           RECOMMENDED FOR FULL-TEXT PUBLICATION
                Pursuant to Sixth Circuit Rule 206
        ELECTRONIC CITATION: 2000 FED App. 0196P (6th Cir.)
                    File Name: 00a0196p.06


UNITED STATES COURT OF APPEALS
                  FOR THE SIXTH CIRCUIT
                    _________________


                               ;
                                
 SALVADOR A. GAUDIANO,
                                
 et al.,
                                
         Petitioners-Appellants,
                                
                                   No. 99-1294

                                
           v.                    >
                                
                                
                                
 COMMISSIONER OF INTERNAL

         Respondent-Appellee. 
 REVENUE,
                                
                               1
     On Appeal from the United States Tax Court.
    Nos. 25712-96; 25713-96; 25714-96; 25716-96—
           Juan F. Vasquez, Tax Court Judge.
                  Argued: December 17, 1999
                Decided and Filed: June 8, 2000
Before: BOGGS and NORRIS, Circuit  Judges; NUGENT,
                  District Judge.*




    *
     The Honorable Donald C. Nugent, United States District Judge for
the Northern District of Ohio, sitting by designation.

                                 1
2       Gaudiano, et al. v. Commissioner               No. 99-1294       No. 99-1294          Gaudiano, et al. v. Commissioner      23

                      _________________                                  testimony of a witness may “simply disregard it,” the
                                                                         disregarded testimony is usually not considered sufficient
                           COUNSEL                                       grounds for drawing the opposite conclusion. Bose Corp. v.
                                                                         Consumers Union of U.S., Inc., 466 U.S. 485, 512, 104 S. Ct.
ARGUED: William C. Myers, Jr., WAGNER, MYERS &                           1949, 1966, 80 L. Ed.2d 502 (1984).
SANGER, Knoxville, Tennessee, for Appellants. Teresa E.
McLaughlin, U.S. DEPARTMENT OF JUSTICE,                                     Absent the testimony of the Taxpayers regarding the
APPELLATE SECTION TAX DIVISION, Washington, D.C.,                        alleged lack of consideration, the Guarantees appear on their
for Appellee. ON BRIEF: William C. Myers, Jr., Kathleen                  faces to be valid and enforceable. Indeed the testimony of the
M. Flynn, WAGNER, MYERS & SANGER, Knoxville,                             Price Waterhouse auditor was compelling on that point.
Tennessee, for Appellants. Teresa E. McLaughlin, Edward T.               Accordingly, we do not find clear error in the Tax Court’s
Perelmuter, U.S. DEPARTMENT OF JUSTICE,                                  finding that the Continuing Guaranty was valid and
APPELLATE SECTION TAX DIVISION, Washington, D.C.,                        enforceable; and therefore, the Asher Taxpayers’ bad debt
for Appellee.                                                            deductions were properly disallowed.
                      _________________                                                          Conclusion
                          OPINION                                          For the reasons stated herein, the Tax Court’s disallowance
                      _________________                                  of all of the deductions in dispute is AFFIRMED.
                                                                         Specifically, the Taxpayers were not entitled to deduct their
  NUGENT, District Judge. The Commissioner of Internal                   suspended and ordinary losses for tax year 1993 because those
Revenue (hereinafter the “Commissioner”) assessed tax                    losses were offset at the corporate level by the COD income
deficiencies against Salvador A. and Kathleen M. Gaudiano,               realized by Four A. To the extent that COD income remains
Randy C. and Kathleen R. Edgemon, Gary D. Asher, and                     after exhausting the current and suspended losses of Four A
Larry A. Asher (collectively the “Taxpayers”) for the year               (and its shareholders), such COD income passes through to
1993. The Commissioner determined that the Taxpayers had                 the shareholders and increases their basis in their stock. In
improperly utilized discharge of indebtedness income to                  addition, the Asher Taxpayers were not entitled to a bad debt
increase their bases in the 1 stock of their Subchapter S                deduction because the debt was guaranteed by the valid and
corporation Four A Coal Co. Each Taxpayer then used the                  enforceable Guarantees of the Four A Taxpayers.
increase in basis to deduct certain losses. The Commissioner
disallowed the deductions. In his answer to the Taxpayers’
petitions in the Tax Court, the Commissioner asserted
increased deficiencies against Taxpayers Gary Asher and
Larry Asher for their pro rata share of a bad debt deduction
taken by their Subchapter S corporation Appolo Fuels, Inc.,
for loans made to Four A Coal Co. After a trial, the United

    1
     Kathleen M. Gaudiano and Kathleen R. Edgemon were not
shareholders in Four A Coal Co. They are parties to these actions only
because they filed joint tax returns with their husbands.
22   Gaudiano, et al. v. Commissioner            No. 99-1294      No. 99-1294               Gaudiano, et al. v. Commissioner               3

by Mr. Gaudiano or Appolo to include the consideration            States Tax Court upheld all of the Commissioner’s deficiency
language in the Guarantees; and Mr. McGowan, the Price            determinations. The Taxpayers filed this timely appeal.2 We
Waterhouse auditor, “who corroborated the Taxpayers’              exercise jurisdiction pursuant to 26 U.S.C. § 7482(a)(1) and
testimony that Appolo never made promises to the Four A           AFFIRM for the reasons stated below.
shareholders regarding future advances or collection
forbearance and that the Guaranties were respectively                           Procedural and Factual Background
backdated to January 1, 1989, and April 30, 1990, to give the
appearance of enforceability.” Appellant’s Opening Brief at       I. Discharge of Indebtedness Income
p. 56. Taxpayers also argue that with Four A hopelessly
insolvent, any threat to foreclose on Four A’s debt by Appolo       During 1993, and relevant prior years, Taxpayers Salvador
would have been meaningless.                                      Gaudiano, Gary Asher, Larry Asher, and Randy Edgemon
                                                                  were each 25% shareholders of Four A Coal Co. (hereinafter
   The Commissioner counters that Appolo’s promise to             “Four A”), a Kentucky corporation electing to be taxed under
forbear from suit was not meaningless for two reasons. First,     Subchapter S of the Internal Revenue Code (26 U.S.C.
Four A possessed sufficient assets to satisfy at least some of    §§ 1361 through 1379). Until February of 1991, Four A
its indebtedness to Appolo at the time the Continuing             engaged in the business of underground coal mining and
Guaranty was executed. Second, the Guarantees resulted in         operated as a contract miner for another Subchapter S
a better financial statement for Appolo, from which the           corporation, Appolo Fuels, Inc. (hereinafter “Appolo”).
Ashers could benefit.                                             Taxpayers Gary D. Asher and Larry A. Asher were 24%
                                                                  shareholders in Appolo.
  Moreover, upon review of the record, the non-taxpayer
testimony of Mr. Stites and Mr. McGowan did not do much             In January, 1993, Four A filed for protection under
to corroborate the Taxpayers’ testimony. Rather, the              Chapter 7 of the Bankruptcy Code and was insolvent within
testimony simply informed the Court that Mr. Stites and Mr.       the meaning of 26 U.S.C. § 108(d)(3). As a result of the
McGowan had no idea whether a promise was made or not.            bankruptcy, Appolo wrote off as bad debt the loans it had
Indeed, Mr. McGowan testified that he believed that the           made to Four A. Thus, Four A realized $1,289,048 in
Guarantees were valid and that he would not have accepted         discharge of indebtedness income, also known as cancellation
them if he believed that they were not valid.                     of debt income (hereinafter “COD” income). While gross
                                                                  income generally   includes income from the discharge of
   Considering the Tax Court’s ability to assess the demeanor     indebtedness3, §108 (a)(1)(B) provides an exclusion of
of the witnesses and the credibility of the testimony provided    discharge of indebtedness income from gross income when
by the witnesses, and the reasons why the Asher Taxpayers         the taxpayer is insolvent. Pursuant to 26 U.S.C. § 108
might have had motive to provide the Guarantees, we cannot
find that the Tax Court clearly erred in disregarding the
Taxpayers’ testimony. A trial court’s findings based on               2
determinations regarding the credibility of witnesses are               The Taxpayers do not appeal the Tax Court’s determination
                                                                  regarding the Taxpayers’ claims for refund for their distributive shares of
generally entitled to great deference. See Owens-Illinois, Inc.   the increased § 1231 loss claimed by Four A in an amended Form 1120S
v. Aetna Cas. & Sur. Co., 990 F.2d 865, 870 (6th Cir. 1993);      which reported the amount realized on the sale of mining equipment as
In re H.J. Scheirich Co., 982 F.2d 945, 949 (6th Cir. 1993).      $145,430 instead of $445,000 as previously reported in 1993.
Moreover, while a factfinder who does not believe the
                                                                      3
                                                                          See 26 U.S.C. § 61 (a)(12).
4       Gaudiano, et al. v. Commissioner                    No. 99-1294         No. 99-1294          Gaudiano, et al. v. Commissioner       21

(d)(7)(A), the exclusion is determined at the S corporation                     promised to forbear suing Four A on Four A’s past debt,
level (not the shareholder level) in cases of discharge of S                    Appolo never actually made such a promise. The Tax Court
corporation indebtedness. The exclusion applied to Four A’s                     noted that the only evidence submitted to disprove the
discharge of indebtedness income. Thus, Four A’s discharge                      existence of Appolo’s promise was “their own self- serving
of indebtedness income was excluded from gross income                           testimony,” which the Court, citing Tokarski v.
because Four A was insolvent when the debt was discharged.                      Commissioner, 87 T.C. 74 (1986), declined to accept.
   Relying on the pass through and basis adjustment                                The Asher Taxpayers contend that the Tax Court
provisions applicable to Subchapter S corporations in 26                        improperly ignored their evidence demonstrating that the
U.S.C. §§ 1366 and 1367, the Taxpayers increased their                          Guarantees lacked valid consideration. They maintain that “it
respective bases in the stock of Four A by $322,262,                            is inconceivable that Four A’s shareholders would have put
representing a 25% share of the discharge of indebtedness                       their personal assets on the line in exchange for Appolo’s
income4. Each Taxpayer then used the increase in basis to                       collection forbearance of Appolo’s future advances to Four
deduct suspended losses from prior tax years as well as                         A.” The Asher Taxpayers assert that Tokarski, and the line of
ordinary losses from 1993 which would not have been                             cases cited therein, which stand for the proposition that the
deductible without the increase in the shareholders’ bases.                     court need not accept a petitioner’s self-serving testimony
Upon audit, the Commissioner determined that the Taxpayers                      when it is uncorroborated and inconsistent with other facts
were not entitled to increase their adjusted bases in the stock                 and circumstances presented at trial, is distinguishable from
of Four A by their pro rata shares of the excluded discharge                    the facts in this case.
of indebtedness income. Therefore, the Commissioner denied
the loss deductions claimed by the Taxpayers as a result of the                   In Tokarski, a taxpayer and his mother testified that a bank
upward basis adjustments and assessed the deficiencies at                       deposit by the taxpayer was an inheritance from his father, not
issue here. Taxpayers filed Tax Court petitions contesting the                  income from working. The taxpayer testified that he had
deficiency determinations.                                                      never worked and that he received funds to live on from his
                                                                                uncles. The court found it incredible that the taxpayer, who
II. Disallowance of Appolo Bad Debt Deduction                                   appeared to be a normal, healthy, 32-year old, had never been
                                                                                productively employed. The court noted that it weighed
  Appolo is an S corporation which began as a surface                           against the taxpayer that he did not offer any corroborative
mining operation but changed to a coal processing and coal                      testimony from his uncles or offer any explanation for not
sales company by 1988. Taxpayers Larry Asher and Gary                           doing so. The court also questioned the taxpayer’s proffered
Asher were 24% shareholders of Appolo. Appolo purchased                         reason for waiting 6 weeks to deposit the money. “Under all
                                                                                the circumstances,” the court held, “we are not required to
                                                                                accept the self-serving testimony of petitioner or that of his
    4                                                                           mother as gospel.” Tokarski, 87 T.C. at 77.
         26 U.S.C. § 1366(a)(1) provides that, in determining an S
corporation shareholder’s tax liability, “there shall be taken into account
the shareholder’s pro rata share of the corporation’s–                            The Taxpayers argue that, unlike the situation in Tokarski,
         (A) items of income (including tax-exempt income) . . . the separate   the testimony of each Taxpayer was internally consistent with
treatment of which could affect the liability for tax of any shareholder        and corroborated by the other Taxpayers’ testimony. They
. . . .”
26 U.S.C. § 1367(a)(1)(A) provides that “the basis of each shareholder’s        also point to the testimony of non-taxpayers, Mr. Stites,
stock in an S corporation shall be increased . . . by . . . (A) the items of    Appolo’s legal counsel, who testified that he was not directed
income described in subparagraph (A) of section 1366(a)(1).”
20       Gaudiano, et al. v. Commissioner                   No. 99-1294        No. 99-1294          Gaudiano, et al. v. Commissioner           5

to the shareholders pursuant to §1366 and increase the                         coal from Four A. Between the years 1988 and 1991, Appolo
shareholder’s basis pursuant to §1367. The shareholder may                     advanced large sums of money to Four A. Four A ceased
then use his increased basis to deduct any losses that may                     mining operations in February of 1991. In March, 1991, Price
accumulate in the future.                                                      Waterhouse LLP audited Appolo’s 1990 financial statements.
                                                                               During that audit Price Waterhouse questioned the
  In this case Four A realized $1,289,048 in COD income.                       collectibility of the Four A debt and raised the question of
Each shareholder deducted $309,914 in suspended and                            whether a bad debt reserve should be established on Appolo’s
ordinary losses.     The shareholders’ combined losses                         books. Appolo, through its chief financial officer Taxpayer
($1,239,656) are completely offset by the $1,289,048 in COD                    Salvadore Gaudiano, asserted that the debt was collectible
income. Accordingly, the losses were not available to the                      and presented a repayment plan developed by the Four A
Taxpayers to use as deductions on their 1993 returns and9 the                  shareholders to repay the debt to Appolo over eight years
Tax Court’s disallowance of the deductions is affirmed.                        from equipment rental fees, the residual value of the Four A
                                                                               mining equipment, and Taxpayer loans to Four A.
II. Bad Debt Deduction
                                                                                  Price Waterhouse reviewed the repayment plan and
   The Tax Court held that Appolo was not entitled to a bad                    determined that the loans should have some sort of personal
debt deduction under § 166 for amounts advanced to Four A                      guarantee of the shareholders. Mr. Gaudiano and Price
because the debt was guaranteed by Four A’s shareholders                       Waterhouse agreed that the Four A Taxpayers would execute
and the Guarantees were enforceable under Kentucky law.                        guarantees to Appolo for the Four A debt and that Appolo
The Taxpayers contend that the Guarantees were invalid and                     would not be required to establish a reserve against the Four
unenforceable due to lack of consideration. The question of                    A debt. On or about May 13, 1991, the Taxpayers executed
whether a contract lacks consideration is a fact question,                     two guaranty agreements (collectively, the Guarantees). The
subject to review for clear error. See Prichard v. Bank                        first guaranty, which is titled “Continuing Guaranty”, was
Josephine, 723 S.W.2d 883, 886 (Ky. Ct. App. 1987); Roach                      backdated to January of 1989. The Continuing Guaranty
v. United States, 106 F.3d 720, 723 (6th Cir. 1997).                           provides in relevant part:
  The Tax Court found that the first guaranty, the                               [Appolo] has from time to time loaned money to Four A
“Continuing Guaranty,” stated that Appolo promised to                            on a demand basis, some of which loans remain
forbear suing Four A on Four A’s past debt; thus, the                            outstanding . . . . [T]he guarantors desire to grant this
Continuing Guaranty was supported by adequate and                                Guaranty to Appolo as consideration for Appolo not
sufficient consideration and is enforceable. Further, the Court                  demanding immediate payment of its existing loans to
found that the Four A shareholders were financially capable                      Four A, and as an inducement to Appolo to make future
of satisfying the Guarantees. The Asher Taxpayers argued                         advances to Four A, without which Guaranty Appolo
that while the Continuing Guaranty recites that Appolo                           would not take such action; . . . Therefore, . . . in
                                                                                 exchange for good and valuable consideration, the receipt
                                                                                 and sufficiency of which all the Guarantors hereby
     9                                                                           acknowledge, the Guarantors do hereby absolutely,
      Because the Taxpayers’ losses were less than the amount of COD
income realized by Four A, each taxpayer is entitled to increase the basis       unconditionally and irrevocably guaranty to Appolo . . .
of their stock by their share of the excess COD income. Since Four A is          [t]he repayment in full (without interest) of all loans and
no longer operating, however, it is unlikely that the corporation will incur     advances made by Appolo to Four A, including both
future losses.
6      Gaudiano, et al. v. Commissioner            No. 99-1294      No. 99-1294          Gaudiano, et al. v. Commissioner       19

    those currently outstanding and those made in the future.       shareholder losses) would never occur since there would be
    ...                                                             no income left at the corporate level to apply against the
                                                                    losses. While § 108(b)(4)(A) provides that the reduction in
(Joint Ex. 19-s, JA 356-58). The Continuing Guaranty further        attributes shall be made after the determination of the tax
states: “Each of the Guarantors expressly agrees that neither       imposed by this chapter for the taxable year of the discharge,
the bankruptcy, insolvancy [sic], reorganization, liquidation,      it does not preclude the reduction of certain attributes in the
dissolution, death or disability of any or all of Four A and the    year of discharge. Specifically, § 108(b)(4)(B) provides that
other Guarantors shall diminish, impair, discharge or release,      reductions of net operating loss for the taxable year of
or otherwise affect, the obligations and liability of the           discharge and any net operating loss carryover and any capital
Guarantor under this Guaranty. . . .” Id. at JA 357.                loss carryover shall be made “first in the loss for the taxable
                                                                    year of discharge.” Thus, the corporation must determine its
   The second Guaranty, backdated to April 30, 1990,                net operating losses and suspended operating losses for the
guarantees two loans from Appolo to Four A in the amounts           year of discharge and reduce those attributes by the amount of
of $500,000 and $170,000. The Guaranty states that “the             COD income realized. If the losses exceed the COD income,
Guarantors have previously agreed to guarantee the First Note       then the extra losses pass through to the shareholders.
and the Guarantors desire to guarantee the Second Note as an
inducement to Appolo to make the loan evidenced thereby,               We disagree with the Tax Court and the Tenth Circuit in
without which guarantee Appolo would not take such action”.         their findings that COD income is not income within the
(Joint Ex. 20-t, JA 359). As in the Continuing Guaranty, the        meaning of § 1366(a)(1)(A) and thus does not pass through to
second Guaranty asserts that the Guaranty is provided in            the shareholders and increase the basis of their shares.
exchange for “good and valuable consideration, the receipt          Section 1366 (a)(1)(A) explicitly includes tax-exempt income.
and sufficiency of which all the Guarantors hereby                  The Tax Court and the Tenth Circuit have determined that
acknowledge” and that “neither the bankruptcy, insolvancy           COD income is not really tax-exempt since COD income
[sic], reorganization, liquidation, dissolution, death or           reduces suspended losses and thus operates to defer rather
disability of any or all of Four A and the other Guarantors         than eliminate taxes. However, as Judge Posner explained in
shall diminish, impair, discharge or release, or otherwise          Witzel, COD income is not always tax deferred; it may be
affect, the obligations and liability of the Guarantor under this   truly tax exempt if there are no suspended losses to offset the
Guaranty”. Id. at JA 360.                                           income. Moreover, § 1366 is not “limited to tax-exempt
                                                                    income, so if COD income is not ‘really’ tax exempt this
  Four A filed a petition for relief under Chapter 7 of the         would not take it out of the section.” Witzel, 200 F.3d at 505.
Bankruptcy Code in December, 1993. At the time of its
bankruptcy filing, Four A owed $1,106,000 to Appolo.                  Since COD income falls within § 1366(a)(1)(A), it follows
Appolo determined that the Four A debt was “worthless” and          that pursuant to § 1367(a)(1)(A), COD income increases the
deducted the $1,106,000 Four A debt as a business bad debt          basis of the S corporation shareholder’s stock by the amount
pursuant to 26 U.S.C. §166 (a) on its 1993 Form 1120S, U.S.         of COD income passed through to the shareholder.
Income Tax Return for an S Corporation. Appolo never                Consequently, we hold that the S corporation must reduce any
demanded payment from Four A or any of its shareholders.            existing tax attributes, including shareholder suspended
Taxpayers Larry Asher and Gary Asher, as Appolo                     losses, by the amount of COD income realized by the S
shareholders, each reported an ordinary loss of $80,246 on          corporation. If any COD income remains after losses and
                                                                    suspended losses are deducted, that income may flow through
18    Gaudiano, et al. v. Commissioner              No. 99-1294      No. 99-1294          Gaudiano, et al. v. Commissioner        7

  §108(d)(7)(A), tax attributes [sic] reductions must be             their individual 1993 tax returns based on their distributive
  applied at the corporate level with subchapter S                   shares of Appolo’s bad debt write-off.
  corporations. Taxpayers’ proposal would not give effect
  to the attribute reduction scheme. Taxpayers’ approach,              The Commissioner did not disallow the loss deductions
  in fact, would thwart the purpose of the net operating loss        claimed by the Ashers upon audit. Rather, in his answer in
  tax attribute. . . . As we see it, §108(b)(4)(A) is simply         the Larry Asher case, and in an amendment to his answer in
  designed to compute certain tax applications ... before            the Gary Asher case, the Commissioner asserted that Appolo
  reducing tax attributes. We do not read the statute as             was not entitled to a bad debt deduction for the amounts owed
  mandating that attribute reductions be made in the tax             by Four A because those debts were not worthless in 1993 in
  year following the year of the discharge. We concede               that the debts were guaranteed by the Four A shareholders
  that, if §108(b)(4)(A) is read narrowly and in isolation, it       who were financially able to make full payment on Four A’s
  is plausible to conclude Congress intended tax attributes          debts to Appolo. Consequently, the Commissioner requested
  to be reduced only in the tax year following the taxable           that the Tax Court determine that the Ashers were liable for
  year of the discharge. But we must read the Internal               increased deficiencies for 1993.
  Revenue Code as a whole. . . . Taxpayers’ interpretation
  of §108(b)(4)(A) would negate the effect of the tax                  The Ashers opposed the Commissioner’s requests for
  attribution scheme and would give taxpayers an                     increased deficiencies, contending that the Guarantees were
  unwarranted windfall.                                              not given in exchange for consideration, and thus, were not
                                                                     enforceable under Kentucky law. During a brief trial before
Gitlitz, 182 F.3d at 1149. In Witzel, without specifically           the Tax Court, the Taxpayers offered testimony that they were
addressing the ordering requirements of § 108(b)(4)(A), the          told the Guarantees were for the auditors and that Appolo
Seventh Circuit determined that the tax attributes must be           never demanded that the Guarantees be executed. Further, the
reduced before COD income passes through: “if (b)[§108(b)]           Taxpayers testified that it was understood by Appolo and the
is to be applied at the corporate level, the implication . . . is    Taxpayers that Appolo did not require and would never
that the excluded income must be set off against the                 enforce the Guarantees; the Guarantees were executed solely
suspended losses and the latter reduced accordingly. The             to appease the Price Waterhouse auditor. The Taxpayers
argument is not conclusive; the interpretive question could be       asserted that the Guarantees were given to the auditor and that
resolved either way; but in these circumstances of dubiety the       no copies were kept by the Taxpayers or Appolo. Moreover,
sensible result--denying the taxpayers the double windfall--         the Taxpayers contended that the consideration language in
seems to us the preferable one.” Witzel, 200 F.3d at 503-04.         the Guarantees was merely form language added by Appolo’s
                                                                     legal counsel John Stites which Appolo had not requested.
   While this is a very close call, we feel inclined to follow the   Finally, the Taxpayers testified that Appolo had never
reasoning of the Tenth and Seventh Circuits on the ordering          promised to forbear from suing Four A on Four A’s past debt.
issue. Section 108 (d)(7)(A) clearly requires that the
insolvency determination and the attribute reduction take              The Tax Court held that Appolo was not entitled to a bad
place at the corporate level. If the attribute reduction is made     debt deduction for the amounts loaned to Four A; and thus,
after the COD income passes through then there will be no            the Ashers were not entitled to the ordinary losses they
attribute reduction at the corporate level.               As the     claimed as their distributive share of Appolo’s deduction.
Commissioner notes, the mandated reduction of the                    The Tax Court’s decision was based on its observation that
corporation’s net operating losses (which include suspended          the Guarantees appeared valid and enforceable on their faces.
8     Gaudiano, et al. v. Commissioner             No. 99-1294      No. 99-1294           Gaudiano, et al. v. Commissioner         17

The Tax Court focused on the first Continuing Guaranty,             excluded from gross income under § 108(a)(1)(B) shall not
which stated on its face that consideration was given to the        exceed the amount by which the taxpayer is insolvent.
Four A shareholders in that Appolo promised not to demand           § 108(a)(3). Further, the amount of COD income excluded
immediate payment on past loans to Four A and to make               under § 108(a)(1)(B) shall be applied to reduce the tax
future loans to Four A. Noting that forbearance to sue is           attributes of the taxpayer in the order listed in § 108(b)(2)
sufficient consideration to support a promise, the Tax Court        [Net operating loss, general business credit, minimum tax
found that the first Guaranty was supported by sufficient           credit, capital loss carryovers, basis reduction, Passive activity
consideration and held that the Guaranty was valid and              loss and credit carryovers, and foreign tax credit carryovers].
enforceable. In making this finding the Tax Court did not           § 108(b)(1). Section 108(b)(4) provides that the reductions
accept the self-serving testimony of the Taxpayers offered to       described in § 108(b)(2) shall be made after the determination
prove that Appolo did not give consideration for the                of the tax imposed by this chapter for the taxable year of the
Guarantees. The Tax Court also found that the Taxpayers             discharge. Section 108(d)(7) contains special rules for S
were financially able, both in 1993 and at the time of the trial,   corporations. Section 108(d)(7)(A) provides that in the case
to satisfy Four A’s debts to Appolo. Consequently, the Tax          of an S corporation, subsections (a) [exclusion of COD
Court concluded that since the first Continuing Guaranty is         income if taxpayer is insolvent or is in Title 11], (b)
enforceable, the debt was not worthless, regardless of whether      [reduction of tax attributes] and (g) [qualified farm
the second Guaranty is enforceable.                                 indebtedness] shall be applied at the corporate level.
                           Analysis                                    As the Tenth Circuit recognized in Gitlitz, the timing of the
                                                                    attribute reduction brings § 108(b)(4)(A) into conflict with
I. Pass Through Issue                                               § 108(d)(7)(A). Under the Taxpayers’ position, excluded
                                                                    COD income does not reduce S corporation losses as required
  The initial issue in this case raises a question of first         by § 108(b)’s attribute reduction requirement if the reduction
impression in this Circuit. Whether the Taxpayers, as the           is made in the year following the year of discharge. Rather,
shareholders of Four A, an S corporation, are entitled to           current and suspended losses are deducted by the shareholders
increase their bases in the stock of Four A by their pro rata       by virtue of their increased basis, thus offsetting other income
share of discharge of indebtedness income (“COD income”)            the shareholders may have. In practice, there would be no
realized by Four A, but excluded by Four A pursuant to 26           income left to offset any tax attributes at the corporate level
U.S.C. §108(a)?                                                     in the year following discharge.
  There are no facts in dispute, thus the Tax Court’s decision         The Commissioner argues that § 108(b)(4)(A) does not
on this legal issue is a question of law that is reviewed de        require that the reduction of tax attributes be made in the year
novo. Estate of Mueller v. Commissioner, 153 F.3d 302, 304          following the year of discharge. See § 108(b)(4)(B)
(6th Cir. 1998).                                                    (reductions under § 108(b)(2)(A) & (D)[net operating loss and
                                                                    capital loss carryover] shall be made first in the loss for the
    A. The Tax Court Decision                                       taxable year of the discharge.)          Faced with the same
                                                                    argument from the taxpayers in Gitlitz, the Tenth Circuit held:
  The Tax Court held that the COD income that Four A
excluded from gross income under § 108 (a) is not a                   Although a close question, we ultimately conclude the
separately stated item of tax-exempt income for purposes of           taxpayers’ theory is not compelling. According to
§ 1366 (a)(1)(A). Therefore, Taxpayers were not entitled to
16       Gaudiano, et al. v. Commissioner                No. 99-1294        No. 99-1294           Gaudiano, et al. v. Commissioner          9

losses were completely offset by the amount of the COD                      increase their bases in the Four A stock due to Four A’s COD
income), the increased    basis may enable the taxpayer to                  income. In reaching this decision, the Tax Court relied, with
deduct future losses.8 Id. at 505.                                          little discussion, on its reviewed decision in Nelson v.
                                                                            Commissioner, 110 T.C. 114 (1998), aff’d, 182 F.3d 1152
  C. The Parties’ Arguments                                                 (10th Cir. 1999).
  The parties in this case raise the same arguments made by                   In Nelson, the Tax Court held that a taxpayer was not
the parties in Gitlitz, Farley, Witzel, and Hogue. The                      entitled to increase the basis in his S corporation stock by his
Commissioner argues that the only reasonable interpretation                 pro rata share of the insolvent corporations’s COD income.
of § 108 is that COD income is recognized only at the                       The Nelson court set out the arguments as follows:
corporate level, does not pass through to the shareholder, does
not raise the shareholder’s basis and instead eliminates                         The parties’ dispute herein centers on the language in
suspended losses at the corporate level. Taxpayers argue that                 section 108 (d)(7)(A). Specifically, the parties differ on
§ 108(d)(7)(A)-(C) does not override or vary the general S                    the precise meaning of the phrase, “in the case of an S
corporation pass through and basis provisions set forth in                    corporation, * * * [section 108] shall be applied at the
§§ 1366 and 1367, nor does § 108(d)(7)(A) preclude pass                       corporate level.”          Sec. 108(d)(7)(A). [The
through of COD income under § 1366(a)(1)(A).                                  Commissioner] argues that section 108(d)(7)(A)
                                                                              represents an adjustment and/or exception to the
  As the conflicting decisions of the other courts which have                 principles underlying the subchapter provisions that
analyzed this issue demonstrate, interpreting the Internal                    items of income realized or recognized at the corporate
Revenue Code is about as easy as swimming through mud.                        level are passed through to the shareholders. On the
The sections at issue, 108, 1366, and 1367, while seemingly                   other hand, [Taxpayer] contends that section
clear on their faces, become muddy when they are applied in                   108(d)(7)(A) stands for the proposition that prior to the
conjunction with each other.                                                  determination of an individual shareholder’s income tax
                                                                              liability, the S corporation must be ascertained to be
  The analysis begins with § 108(a)(1)(B) which provides                      insolvent.
that gross income does not include any amount which would
be includible in gross income by reason of the discharge of                      [The Taxpayer], in effect, argues that the result of the
indebtedness of the taxpayer if the discharge occurs when the                 interaction between section 108(d)(7)(B) and (b)(2), as
taxpayer is insolvent. In this case the parties agree that Four               governed by section 108(b)(4), is to apply the attribute
A was insolvent at the time that its debt to Appolo                           reduction rules of section 108(b)(2) at the shareholder
(approximately $2 million) was discharged. The amount                         level. Section 108(b)(4) states that the reduction in tax
                                                                              attributes will be made “after the determination of the tax
                                                                              imposed * * * for the taxable year of the discharge.”
     8
                                                                              (Emphasis added.) Next, [Taxpayer] points out that
      Presumably, the shareholder’s basis in his S corporation stock          “suspended losses” under section 1366(d)(i)-(3) are
would only increase by the amount of the COD income which was not             deemed to be net operating losses. Sec. 108(b)(2). Such
offset by the existing suspended losses. Thus, the S corporation had $5.4     “suspended losses” are determined at the shareholder
million in excluded COD income which was offset by approximately $3
million in existing suspended losses leaving approximately $2.4 million       level. Sec. 1366(d)(1). Consequently, [Taxpayer]
in COD income to pass through to the shareholder to increase the              extrapolates that the reduction in tax attributes occurs on
shareholder’s basis.
10   Gaudiano, et al. v. Commissioner             No. 99-1294     No. 99-1294              Gaudiano, et al. v. Commissioner             15

  the shareholder level. Similarly, [Taxpayer] reasons that       section 108(d)(7)(A) requires that COD income of a
  COD income excluded under section 108(a)(1) passes              subchapter S corporation be offset against any existing
  through to the shareholder, increases his or her stock          suspended losses arising from the operation of the
  basis, and thus affects his or her “suspended losses”           corporation.” Id. at 506. Thus, the taxpayer in Witzel was
  under section 1366(d). According to [Taxpayer], all of          forbidden to deduct his existing suspended losses because
  this occurs at the shareholder level, prior to the reduction    they were offset at the corporate   level by the amount of his
  in tax attributes under section 108(b)(2).                      corporation’s COD income.6 The Seventh Circuit noted that
                                                                  resolving the interpretive question in this way, which denies
    Accordingly, in order for [Taxpayer] to prevail in this       the taxpayers the double windfall, seemed to be preferable.
  matter, the COD income otherwise excluded from gross            Id. at 504. While Judge Posner did not specifically address
  income must pass through the corporate form and be              the timing of the attribute reduction as set forth in §108(b)(4),
  apportioned on a pro rata basis among the subchapter            his holding indicates that he sided with the Gitlitz Court in
  shareholders. We disagree with [Taxpayer]’s statutory           finding that attribute reduction precedes pass through.
  approach with respect to the COD income exclusion
  provision because it is simply not plausible. In this             However, in contrast to Gitlitz, Judge Posner determined
  instance, section 108(d)(7)(A) explicitly provides that the     that COD income passes through to the shareholder pursuant
  COD income exclusion operates, for purposes of the              to § 1366(a)(1)(A), which explicitly includes tax exempt
  subchapter S regime, on the corporate level.                    income, and increases the basis of the shareholder’s stock
                                                                  pursuant to § 1367. The Court was unpersuaded by the Tax
Nelson, 110 T.C. at 120-21. The court held that the literal       Court’s conclusion that COD income is merely tax deferred,
language of §108(d)(7)(A) provides that the reduction in tax      not really tax exempt, noting that there could be occasions
attributes applies at the corporate level. Id. at 121. Further,   when COD income is truly tax exempt as opposed to merely
§ 1366(b) provides that the character of any item included        tax deferred. In any event, Judge Posner noted that § 1366 is
under § 1366(a)(1)(A) is determined as if realized directly       not limited to tax-exempt income, so even if COD income7
from the source from which realized by the corporation, or        really was not tax exempt it would not take it out of § 1366.
incurred in the same manner as incurred by the corporation.       Thus, while the taxpayer cannot use his increased basis to
Thus, the court determined that construing § 1366(a)(1)(A) in     deduct existing suspended losses (because in Witzel those
combination with § 108(d)(7)(A) meant that COD income
was precluded from recognition at the shareholder level and
could not, therefore, increase the shareholder’s basis. Id. at        6
                                                                        Mr. Witzel was the sole shareholder of an S corporation with $5.4
122.                                                              million of COD income and suspended losses of almost $3 million.
   In addition, the Tax Court held that § 108(b)(4)(A), which         7
                                                                        The court noted a recent Treasury Regulation which supports the
states that the reduction of tax attributes occurs after the      Commissioner’s and the Tax Court’s interpretation of § 1366, but
determination of the tax imposed for the taxable year of the      declined to follow the regulation since it is only applicable to tax years
discharge, requires the S corporation to reduce its tax           beginning on or after August 18, 1998. The regulation states “‘Tax-
attributes by the amount excluded from gross income at the        exempt income’ does not include income from discharge of indebtedness
end of the corporation’s taxable year. Id. at 123. The court      excluded from income under section 108 because such income is not
                                                                  permanently excludible from income in all circumstances in which section
rejected taxpayer’s argument that the income was “tax             108 applies.” Treas. Reg. §1.1366-1(a)(2)(viii), 64 Fed. Reg. 71641,
exempt” and thus statutorily required to pass through to S        71643 (Dec. 22, 1999). Similarly, this regulation does not apply here
                                                                  because the tax year at issue is 1993.
14   Gaudiano, et al. v. Commissioner             No. 99-1294      No. 99-1294           Gaudiano, et al. v. Commissioner       11

S corporation shareholders. The court determined that once         corporation shareholders under § 1366(a)(1)(A). Instead, the
COD income is excluded from gross income pursuant to               court noted that the exclusion could be subject to taxation in
§ 108(a)(1), it is treated as tax-exempt income pursuant to        the future, and therefore was not necessarily tax exempt on a
§ 1366(a)(1) and is passed through to S corporation                permanent basis. Id. at 125. After reviewing the “relatively
shareholders under that section. Pursuant to § 108(b)(2), the      sparse legislative history,” the court also observed that
amount of COD income excluded from gross income is                 allowing taxpayer to increase his basis by using income for
applied to reduce tax attributes. That reduction of tax            which the creditors, not taxpayer, had borne an economic cost
attributes is made after the determination of the tax imposed      would produce an unintended windfall for taxpayer. Id. at
by this chapter for the taxable year of the discharge.             127-28.
§ 108(b)(4)(A). Thus, the court concluded that COD income
passes through to S corporation shareholders in the year that        B. Decisions of other courts on the COD pass through
the debt is discharged and the tax attributes are decreased in          issue.
the year following the discharge because the determination of
the tax imposed for the tax year in which the discharge               In July 1999, the Tenth Circuit, the first circuit to rule on
occurred cannot take place until that tax year ends. Id. at *2-    this issue, affirmed the Nelson decision for the reasons stated
3. As a result, the S corporation shareholders in Hogue were       in Gitlitz v. Commissioner of Internal Revenue, 182 F.3d 1143
allowed to increase shareholder basis in the year of the           (10th Cir. 1999). The Tenth Circuit determined that:
discharge and claim suspended losses against the increased
basis. The attribute reduction mandated by § 108(b)(2) would         The outcome of this case is ultimately determined by the
occur in the year following the year of discharge. The court,        timing of the pass-through. If the attribute reduction
noting that the Tenth Circuit’s decision in Gitlitz was driven       procedures precede the pass-through, the corporation’s
by the court’s desire to avoid allowing the taxpayers to realize     excluded discharge of indebtedness income is absorbed
a windfall, stated that “[t]he Internal Revenue Code is too          before it can pass through to shareholders and compel
complicated for courts to strain against the language in an          basis adjustments. Potential windfalls are thus avoided.
effort to achieve particular results.” Id. at *3.                    If, on the other hand, attribute reduction takes place after
                                                                     the pass-through, the taxpayers’ theory must prevail.
   Chief Judge Posner, writing for the Seventh Circuit,
addressed this issue in Witzel v. Commissioner of Internal         Id. at 1148. The court concluded that attribute reduction must
Revenue, 200 F.3d 496 (7th Cir. 2000), and settled on a result     precede the pass through. In reaching this conclusion the
somewhere in the middle between the Tenth Circuit’s position       court reviewed § 108(d)(7)(B) which provides that, in
in Gitlitz and the positions of the Third Circuit in Farley and    administering the tax attribute reduction scheme, shareholder
the District Court of Oregon in Hogue. The Seventh Circuit         losses suspended pursuant to § 1366(d)(1) must be treated as
noted that while the “at the corporate level” language of          net operating losses for purposes of § 108(b)(2)(A), “thereby
§108(d)(7)(A) was not susceptible to conclusive                    precluding subchapter S corporation shareholders with
interpretation, “[i]f (b) [the subsection that reduces tax         carryover losses from enjoying the tax benefits of ordinary
attributes by the amount of the excluded COD income] is to         losses while simultaneously avoiding taxation on discharge of
be applied at the corporate level, the implication, as the         indebtedness income.” Id.           The Court interpreted
government argues, is that the excluded income must be set         § 108(d)(7)(B) as requiring that shareholder suspended losses
off against the suspended losses and the latter reduced            be added to the corporation’s annual net operating losses in
accordingly.” Id. at 503-04.       Thus, the Court held “that      applying the net operating loss tax attribute reduction. The
                                                                   court conceded that since a subchapter S corporation’s losses
12       Gaudiano, et al. v. Commissioner                  No. 99-1294        No. 99-1294          Gaudiano, et al. v. Commissioner       13

are normally deductible only by its shareholders, the                         the basis of their stock, the taxpayers were able to deduct
corporation itself is not permitted to take a net operating loss              previously suspended losses. The Court noted that the key to
deduction. However, the court noted, “nothing in the Internal                 unraveling the case was determining how sections 1366,
Revenue Code mandates that corporate net operating losses                     1367, and 108 interact. As in Gitlitz, the Third Circuit noted
pass through immediately to shareholders. If pass through                     that the timing of the pass through, which is controlled by
was immediate, “shareholders could secure a windfall by (1)                   § 108(b)(4)(A), determines the outcome of the case. Unlike
avoiding tax on corporate discharge of indebtedness income                    the Tenth Circuit in Gitlitz, the Third Circuit held that:
under § 108(a), and (2) employing the corporation’s passed-
through net operating losses to reduce their own non-                            “[t]he language in section 108(b)(4)(A) clearly indicates
corporate related gross income without having first decreased                   that tax attributes are reduced on the first day of the tax
the net operating losses by the amount of the corporation’s                     year following the year of the discharge of indebtedness.
discharged debt.” Id.                                                           The statutory language is straight forward. Discharge of
                                                                                indebtedness income, considered income under section
   The Tenth Circuit concluded that “when § 108(a)’s                            61(a)(12), is excluded from gross income pursuant to
discharge of indebtedness income exclusion is triggered, a                      section 108(a)(1)(B) if, as in this case, the S corporation
shareholder’s pro rata share of the corporation’s net operating                 is insolvent. This solvency determination is made at the
losses passes through to him only to the extent such losses are                 corporate level rather than the individual shareholder
not absorbed by the shareholder’s pro rata share of the                         level pursuant to section 108(d)(7)(A). Discharge of
excluded canceled debt.” Id. Further, should any debt                           indebtedness income excluded from gross income under
discharge amount remain after the tax attributes are reduced,                   section 108(a)(1)(B) then passes through to the S
it is disregarded and has no tax5 consequences; it does not                     corporation’s shareholders pursuant to section
increase the shareholder’s basis.                                               1366(a)(1)(A).      Upon passing through to the S
                                                                                corporation’s shareholders, the discharge of indebtedness
  Two other circuit courts and one district court have also                     income causes an upward adjustment in the basis of the
recently addressed this issue and have come to different                        shareholder’ S corporation stock pursuant to section
conclusions. In United States v. Farley, No. 99-3209, 2000                      1367(a)(1)(A), thus allowing deductions for losses
WL 72087 (3rd Cir. Jan. 27, 2000), the taxpayers obtained                       previously suspended because the corporation’s stock
refunds after adjusting the basis of their S corporation stock                  lacked adequate basis. Finally, the tax attribute reduction
upward to account for excluded COD income. By increasing                        required by section 108(b) takes place on the first day of
                                                                                the tax year following the year of the discharge of
                                                                                indebtedness, as mandated by section 108(b)(4)(A).
     5
      The Tenth Circuit set out examples which show how their
interpretation of the interplay between §§ 108 and 1366-1368 operates in      Farley, 2000 WL 72087 at *8. Accordingly, the Third Circuit
practice. The steps which need to be taken in each calculation are: 1)        determined that the taxpayers in Farley were entitled not only
corporation computes its COD income and sets this figure aside                to increase the basis of their S corporation stock but also to
temporarily; 2) corporation calculates its net operating loss tax attribute   take deductions for their current and suspended losses. Id.
(net operating loss + shareholder suspended losses); 3) corporation
applies the excluded COD income to reduce its tax attributes. After these        Similarly, in Hogue v. United States, No. 99-302-KI, 2000
calculations are complete, if any COD income remains it is ignored and
has no tax consequences. If any net operating losses or suspended losses      WL 2651 (D. Or. Jan. 3, 2000), the court noted that § 108 is
remain, they flow through to the shareholder and, depending on his basis,     silent with respect to whether COD income passes through to
may be used by him to offset his own gross income. 182 F.3d at 1150 n.6.
