February 12, 2014
R BALL FOR R BALL III BY APPT
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17593) R BALL CHILDREN TRUST 9/9/1969
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17594) ETHEL BALL FOR R BALL III APT 2/9/1967
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17595) ETHEL BALL FOR A L BALL AS APPT
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17596) R BALL JR. CHILDRENTRUST 1/29/1970
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17597) R BALL JR. F/B/O R BALL III 12/22/1976
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17598) R BALL FOR A L BALL BY APPT
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17599) R BALL CHILDREN TRUST 1/24/1973
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17600) RUSSELL BALL JR SEC FIRST 9/9/1967
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 11-17601) 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 JR. CHILDRENTRUST 1/29/1970; R BALL JR. F/B/O R BALL III 12/22/1976; R BALL FOR A L BALL BY APPT; R BALL CHILDREN TRUST 1/24/1973; RUSSELL BALL JR SEC FIRST 9/9/1967, Appellants
Argued: December 17, 2013
On Appeal from the United States Tax Court (Tax Court Nos. 17593-11, 17594-11, 17595-11, 17596-11, 17597-11, 17598-11, 17599-11, 17600-11, 17601-11) Tax Court Judge: Honorable Kathleen Kerrigan
Nancy Winkelman, Esq. [ARGUED] Timothy K. Lewis, Esq. Schnader Harrison Segal & Lewis LLP Attorneys for Appellants
Francesca Ugolini, Esq. [ARGUED] Richard Farber, Esq. Kathryn Keneally, Esq. United States Department of Justice, Tax Division Attorneys for Appellee
Before: JORDAN, VANASKIE, and VAN ANTWERPEN, Circuit Judges.
VAN ANTWERPEN, Circuit Judge.
An S corporation ("S Corp.") is a small business corporation that is permitted to have its corporate income, losses, deductions, and credits attributed to its shareholders. This appeal arises out of nine consolidated cases before the United States Tax Court regarding the tax implications of an S Corp.'s election to treat its subsidiary as a "qualified subchapter S subsidiary" ("Qsub") under Internal Revenue Code § 1361. Specifically, the parties disagree as to whether the Qsub election and subsequent sale of the S Corp. parent creates an "item of income" under § 1366(a)(1)(A) thereby requiring the parties who held stock in the parent S Corp. to adjust their bases in stock under § 1367(a)(1)(A). For reasons which follow, we affirm the decision of the Tax Court, finding an increase in stock bases and declared losses to be improper.
In June 1997, ten trusts for the benefit of the Ball family ("Trusts") acquired direct ownership of all shares of American Insurance Service, Inc. ("AIS") with an aggregate basis in AIS stock totaling $5, 612, 555. In 1999, the Trusts formed Wind River Investment Corporation ("Wind River"), a Delaware corporation. The Trusts then contributed their shares in AIS in exchange for all of the shares of Wind River. This resulted in Wind River owning all of the shares of AIS. Effective June 4, 1999, Wind River designated itself a subchapter S Corporation. On February 28, 2003, Wind River elected to treat AIS as a Qsub under § 1361(b)(3). Prior to the Qsub election, the Trusts' aggregate adjusted basis in the Wind River stock was $15, 246, 099. Following the Qsub election, the Trusts increased their bases in the Wind River stock from $15, 246, 099 to a new basis of $242, 481, 544.
Following the Qsub election and stock basis adjustments, the Trusts sold their interests in Wind River to a third party, Fox Paine, on September 5, 2003. After transaction costs, this sale yielded $230, 111, 857 in cash and securities in exchange for all of the Wind River stock. Even though they had received $230, 111, 857 from the sale, the Trusts claimed a loss in the amount of $12, 247, 229. This was calculated as the difference between the amount actually received for the sale and the new basis in the Wind River stock. The Trusts shareholders' 2003 tax returns were filed citing the aforementioned capital loss.
The Internal Revenue Service ("IRS") determined the Trusts should not have increased their bases in the Wind River stock to $242, 481, 544 following the Qsub election. The IRS determined instead that a capital gain of approximately $214 million had been realized from the sale of Wind River to Fox Paine. This resulted in a cumulative tax deficiency of $33, 747, 858 for the nine trusts that have filed appeals in this case. Deficiency notices were sent to the Trusts on May 18 and 19, 2011, stating "the Qsub election and the resulting deemed I.R.C. § 332 liquidation did not give rise to an item of income under I.R.C. § 1366(a)(1)(A); therefore, [the Trusts] could not increase the basis of their [Wind River] stock under I.R.C. [§] 1367(a)(1)(A)." (Appendix ("App.") at A373.) The Trusts filed petitions with the United States Tax Court seeking a redetermination of deficiencies under the jurisdiction of §§ 6213(a) and 7442. The cases were consolidated and submitted for decision on stipulated facts, under Tax Court Rule 122,  as R. Ball for R. Ball III By Appt., et al. v. Commissioner, 105 T.C.M. (CCH) 1257, 2013 WL 452722 (2013). As previously noted, the Tax Court found the increase in stock basis and declared loss to be improper.
III. TAX COURT PROCEEDINGS
The main issue before the Tax Court and now on appeal is whether or not a Qsub election creates an "item of income" for the parent corporation under § 1366(a)(1)(A). The Trusts relied on their assertion that the election "resulted in a gain derived from dealings in property and, therefore, created an item of income under § 61(a)." R. Ball, 2013 WL 452722, at *4. If the election resulted in an "item of income, " the new higher bases and resulting tax losses are proper. If it did not result in an "item of income, " the increase in stock bases and declared tax losses are improper.
More specifically, before the Tax Court, the Trusts argued that the deemed liquidation of AIS was, under § 331, a sale or exchange of property creating a realized gain to Wind River. They further claimed that gains from dealings in property are expressly included in gross income under § 61(a). They then contended that, although § 332 provides for the nonrecognition of that gain, it was still "an item of income (including tax exempt income)" under § 1366(a)(1)(A), which passed through to them and increased their bases in Wind River stock under § 1367(a)(1)(A). To support their position, the Trusts raised several contentions to the Commissioner's deficiency finding: (1) their bases were properly adjusted pursuant to § 1367(a)(1)(A), (2) the losses were properly claimed from the sale of Wind River, and (3) "the Qsub election resulted in an item of income pursuant to [§] 1366(a)(1)(A)." See R. Ball, 2013 WL 452722, at *4. Lastly, the Trusts cited United States v. Farley and Gitlitz v. Commissioner,  arguing that the "realized" liquidation gain under §§ 331 and 61(a)(3), allowed an increase in basis, but that gain is not taxable under the non-recognition provision of § 332(a). The Commissioner responded to the Trusts' arguments by asserting that the Qsub election did not create an "item of income (including tax exempt income)" under § 1366(a)(1)(A).
The Tax Court rejected the Trusts' arguments, relying on the differences between "realization" and "recognition" of income in determining what constitutes an "item of income" under § 1366 as it relates to §§ 1367, 331, 332, and 61(a). R. Ball, 2013 WL 452772, at *4-5 (2013). The Tax Court held that gain from a Qsub election is "realized" and calculated under § 1001,  yet it is not "recognized" due to the non-recognition provision of § 332. Id. ("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."). Furthermore, the Court found, under § 1366, that when a gain is unrecognized, it "does not rise to the level of income" and is not an "item of income for tax purposes." Id. at *7. Finally, the Court distinguished Gitlitz and Farley and determined that "neither case is squarely on point." R. Ball, 2013 WL 452722, at *8. The Court reasoned that Gitlitz and Farley only established that the nature of "discharge of indebtedness" as income is not affected by an exclusion elsewhere in the Code. See id. Here, however, "realized gain from the Qsub election was never included explicitly in gross income and was never excluded from gross income." Id. Therefore, the Tax Court determined Gitlitz and Farley were unpersuasive in qualifying the Qsub election as an "item of income" under § 1366.  Id.
In sum, the Court held that "unrecognized gain resulting from the Qsub election did not create an item of income or tax exempt income pursuant to section1366(a)(1)(A)." Id. at *10. Accordingly, the Trusts were found deficient for improperly adjusting their bases in Wind River stock following the Qsub election and this appeal followed. Id..
Section 7482(a) provides exclusive jurisdiction by this Court over decisions before the United States Tax Court. Our review of the Tax Court's construction of the Internal Revenue Code is plenary. Nat'l Starch & Chem. Corp. v. Comm'r, 918 F.2d 426, 428 (3d Cir. 1990).
A. Items of Income
As previously noted, the main issue before us is whether or not the Qsub election created an "item of income." An "item of income" is required for a shareholder of an S Corp. to increase the basis in his or her of the S Corp.. See § 1366(a)(1)(A). Despite use of the term "item of income" in § 1366, it is not defined in the Internal Revenue Code and the Treasury regulations provide only guidance. See 26 C.F.R. § 1.1366-1(a)(2); see also Comm'r v. Glenshaw Glass Co., 348 U.S. 426 (1955). "Gross income, " however, is defined. It is governed by § 61, and includes "[g]ains derived from dealings in property, " as well as "[i]ncome from discharge of indebtedness." Id. § 61(a)(3), (12). Further, the Supreme Court has defined "gross income" as "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." Glenshaw Glass, 348 U.S. at 431. Gains derived from the property obtained by electing and liquidating the Qsub are claimed by the Trusts to be "items of income" for the purpose of § 1366. Fundamentally, the Trusts claim there was a gain from liquidation (§ 61(a)), that gain was "realized" (§ 331) and calculated (§ 1001), and thus is an "item of income" (§ 1366). (Appellant Br. at 17.) The Trusts summarily dismiss the effect of non-recognition on whether a gain is income; however, this premise is undermined by regulations corresponding to § 61(a). Under the § 61(a) Treasury Regulations, gains from the sale or exchange of property, including those derived under § 331, are not "recognized, " and thus "not included in or deducted from gross income at the time the transaction occurs." 26 C.F.R. § 1.61-6(b)(1).
While "item of income" is a broad and undefined term, it is not one without limits. § 61(a) provides a "broad definition of 'gross income, '" that is "sweeping [in] scope, " unless "excepted by another provision in the tax code." Comm'r v. Schleier, 515 U.S. 323, 328-29 (1995). The Supreme Court concluded that "income" requires an "accession to wealth." Glenshaw Glass, 348 U.S. at 431. The Qsub election did not add wealth, it merely changed the tax treatment of the income flowing from the Qsub. This reformation by liquidation did not provide an "accession to wealth" for the corporation and therefore could not create "income" for the Trusts.
B. Realization and Recognition of Gains
The Internal Revenue Code
defers the tax consequences of a gain or loss in property value until the taxpayer 'realizes' the gain or loss. The realization requirement is implicit in § 1001(a) of the Code, which defines '[t]he gain [or loss] from the sale or other disposition of property' as the difference between 'the amount realized' from the sale or disposition of the property and its 'adjusted basis.'
Cottage Sav. Ass'n v. Comm'r, 499 U.S. 554, 559 (1991) (quoting 26 U.S.C. § 1001(a-b)). "To realize a gain or loss in the value of property, the taxpayer must engage in a 'sale or other disposition of [the] property.'" Id. (quoting § 1001(a)). The Commissioner and the Trusts differ as to whether "realizing" a gain is enough to create an "item of income" under § 1366, or whether this section requires the gain to be "recognized." The Tax Court concluded that "nonrecognition provisions prevent realized gain from being included in a taxpayer's gross income." R. Ball, 2013 WL 452722, at *5. The Trusts contend that the Tax Court "confused the concepts of realization and recognition." (Appellants' Opening Br. at 14.) They argue that the Tax Court reached the "unprecedented conclusion that because 'no gain was recognized, . . . the unrecognized gain did not create an item of income under § 61(a)(3), ' or § 1355(a)(1)(A)." (Id. at 15 (quoting App. at 24.) The Trusts assert that the "crux of the Tax Court's error" is its determination that "unrecognized gain does not rise to the level of income." (Id.) They argue that the Code cannot be parsed to create some realized gain that is income and some realized gain that, by virtue of nonrecognition, is not. According to the Trusts, realized gain is always income, a categorization that does not change if that realized gain is then unrecognized.
Inherent in this conflict is which statutory provision, §§ 331 or 332, applies to the liquidation of AIS via Qsub election. Section 331, governing "gain or loss to shareholders in corporate liquidations, " states "[a]mounts 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." The payment via liquidation is realized and calculated by adding "any money received plus the fair market value of the property (other than money) received." 26 U.S.C. § 1001(b). At this point, the Trusts argue that the realized gain becomes an "item of income" by way of § 61(a)(3) and the Supreme Court's holding in Gitlitz. Id. § 61(a)(3) ("[G]ross income means all income from whatever source derived, including . . . [g]ains derived from dealings in property . . . ."); 531 U.S. at 213. The Trusts argue § 331 applies to "realize" the gain. The Trusts claim the gain is defined in § 61(a) and that it is then calculated under § 1001(a). The Trusts deem § 332's non-recognition provision to apply only after realization under § 331, without effect on whether the gain is an "item of income." 26 U.S.C. § 331. The Trusts position is that this realized but unrecognized gain is considered an "item of income" and they are permitted to increase their bases in their Wind River stock.
In contrast, the Commissioner claims the gain must first be "recognized" to qualify as an "item of income, " and the gain in this case is not recognized due to § 332's non-recognition provision. Section 332 governs "complete liquidations of subsidiaries." Id. § 332 (emphasis added). An S Corp. may elect Qsub status for its subsidiary if "(1) the [S Corp.] parent holds 100 percent of the subsidiary's stock, (2) the subsidiary is otherwise eligible to qualify as an [S Corp.] on its own, but for the fact that it has a corporate shareholder, and (3) the [S Corp.] parent makes the appropriate election . . . ." In re Majestic Star Casino, LLC, 716 F.3d 736, 743 n.6 (2013) After a Qsub election, for tax purposes, "the subsidiary is deemed to have liquidated into the parent under I.R.C. §§ 332 and 337." 26 C.F.R. § 1.1361-4 (2012). Thus, "[a] Qsub does not even exist for federal tax purposes." Majestic Star Casino, 716 F.3d at 759. Section 332 then states "[n]o gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation." 26 U.S.C. § 332(a) (emphasis added); see also § 337(a) ("No gain or loss shall be recognized to the liquidating corporation on the distribution to the 80-percent distributee of any property in a complete liquidation to which section 332 applies.").
The Treasury Regulations further distinguish between §§ 331 and 332. "Section 332 applies only to those cases in which the recipient corporation receives at least partial payment for the stock which it owns in the liquidating corporation." 26 C.F.R. § 1.332-2(b).
Ultimately, the Tax Court rejected the Trusts' arguments under § 331, specifically noting that § 332, which governs the liquidation of a subsidiary of which the parent corporation owns eighty percent or more, applies here, not § 331, which governs "all other liquidations." R. Ball, 2013 WL 452722, at *6. The Court held that a liquidation cannot be governed by both § 331 and § 332, thereby foreclosing the Trusts' argument that the gain was first realized under § 331 and then subject to nonrecognition treatment under § 332.
The Tax Court is correct. The Trusts fail to address the fact that § 332, by its plain text, applies to a special set of liquidations that are treated under a different statutory scheme and do not create "items of income." Under the Internal Revenue Code, a Qsub election results in a § 332 liquidation. See 26 C.F.R. § 1.1361-4 (providing that a Qsub election is a deemed liquidation into the parent corporation); 26 U.S.C. § 332 (covering the complete liquidation of a wholly owned subsidiary). Section 332 applies to the liquidation of a "controlled subsidiary" into its parent. Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations & Shareholders ¶ 10.20 (7th ed. 2006). A Qsub is a wholly owned subsidiary under § 1361(b)(3)(B)(i) ("[one hundred] percent of the stock of such corporation is held by the S corporation.").
The Trusts argue that § 332(d) ("Recognition of gain on liquidation of certain holding companies") provides that "subsection (a) and section 331 shall not apply to such distribution." 26 U.S.C § 332(d)(1)(A). This, according to them, is proof that the sections are not mutually exclusive, because, if they were, there would be no need for the exception. That subsection, however, does not affect the analysis of a Qsub liquidation at issue here. Instead, it focuses on "distribution[s] to foreign corporation in complete liquidation of an applicable holding company." Id. It is not incongruous to say that a Qsub liquidation, governed by § 1361, is only covered by § 332 but that other liquidations, covered by other sections of the Code, may be covered by both § 332 and § 331. Rather, the complexities of intersecting provisions should be maintained. The tax treatise cited by both parties states that § 332 is an "important exception" to the general rule provided in § 331. Bittker & Eustice ¶ 10.20. As such, a liquidation is either governed by the general rule in § 331, or it is covered by the exception in § 332. As the Tax Court correctly held, "[a] liquidation cannot be governed by both." R. Ball, 2013 WL 452722, at *6.
C. Gitlitz and Farley
The Trusts contend, however, regardless of "whether or not Sections 331 and 332 are viewed as separate corporate liquidation schemes does not alter the result." (Appellants' Opening Br. at 42.) Rather, the results of Gitlitz and Farley and the treatment of gains as income under § 61(a) are dispositive.
The Trusts rely on the holdings of Gitlitz and Farley, allowing a discharge of indebtedness to pass through to shareholders as an "item of income, " as justification for their own "items of income" argument. Specifically, the Trusts argue that an "item of income" may be defined as gross income under one provision of the Code, yet not recognized under another provision, and still remain an "item of income" for the purpose of § 1366. In Gitlitz, petitioners were shareholders of an insolvent S corporation, which realized over two million dollars of discharge of indebtedness income in 1991. 531 U.S. at 208. Even after the discharge of indebtedness income, the S Corp. was still insolvent and so the entire discharge of indebtedness was excluded from gross income under §§ 108(a) and 108(d)(7)(A). Id. at 209-10. On their tax returns, the Gitlitz petitioners increased their bases in the S corp.'s stock by their pro rata share of the discharge of indebtedness income under the theory that the discharge of indebtedness income was an "item of income" that was passed through to the taxpayers under § 1366(a)(1)(A). Id. at 210. The petitioners in Gitlitz then used the increased bases to deduct their total losses. Id. The Supreme Court agreed, finding "[that] section  is worded broadly enough to include any item of income, even tax-deferred income, that 'could affect the liability for tax of any shareholder.'" Id. at 216 (quoting § 1366(a)(1)(A)).
This Circuit in Farley issued a similar, and even more expanded, holding. 202 F.3d at 206.
We hold that because the controlling statutes clearly provide that tax attribute reduction takes place after income has passed through the S corporation to its shareholders (pass through being a necessary prerequisite to "determin[ing] the tax imposed by this chapter for the taxable year of discharge"), in the case of an insolvent S corporation, discharge of indebtedness income that is excluded from gross income by section 108(a), passes through to the shareholders, increases the shareholder's basis in their S corporation stock, thus allowing the shareholders to take deductions for S corporation losses suspended under section 1366(d)(1).
Id. The Supreme Court in Gitlitz acknowledged that all "items of income" need not qualify as gross income and the indebtedness in Gitlitz still was "income" as included under § 61(a)(12). Id. at 213. In contrast to Gitlitz, a similar inclusion under § 61(a) is not present in the "gain" in the appeal before us. See Nathel v. Comm'r, 615 F.3d 83, 91 (2d Cir. 2010) ("The argument ignores the crucial difference between Gitlitz and this case: Gitlitz addressed payments that explicitly were included in gross income under § 61(a)."). Rather, the "gain" under § 61(a) is not recognized nor is it income, and thus it cannot be an "item of income."
The Tax Court noted that any conclusion other than a holding that "unrecognized gain from a Qsub election does not constitute an item of income or tax-exempt income under § 1366(a)(1)(A), " would lead to "absurd results" and "open the door to a myriad of abusive transactions." R. Ball, 2013 WL 452722, at *9-10. The Supreme Court in Gitlitz, however, refused to address this policy argument when the text of the Code was clear. Gitlitz, 531 U.S. at 220 ("Because the Code's plain text permits the taxpayers here to receive these benefits, we need not address this policy concern."). Although statutory text cannot be read in a way that creates an absurdity, the payment of some taxes and not others is not an absurdity, but rather a policy choice rightly left to Congress. Id. Indeed, Congress, subsequent to Gitlitz, made changes to the statute at issue in that case to prevent further uses of the tax code loophole.
Interconnecting these regulations demonstrates that the gain is not recognized and under the definition of the Supreme Court is not income, and therefore if not income, cannot be deemed an "item of income" under § 1366. In sum, the S Corp. shareholders could not increase their bases under § 1367. The Trusts fail to cite any authority for the alternative.
For the foregoing reasons, we will affirm the Order of the Tax Court.