967                 14,911,248


      Because of this sale, WRIC ceased to be taxed as an S corporation as of

September 4, 2003, and became taxable as a C corporation.

      Petitioners timely filed their Forms 1041, U.S. Income Tax Return for Estates

and Trusts, for tax year 2003. In their income tax returns petitioners claimed the

following losses from their sale of WRIC stock:
                                           -9-

                       [*9] Petitioner           Claimed loss
                   R Ball for R Ball III
                    by Appt                      $2,149,852
                   R Ball Children Trust
                    9/9/1969                      1,951,938
                   Ethel Ball For R Ball
                    III Apt 2/9/1967              1,611,770
                   Ethel Ball For A L
                    Ball As Appt                  1,611,770
                   R Ball Jr. Children
                    Trust 1/29/1970               1,180,068
                   R Ball Jr F/B/O R
                   Ball III 12/22/1976               122,460
                   R Ball For A L Ball
                    By Appt                       2,149,852
                   R Ball Children Trust
                    1/24/1973                        667,963
                   Russell Ball Jr Sec
                    First 9/9/1967                   801,556


Petitioners calculated these claimed losses using the adjusted bases in the WRIC

stock that they increased after the Qsub election.

      On May 18 and 19, 2011, respondent sent notices of deficiency regarding

tax year 2003 to petitioners. The notices of deficiency disallowed petitioners’

claimed bases adjustments in their WRIC shares following the Qsub election.

Because of a computational error, the notices of deficiency failed to fully disallow
                                        - 10 -

[*10] petitioners’ claimed bases adjustments. For seven petitioners,5 the notices of

deficiency understated the capital gains adjustments. Respondent asserts increased

deficiencies for those seven petitioners. For two petitioners,6 the notices of

deficiency provided incorrect alternative minimum tax calculations. Respondent

asserts decreased deficiencies for those two petitioners.

      In the notices of deficiency respondent also determined that petitioners were

liable for accuracy-related penalties under section 6662(d) for tax year 2003.

Respondent has waived the accuracy-related penalties for all petitioners.

                                      Discussion

      An S corporation is defined as a small business corporation for which an

election under section 1362(a) is in effect for the year. Sec. 1361(a)(1).

Generally, an S corporation is not subject to Federal income tax at the entity level.

Sec. 1363(a); see also Taproot Admin. Servs., Inc. v. Commissioner, 133 T.C. 202,

204 (2009), aff’d, 679 F.3d 1109 (9th Cir. 2012). Like a partnership, an S

corporation is a conduit, through which income flows to its shareholders, resulting

      5
       Petitioners R Ball for R Ball III by Appt; R Ball Children Trust 9/9/1969;
Ethel Ball For R Ball III Apt 2/9/1967; Ethel Ball For A L Ball As Appt; R Ball For
A L Ball By Appt; R Ball Children Trust 1/24/1973; and Russell Ball Jr Sec First
9/9/1967.
      6
        Petitioners R Ball Jr. Children Trust 1/29/1970 and R Ball Jr F/B/O R Ball
III 12/22/1976.
                                        - 11 -

[*11] in only one level of taxation. See Taproot Admin. Servs., Inc. v.

Commissioner, 133 T.C. at 204.

      Generally, a shareholder in an S corporation begins with a tax basis in his or

her stock equal to the amount of the contributions he or she makes to the capital of

the S corporation; the shareholder’s capital contributions are not included in the

income of the S corporation. Secs. 118, 1016(a)(1), 1371(a); Commissioner v.

Fink, 483 U.S. 89, 94 (1987); Edwards v. Cuba R.R. Co., 268 U.S. 628, 633

(1925); sec. 1.118-1, Income Tax Regs.

      Pursuant to section 1367(a)(1)(A), a shareholder’s tax basis in the stock of an

S corporation is adjusted to reflect the shareholder’s pro rata share of income,

losses, deductions, and credits of the S corporation, as calculated under section

1366(a)(1). More specifically, under section 1367(a)(1)(A), a shareholder’s tax

basis in the stock of an S corporation is increased by the shareholder’s share of the

S corporation’s income items (including tax-exempt income), among other things.

Under section 1367(a)(2), a shareholder’s tax basis in the stock of an S corporation

is decreased (but not below zero) by the shareholder’s pro rata share of losses and

deductions, among other things, as specified in section 1367(a)(2).
                                         - 12 -

[*12] Pursuant to section 1361(b)(3)(B), a parent S corporation may elect to treat a

wholly owned domestic corporation7 as a Qsub. Once the parent S corporation has

made the Qsub election, the Qsub is no longer treated as a separate corporation;

rather, all assets, liabilities, items of income, deductions, and credits of the Qsub are

treated as the assets, liabilities, items of income, deductions, and credits of the

parent S corporation. Sec. 1361(b)(3)(A). The Qsub is deemed to have liquidated

into the parent S corporation. Sec. 1.1361-4(a)(2)(i), Income Tax Regs.

I.    Petitioners’ Arguments and Analysis

      Petitioners contend that they properly adjusted their bases in the WRIC

shares after the Qsub election pursuant to section 1367(a)(1)(A) and that they

properly claimed losses from the sale of WRIC on their 2003 income tax returns.

Specifically, petitioners contend that the Qsub election resulted in an item of income

pursuant to section 1366(a)(1)(A).

      Notably, petitioners have not cited and we have not found any cases in which

a Qsub election has been held to create an item of income for the parent S

corporation.




      7
        The wholly owned domestic corporation must also meet the specifications
set forth in sec. 1361(b)(2).
                                          - 13 -

[*13] A.     Section 61(a)(3) and Nonrecognition

      Petitioners contend that the Qsub election resulted in a gain derived from

dealings in property and, therefore, created an item of income under section 61(a).

Section 61(a) defines gross income as “all income from whatever source derived”,

which includes gains derived from dealings in property. Sec. 61(a)(3). In their

opening brief, petitioners claim that “the exchange of the S corporation’s shares of

stock in the subsidiary for the subsidiary’s assets * * * [is] plainly ‘gains derived

from dealings in property.’”

      Petitioners overlook the role of realization and recognition in determining

what constitutes gain from the sale or disposition of property. Any gain from the

sale or disposition of property must first be realized. See Cottage Sav. Ass’n v.

Commissioner, 499 U.S. 554, 559 (1991) (“Rather than assessing tax liability on the

basis of annual fluctuations in the value of a taxpayer’s property, the Internal

Revenue Code defers the tax consequences of a gain or loss in property value until

the taxpayer ‘realizes’ the gain or loss.”).

      Once a realization event has occurred, the amount of realized gain must be

calculated pursuant to section 1001. Section 1001 provides, in pertinent part, the

following:
                                        - 14 -

      [*14] SEC. 1001. DETERMINATION OF AMOUNT OF AND
                       RECOGNITION OF GAIN OR LOSS.

             (a) Computation of Gain or Loss.--The gain from the sale or
      other disposition of property shall be the excess of the amount realized
      therefrom over the adjusted basis provided in section 1011 for
      determining gain, and the loss shall be the excess of the adjusted basis
      provided in such section for determining loss over the amount realized.

             (b) Amount Realized.--The amount realized from the sale or
      other disposition of property shall be the sum of any money received
      plus the fair market value of the property (other than money) received.
      ***

              (c) Recognition of Gain or Loss.--Except as otherwise provided
      in this subtitle, the entire amount of the gain or loss, determined under
      this section, on the sale or exchange of property shall be recognized.


      Once the amount of the realized gain has been calculated, the entire amount

of the realized gain is recognized unless a Code section provides for nonrecognition

treatment. Sec. 1001(c). Unrecognized gains “are not included in or deducted from

gross income at the time the [nonrecognition] transaction occurs.” Sec. 1.61-6(b),

Income Tax Regs.

      Recognition is a cardinal and longstanding principle of tax law. There are

many Code sections that provide for nonrecognition treatment, including sections

351(a), 354, 361(a), 371(a)(1), 371(b)(1), 721, 1031, 1035, and 1036, among

others. Sec. 1.1002-1(c), Income Tax Regs. These sections describe “certain
                                         - 15 -

[*15] specific exchanges of property in which at the time of the exchange particular

differences exist between the property parted with and the property acquired, but

such differences are more formal than substantial.” Id. Because these differences

are more formal than substantial, the Code provides that “such differences shall not

be deemed controlling, and that gain or loss shall not be recognized at the time of

the exchange.” Id. The underlying assumption for nonrecognition treatment is that

“the new property is substantially a continuation of the old investment still

unliquidated”. Id.

      Notably, “[t]hese [nonrecognition] provisions do not forgive taxation of the

realized gain; they merely defer its recognition and inclusion in gross income until

the property is disposed of in a taxable transaction.” Boris I. Bittker et al., Federal

Income Taxation of Individuals, para. 30.01[1], at 30-3 (3d ed. 2002).

Nonrecognition transactions generally preserve unrecognized gain by assigning a

“substituted” or “carryover” basis to the acquired property. Id. Nonrecognition

transactions “can be viewed as refinements of the pervasive concept of realization,

which postpones the taxation of appreciation in the value of property (and the

deduction of a decline in value) until the taxpayer sells or otherwise disposes of the

property.” Id.
                                        - 16 -

[*16] In sum, nonrecognition provisions prevent realized gain from being included

in a taxpayer’s gross income. When a gain derived from dealings in property is

realized but not recognized, then the realized gain will not be included in gross

income pursuant to section 61(a)(3) and section 1.61-6(b), Income Tax Regs.

      B.     Sections 331 and 332

      The making of a Qsub election is considered an adoption of a plan of

liquidation immediately before the deemed liquidation, which qualifies the deemed

liquidation for tax-free treatment under sections 332 and 337. Sec. 1.1361-

4(a)(2)(iii), Income Tax Regs.; see sec. 1.1361-4(a)(2)(iv), Income Tax Regs.; cf.

Dover Corp. & Subs. v. Commissioner, 122 T.C. 324, 333 (2004) (like the making

of a Qsub election, “[t]he making of a disregarded entity election ‘is considered to

be the adoption of a plan of liquidation immediately before the deemed liquidation’,

thereby qualifying the parties to the deemed liquidation for tax-free treatment under

sections 332 and 337. Sec. 301.7701-3(g)(2)(ii), Proced. & Admin. Regs.”). A

Qsub election thus results in a section 332 liquidation.

      Section 332(a) specifies that no gain or loss shall be recognized by a parent

corporation on the receipt of property distributed in complete liquidation of a

subsidiary corporation. Section 332(a) is clear and unambiguous. Under a plain
                                        - 17 -

[*17] reading of the statute the phrase “no gain or loss shall be recognized” means

that the parent ignores any gain or loss realized in a section 332 liquidation when

property is distributed from the subsidiary. This reading is also consistent with the

congressional intent behind section 332 and other nonrecognition transactions: A

taxpayer is not taxed on realized gain at the time of a nonrecognition transaction.

See S. Rept. No. 83-1622 at 48 (1954), 1954 U.S.C.C.A.N. 4621, 4678-4679

(contrasting a general liquidation, in which the taxpayer receiving assets is taxed

upon receipt, with a section 332 liquidation, in which the taxpayer receiving assets

is not taxed because no gain or loss is recognized); see also S. Rept. No. 67-275

(1921), 1939-1 C.B. (Part 2) 181, 188 (when a taxpayer receives no cash profit in a

transaction, the taxpayer should not be taxed on the transaction at that time).

Because a Qsub election is a deemed section 332 liquidation, the parent S

corporation shall not recognize gain or loss from the Qsub election.

      Petitioners contend that any gain realized from a Qsub election constitutes

income under section 331, but then section 332(a) exempts the realized gain from

income with nonrecognition. Section 331(a) provides: “Amounts received by a

shareholder in a distribution in complete liquidation of a corporation shall be treated

as in full payment in exchange for the stock.” Section 331 does not provide for the

nonrecognition of any gain realized in a section 331 liquidation.
                                        - 18 -

[*18] Petitioners’ interpretation of sections 331 and 332 is incorrect. Sections 331

and 332 govern two different types of liquidations. Section 332, on the one hand,

governs the liquidation of a subsidiary into a parent corporation when the parent

corporation owns 80% or more of the vote and value of the subsidiary. Secs.

332(b)(1), 1504(a)(2). If a section 332 liquidation occurs, then the subsidiary does

not recognize any gain or loss on the distribution of property to an 80% distributee,

sec. 337(a); the parent corporation takes a carryover basis in the subsidiary’s assets,

sec. 334(b)(1); and the parent corporation succeeds to the subsidiary’s tax

attributes, sec. 381(a)(2). Section 331, on the other hand, governs all other

liquidations, namely when the parent corporation owns less than 80% of the vote

and value of the subsidiary. See sec. 331(a). Sections 334(b)(1), 337(a), and

381(a)(2) are not triggered by a section 331 liquidation.

      Either a liquidation meets the section 332(b) specifications and falls within

section 332, or it does not meet the section 332(b) specifications and falls within

section 331. A liquidation cannot be governed by both.

      Petitioners’ contention that section 331 governs all liquidations but section

332(a) exempts certain liquidations from creating income is erroneous. When

WRIC made the Qsub election, WRIC engaged in a deemed liquidation of AIS
                                        - 19 -

[*19] pursuant to section 332 because WRIC held more than 80% of the vote and

value of AIS. WRIC did not first engage in a section 331 liquidation.

      Accordingly, no gain was recognized when WRIC made the Qsub election,

and the unrecognized gain did not create an item of income pursuant to section

61(a)(3).

      C.     Item of Income Under Section 1366(a)(1)(A)

      Petitioners contend that the realized but unrecognized gain from the Qsub

election created tax-exempt income--and therefore, an item of income--pursuant to

section 1366(a)(1)(A). Section 1366(a) provides the following, in pertinent part:

             SEC. 1366(a). Determination of Shareholder’s Tax Liability.--

                    (1) In general.--In determining the tax under this chapter
             of a shareholder [of an S corporation] 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, * * *

Section 1.1366-1(a)(2)(viii), Income Tax Regs., defines tax-exempt income as

“income that is permanently excludible from gross income in all circumstances in

which the applicable provision of the Internal Revenue Code applies.”
                                        - 20 -

[*20] As discussed above unrecognized gain is not an item of income or tax-exempt

income under section 1366(a)(1)(A) because unrecognized gain does not rise to the

level of income. Nonrecognition treatment prevents realized gain from becoming

income at the time of the nonrecognition transaction. Therefore we hold that

unrecognized gain does not create an item of income under section 1366(a)(1)(A).

      This holding is consistent with our reasoning in McLaulin v. Commissioner,

115 T.C. 255 (2000), aff’d, 276 F.3d 1269 (11th Cir. 2001). The taxpayers in

McLaulin owned 100% of Ridge Pallets, Inc. (Ridge). Ridge coowned Sunbelt

Forest Products, Inc. (Sunbelt), with an individual until Sunbelt redeemed all of the

individual’s shares. Ridge then owned 100% of Sunbelt. Soon after the redemption

Ridge made a pro rata distribution of its Sunbelt stock to the taxpayers in McLaulin.

The sole issue for decision was whether Ridge recognized gain on account of that

distribution. Id. at 259. We reasoned that if Ridge, an S corporation, did not

recognize gain from the distribution, then section 1366(a) would not require the

taxpayers to take their pro rata shares of gain into account. Id. at 259-260. Our

reasoning in McLaulin is the same as ours in these consolidated cases:

Unrecognized gain does not create an item of income under section 1366(a)(1)(A).
                                        - 21 -

[*21] Petitioners claim that the Qsub election created realized gain that began as an

item of income under section 61(a)(3) but was exempted from gross income

pursuant to the nonrecognition provision in section 332(a). Petitioners argue that

this result is consistent with United States v. Farley, 202 F.3d 198 (3d Cir. 2000),

and Gitlitz v. Commissioner, 531 U.S. 206 (2001), which petitioners claim are

“squarely on point” and therefore control in these consolidated cases. Petitioners’

reliance on Farley and Gitlitz, however, is misguided.

      The facts in Farley and Gitlitz were similar. Both cases involved insolvent S

corporations that received a discharge of indebtedness. Pursuant to section

61(a)(12), gross income includes income from discharge of indebtedness. Section

108(a)(1)(B) excludes discharge of indebtedness income from the gross income of

an insolvent taxpayer. Because of this exclusion, these insolvent S corporations

determined that the discharge of indebtedness created tax-exempt income. They

passed the discharge of indebtedness income to their shareholders pursuant to

section 1366(a)(1)(A), and the shareholders adjusted their bases in the S

corporations accordingly pursuant to section 1367(a)(1)(A).

      The Supreme Court in Gitlitz and the Court of Appeals for the Third Circuit

in Farley both held that the excluded discharge of indebtedness income was tax-

exempt income. They reasoned that the discharge of indebtedness began as
                                        - 22 -

[*22] income under section 61(a)(12) but was excluded from the S corporations’

gross income pursuant to section 108(a)(1)(B) because these S corporations were

insolvent. Gitlitz v. Commissioner, 531 U.S. at 212-213; Farley, 202 F.3d at 206.

In particular the Supreme Court reasoned that excluded discharge of indebtedness

does not cease to be an item of income when the S corporation is insolvent; rather,

the excluded discharge of indebtedness simply “ceases to be included in gross

income.” Gitlitz v. Commissioner, 531 U.S. at 213.

      Although Farley and Gitlitz both addressed the meaning of item of income

and tax-exempt income as used in section 1366(a)(1)(A), neither case is squarely on

point. Gitlitz and Farley addressed payments that section 61(a) includes explicitly

in gross income and that section 108(a)(1)(B) excludes from gross income. See

Nathel v. Commissioner, 615 F.3d 83, 91 (2d Cir. 2010), aff’g 131 T.C. 262 (2008).

In these consolidated cases the realized gain from the Qsub election was never

included explicitly in gross income and was never excluded from gross income. As

discussed above, nonrecognition is not an exclusion provision. Nonrecognition

merely prevents realized gain from rising to the level of income. Gitlitz and Farley

did not create new items of income; they held only that the nature of discharge of

indebtedness as income was not changed by the exclusion of section 108(a). See id.
                                           - 23 -

[*23] Gitlitz and Farley are also not squarely on point because unrecognized gain

is conceptually different from discharge of indebtedness income. When a taxpayer

receives a discharge of indebtedness, the taxpayer’s economic net worth increases.

The discharge of indebtedness income thus changes the taxpayer’s situation

substantially. When a taxpayer engages in a nonrecognition transaction, the

taxpayer’s economic net worth stays the same. The nonrecognition transaction

changes the taxpayer’s situation only formally. Additionally, unlike unrecognized

gain, excluded discharge of indebtedness income may affect the tax liability of S

corporation shareholders. Section 108(b)(1) specifies that the amount of discharge

of indebtedness income excluded from gross income is applied to reduce the tax

attributes of the taxpayer. Unrecognized gain, however, does not reduce the tax

attributes of the taxpayer. Therefore unrecognized gain does not affect the tax

liability of S corporation shareholders.

      Because neither Farley nor Gitlitz is squarely on point, we are not bound to

follow them. Even if Gitlitz and Farley were squarely on point, Congress reversed

them prospectively in 2002 when it amended section 108(d)(7)(A). See Job

Creation and Worker Assistance Act of 2002, Pub. L. No. 107-147, sec. 402, 116

Stat. at 40. Pursuant to section 108(d)(7)(A), any discharge of indebtedness

income excluded from gross income by section 108(a) is no longer an item of
                                         - 24 -

[*24] income under section 1366(a). Congress believed that “it was inappropriate

for a shareholder of an insolvent or bankrupt S corporation to take into account

excluded income from the discharge of the S corporation’s indebtedness and thereby

increase the shareholder’s adjusted basis in the stock.” H.R. Rept. No. 107-251, at

52 (2002), 2002-3 C.B. 44, 95. Moreover, Congress believed “that where, as in

the case of the present statute under section 108, the plain text of a provision of the

Internal Revenue Code produces an ambiguity, the provision should be read as

closing, not maintaining, a loophole that would result in an inappropriate reduction

of tax liability.” Id. Thus, Congress not only reversed Gitlitz and Farley

prospectively as they pertained to excluded discharge of indebtedness income;

Congress also proscribed any application of Gitlitz and Farley that would result in

an inappropriate reduction of tax liability. Petitioners’ application of Gitlitz and

Farley to these consolidated cases would result in such an inappropriate reduction.

      This is not the first time that we have declined to extend Gitlitz. In Nathel

we declined to interpret Gitlitz as overriding the cardinal and longstanding

principle of tax law that capital contributions are not treated as income. Nathel v.

Commissioner, 131 T.C. at 270. The taxpayers in Nathel argued that “because

section 118 excludes capital contributions from the gross income of an S
                                         - 25 -

[*25] corporation in all circumstances, capital contributions to an S corporation are

‘permanently excludible’ from the gross income of the S corporation and are thus

tax-exempt income’ under section 1.1366-1(a)(2)(viii), Income Tax Regs.”. Id. at

269. The taxpayers relied heavily on Gitlitz. They claimed that Gitlitz should apply

to other items of income specifically excluded from gross income under sections 101

through 136. Id.

      We rejected the taxpayers’ reasoning and distinguished Nathel from Gitlitz,

noting that contributions to the capital of an S corporation are not listed in section

61 as items of gross income. Id. at 270-271. We held that capital contributions are

not items of income under section 1366(a)(1)(A). Id. at 270. The Court of Appeals

for the Second Circuit affirmed our decision, concluding that the taxpayers could not

“rely on Gitlitz alone to overcome the long-standing treatment of capital

contributions as distinct from income.” Nathel v. Commissioner, 615 F.3d at 91.

      We likewise decline to interpret Gitlitz and Farley as overriding a cardinal

and longstanding principle of tax law, namely that unrecognized gain is not an item

of income. We thus decline to extend the holdings in Gitlitz and Farley to

nonrecognition provisions.
                                        - 26 -

[*26] Accordingly, unrecognized gain from a Qsub election does not constitute an

item of income or tax-exempt income under section 1366(a)(1)(A). We note that

any other conclusion would lead to absurd results. Our reasoning preserves single-

level taxation of S corporations by preventing S corporation shareholders from

creating noneconomic basis adjustments from nonrecognition transactions. Our

reasoning also preserves double-level taxation for C corporations. Before 1986 the

General Utilities doctrine permitted a C corporation to escape corporate-level tax on

certain distributions of appreciated property to its shareholders. See Gen. Utils. &

Operating Co. v. Helvering, 296 U.S. 200, 206 (1935); see also H.R. Conf. Rept.

No. 99-841 (Vol. II), at II-198 (1986), 1986-3 C.B. (Vol. 4) 1, 198. Congress

repealed the General Utilities doctrine in the Tax Reform Act of 1986, thus ensuring

a corporate-level tax on the distribution of appreciated property. H.R. Conf. Rept.

No. 99-841, supra at II-199, 1986-3 C.B. (Vol. 4) at 199. Congress noted that the

General Utilities doctrine undermined the corporate income tax. H.R. Rept. No. 99-

426, at 282 (1985), 1986-3 C.B. (Vol. 2) 1, 274. Congress further cemented the

repeal of the General Utilities doctrine by enacting section 1374 in the Tax Reform

Act of 1986, Pub L. No. 99-514, sec. 632(a), 100 Stat. at 2275. Section 1374

prevents a C corporation from avoiding corporate-level taxation on the sale of

appreciated assets by converting to an S corporation.
                                         - 27 -

[*27] When the S corporation sells assets that it held before the conversion, the S

corporation is taxed at the entity level on the net recognized gain from the sale. Sec.

1374(a). The shareholders are also taxed on the recognized gain under section

1366(a)(1)(A).

      Petitioners’ position would create noneconomic basis adjustments which

would reduce or eliminate tax at the shareholder level. This would not only convert

the single-level taxation of S corporations into a zero-level taxation of S

corporations; it would also undermine the double-level taxation of C corporations,

as preserved in section 1374, and circumvent the repeal of the General Utilities

doctrine. Additionally, these absurd results would open the door to a myriad of

abusive transactions. Using these noneconomic basis adjustments, petitioners

attempted to turn what should have been a $202 million aggregate taxable gain into

a $12 million aggregate loss. Had WRIC sold any of AIS’ appreciated assets at a

gain after the Qsub election, petitioners would have increased their adjusted bases in

WRIC a second time, thus reducing or eliminating more tax.

      D.     Section 1367(a)(1)(A) Basis Adjustment

      Petitioners contend that they properly increased their adjusted bases in

WRIC pursuant to section 1367(a)(1)(A) because the Qsub election created an
                                       - 28 -

[*28] item of income under section 1366(a)(1)(A). Section 1367(a) provides, in

pertinent part, the following:

             SEC. 1367(a). General Rule.--

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

                           (A) the items of income described in subparagraph
                    (A) of section 1366(a)(1), * * *

As discussed above, the Qsub election did not result in an item of income described

in section 1366(a)(1)(A). Accordingly, petitioners improperly increased their

adjusted bases in the WRIC stock following the Qsub election.

II.   Conclusion

      We hold that the unrecognized gain resulting from the Qsub election did not

create an item of income or tax-exempt income pursuant to section 1366(a)(1)(A).

We further hold that petitioners improperly adjusted their bases in their WRIC stock

following the Qsub election pursuant to section 1367(a)(1)(A). In reaching

our decision we have considered all arguments made by the parties. To the extent

not mentioned or addressed they are irrelevant or without merit.
                                  - 29 -

[*29] To reflect the foregoing,


                                           An appropriate decision will be

                                  entered.
