The United States Supreme Court, in Gitlitz, et al. v. Commissioner, has held that excluded S corporation discharge of indebtedness income increases the basis of an S corporation shareholder who may utilize such increase to deduct losses previously suspended due to the shareholder's insufficient basis.
To the extent that losses and deductions from an S corporation exceed a shareholder's basis, the excess is suspended until the shareholder's basis is increased to permit the deduction. The petitioners in the United States Supreme Court proceeding were shareholders of an insolvent S corporation. Certain corporate debt was discharged resulting in discharge of indebtedness income that was excluded from the shareholders' gross income by virtue of the insolvency exception provided by Internal Revenue Code Section 108. The Court held that the excluded discharge of indebtedness income passes through to S corporation shareholders and increases their basis in S corporation stock. This is true even though the shareholders incurred no income tax on such amount. The Court further held that an S corporation shareholder may use this increase in basis to deduct suspended S corporation losses. This offset occurs prior to the tax attribute reduction required by Internal Revenue Code Section 108 when a discharge of indebtedness is excluded from income of an insolvent corporation. If tax attribute reduction occurred first, the suspended losses would be deemed to be net operating losses which would be reduced by the amount of the discharged debt pursuant to the provisions of Internal Revenue Code Section 108.
The Court reversed the 10th Circuit Court of Appeals which held that while excluded discharge of indebtedness income was passed through to the shareholders, tax attributes of the S corporation must first be reduced by the amount discharged pursuant to Internal Revenue Code Section 108, thereby limiting the ability of S corporation shareholders to utilize suspended losses.
The recent United States Supreme Court holding may provide an opportunity for S corporation shareholders to amend their tax returns for open years to take advantage of certain suspended losses. In addition, the holding may impact the analysis as to whether or not an S corporation is preferable over other entities.
