Volume 5 Winter 2011 Number 2 - Charleston Law Review

2011] Tax Aspects—Financially Troubled Entitiesof assets held by the corporation. 198Tax attribute reduction is applied at the corporate level andany cancellation of indebtedness income of a S corporation that isexempt under § 108(a) does not pass through to the shareholdersof the corporation under § 1366(a). 199 Moreover, any loss ordeduction of a S corporation that is disallowed for the taxableyear in which the debt discharge occurs is treated as a netoperating loss for purposes of § 108(b)(2)(A) (relating to taxattribute reduction rules). 200In Gitlitz v. Commissioner, 201 the Supreme Court held thatcancellation of indebtedness income of a S corporation was to beallocated to the shareholders and result in an increase in thebasis of their shares. 202 The increased basis in stock allowedsuspended losses of the corporation to pass through to theshareholders before the corporation is required to reduce its taxattributes (including the suspended losses). 203 Section 108(d)(7)reversed the result in Gitlitz. As a result of the change, excludedcancellation of indebtedness income will not increase the stockbasis of a S corporation shareholder and, thus, will not allowsuch shareholder to utilize losses that would otherwise haveconstituted suspended losses (the suspended losses would then beavailable to be used for attribute reduction). In effect, the newrule prohibits the use of excluded income to generate a basisstep-up, and then use such shield to trigger attribute reduction.A. Indebtedness Contributed to CapitalIn the case of a C corporation, a capital contribution of debt istreated as though the corporation had satisfied the indebtednesswith an amount of money equal to the shareholder’s adjustedbasis in the indebtedness. 204 The rule is different in the case of aS corporation. The Code allows a contributing S shareholder to198. I.R.C. § 108 (b)(2)(E)(i).199. I.R.C. § 108(d)(7)(A); I.R.C. § 1366(a).200. I.R.C. § 108(d)(7)(B).201. 531 U.S. 206 (2001).202. Gitlitz v. Comm’r, 531 U.S. 206, 220 (2001).203. Id.204. I.R.C. § 108(e)(6)(B); I.R.C. § 108(d)(7)(c).265