Volume 5 Winter 2011 Number 2 - Charleston Law Review

CHARLESTON LAW REVIEW [Volume 5based on judicially developed case law, and under such case lawthe taxpayer could be denied the tax results if the transactionlacked substance or economic reality. Given the tax objectives ofthe conversion, it would appear that the taxpayer would have avery difficult time trying to circumvent the new statute.VI. FINANCIALLY DISTRESSED S CORPORATIONSThis portion of the paper will address issues similar to thoseraised in the partnership or LLC context, but the focus will be onthe financially distressed S corporation. For purposes ofdiscussion, it is assumed that the S corporation commencedbusiness as a S corporation and was not originally a Ccorporation. One important difference between a partnership anda S corporation is that the insolvency test for a partnership is atthe partner level and not at the partnership level. On the otherhand, the insolvency test under § 108 applies at the corporatelevel, thereby allowing the taxpayer to take advantage of theinsolvency exception under such section. 192In view of the fact that a S corporation is a conduit for taxpurposes, taxable cancellation of indebtedness income will not betaxable at the entity level, and such income will be spread on apro rata basis to each of the shareholders. 193 Taxable cancellationof indebtedness income should result in an increase in theshareholder’s basis. 194 Because the S corporation cannotdistribute cancellation of indebtedness income, such incomeshould increase the corporation’s accumulated adjustmentsaccount. 195In the case of an insolvent S corporation, cancellation ofindebtedness income is not taxable. 196 As a tradeoff for beingable to deduct this from taxable income, the S corporation isrequired to reduce tax attributes. 197 The most significant assetsthat can be reduced in terms of tax attributes relates to the bases264192. I.R.C. § 108(d)(7)(A) (2006).193. I.R.C. § 1377(a)(1)(B).194. I.R.C. § 1367(a)(1).195. I.R.C. § 1368(e)(1)(A).196. I.R.C. § 108(a)(1)(B).197. I.R.C. § 108(b)(1).