Witzel v. Commissioner of Internal Revenue

Argued December 9, 1999 This is an appeal by taxpayers from a decision by the Tax Court (77 T.C.M. (CCH) 1487 (1999)) holding, consistently with Gitlitz v. Commissioner, 182 F.3d 1143 (10th Cir. 1999), and Nelson v. Commissioner, 110 T.C. 114 (1998), that ""discharge of indebtedness"" (equivalently, ""cancellation of debt"") income that is excluded from gross income under 26 U.S.C. sec. 108(a) does not pass through to a shareholder of a subchapter S corporation and therefore does not increase the shareholder's basis. A debt that is cancelled is income to the debtor, since he has been enriched by the amount of the debt. sec. 61(a)(12); see also United States v. Kirby Lumber Co., 284 U.S. 1 (1931). But when, as in the present case, the debtor is in bankruptcy under Chapter 11 of the Bankruptcy Code, section 108(a) of the Internal Revenue Code exempts the debtor's cancellation-of-debt (COD) income from federal income tax. Mr. Witzel is the sole shareholder of a subchapter S corporation that as part of its discharge from Chapter 11 was permitted to cancel some $5.4 million in debts. Income received by a subchapter S corporation is taxed to each shareholder pro rata as if he had received the income directly, 26 U.S.C. sec. 1366, but by virtue of section 108(a) Witzel incurred no liability to pay tax on any of the $5.4 million in additional cancellation of debt income.