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Valuation analysts who practice in the bankruptcy and reorganization disciplines often
consider the professional guidance provided by recent case law. Usually, the best
sources of professional guidance are decisions of federal bankruptcy and tax courts.
Sometimes, analysts are also informed by judicial decisions not directly related to
bankruptcy matters. The following recent case decisions should be generally instructive
to valuation analysts. The first decision relates to a federal income tax litigation.
The second decision relates to a federal estate tax litigation.
COD Income Increases Stockholder Basis in Financially Troubled S Corporation
In D.A. Gitlitz, S.Ct., 2001-1 ustc ¶50,147, the U.S. Supreme
Court reversed a taxpayer-negative ruling of the Tenth Circuit and held that income
passes through to S corporation shareholders before the reduction of tax attributes.
This decision allows a stockholder to increase its tax basis in an insolvent S
corporation without investing additional cash. This increase in tax basis allows the
stockholder to deduct any "suspended" losses of the distressed S corporation against the
stockholders other income.
Stockholders in a financially troubled S corporation (and their professional advisors)
should be aware of the implication of Gitlitz. Odds are, if a financially distressed
S corporation has to negotiate debt reduction/ forgiveness with its creditors, it
probably also has "suspended" losses. The Gitlitz decision provides financially troubled
S corporation stockholders a way to recognize those suspended losses without investing
more "good money after bad" in the distressed S corporation.
The Facts of the Case
The individual taxpayers were stockholders in an S corporation. The S corporation
was a partner in an unsuccessful real estate venture. The real estate partnership
failed after generating several years of losses. In recognition of its financial
failure and lack of liquidity, the partnership creditors subsequently discharged the
partnership debt.
The S corporation was insolvent at the time the partnership debt was discharged.
Insolvency means that the S corporation liabilities exceeded the fair market value of
the S corporation assets. Under Internal Revenue Code §108(a)(1), cancellation
of debt (COD) income is excluded from the gross income of the S corporation to
the extent of its insolvency.
However, the stockholder/taxpayers treated the COD income as an item of
corporation income, pursuant to §1366(a)(1). This treatment allowed the
stockholders to increase their tax basis in the S corporation. With the increased
basis, the stockholder/taxpayers could then deduct all of the S corporation's "suspended" losses.
[S]ubsequent events that occur after the relevant
valuation date should be ignoredin the valuation
analysis.
The IRS Position
The Internal Revenue Service (IRS) disallowed the loss deduction, claiming that
(1) COD income is not considered an item of income under §1366(a)(1)
because COD income is tax-deferred, not tax-exempt, and (2) COD income would
first have to be offset by the "suspended" losses at the corporate level under
§108(b)(2)(A). That offset would leave no remaining corporate income to pass
through to the S corporation stockholders.
The stockholder/taxpayers contested the IRS's determination. First, the taxpayers
took their case to the U.S. Tax Court, and the tax court ruled against the
taxpayers. Then the taxpayers appealed the unfavorable tax court decision to the U.S.
Court of Appeals for the Tenth Circuit. However, the appeals court also ruled
against the taxpayers.
The Supreme Court Decision
The taxpayers appealed to the U.S. Supreme Court, and the Supreme Court granted
certiorari. The Supreme Court applied a statutory interpretation approach in its analysis
of the Gitlitz case and considered the following two issues: (1) Was the COD
income an item of corporate income for S corporation accounting purposes, and (2)
does the S corporation's adjustment for income tax attributes occur before or after the
corporation's pass-through of the items of income and loss?
According to the Supreme Court, the plain meaning of §108(a) is that COD
income is excluded from gross income if the taxpayer is insolvent at the time of debt
discharge. Section 1366(a)(1)(A) clearly states that all items of income shall
be taken into account¡including tax-exempt income.
According to the court's analysis, §1366 does not distinguish between tax-exempt
income and tax-deferred income. Therefore, the Supreme Court concluded that §1366
should be read to include all income items—including income that is excluded from gross
income under §108.
In determining when income tax attributes are reduced, the Supreme Court again
looked at the plain meaning of the Code. The statute states that COD income will
be set off against income tax attributes at the corporate level—after the income tax
determination to be imposed for the year of debt discharge. Recognizing that S
corporations are pass-through entities with taxation of the corporate income at the
shareholder level, the court concluded that the setoff of income tax attributes must
come after (1) the tax basis adjustment and (2) the pass-through of the items
of income and loss.
Ultimately, the Supreme Court ruled that the Gitlitz taxpayers were correct in
their initial interpretation of the statute. The COD income passes through to increase
a stockholder/taxpayer's basis in an S corporation. This increase in basis then
allows the taxpayer to use the "suspended" losses of the S corporation. Should there
be any residual COD income or losses remaining, then a tax attribution adjustment
will take place, the court concluded.
The Dissenting Opinion
Although the Gitlitz decision appears to be a taxpayer victory for S corporation
stockholders, it is noteworthy that this decision comes with a strong dissenting
opinion. The dissenting opinion agreed with the court's majority reasoning, but the
dissenting justices believed that the majority's conclusion was incorrect. The dissenting
opinion indicated that the ambiguity of the statutory language should have been decided
in favor of congressional intent, and that congressional intent was to prevent an
insolvent corporation from generating income tax benefits for its stockholders.
In addition, the Gitlitz decision does not specifically address the ambiguity in
the language of Treasury Regulation §1366-1. This regulation states that COD
income, because it is excluded income, is not "an item of income."
Case Summary
Even with the dissenting opinion and the remaining ambiguity about Regulation
1366-1, the Gitlitz decision is a favorable ruling to stockholders of financially
troubled S corporations. If the insolvent S corporation has to negotiate debt
reduction/forgiveness, at least the stockholder/taxpayers can use the resulting COD
income to increase their basis in the troubled S corporation.
Tenth Circuit Upholds Valuation Principle Regarding Subsequent Events
It is a basic valuation principle that unanticipated subsequent events that occur
after the relevant valuation date should be ignored in the valuation analysis. This
principle holds for valuations performed for bankruptcy-related purposes—as well as for
numerous other purposes. While the following case review does not relate to a
bankruptcy matter, it is informative to bankruptcy practitioners that another federal
court has upheld this basic valuation principle.
In the Estate of E.M. McMorris, CA-10, 2001-1 ustc ¶30,757,
rev'g. and rem'g., 77 TCM 1552, CCH Dec. 53,291(M), TC Memo.
1999-82, the Tenth Circuit Court of Appeals overturned a tax court decision
and held that post-death events do not affect the valuation of an estate. In this
case, the valuation issue was the estate income tax deduction for the estate's unpaid
taxes. In the McMorris decision, the appeals court ruled that the estate tax
deduction for the decedent's income tax liabilities should not be reduced by the amount
of an unexpected income tax refund that the estate received after the date of death
(i.e., after the valuation date).
With this decision, the Tenth Circuit upholds a valuation principle that has been
accepted by numerous federal, district and circuit courts. Valuation analysts often refer
to this principle as the "known or knowable" rule. That is, if a subsequent event
was not known or knowable as of the valuation date, then the analyst should exclude
the event for consideration in a retrospective valuation. Accordingly, the McMorris
decision is instructive to analysts who perform valuations that are subject to any
judicial scrutiny—and not just valuations for estate tax purposes.
The Facts of the Case
In 1990, Mrs. McMorris received approximately 13.5 shares of close
corporation stock from the estate of her late husband, who died in that year. Mr.
McMorris's federal estate tax return listed the value of the stock at approximately
$1.7 million per share as of the date of his death. This $1.7 million per
share value became the wife's tax basis in the transferred stock. Accordingly, the
husband's estate tax return established the transfer basis in the stock, even though
Mrs. McMorris's conservator entered into an agreement to redeem the stock and pay her
$29.5 million—or approximately $2.2 million per share—over 120 months (at a
10 percent interest rate).
In 1991, Mrs. McMorris died. On her estate tax return, the estate claimed
federal and state income tax deductions of approximately $4 million and
$640,000, respectively. The estate claimed these deductions based on Mrs.
McMorris's 1991 income tax liabilities, primarily from the gain on the redemption
of the transferred stock.
In 1994, the IRS issued a notice of deficiency to the husband's estate. The
IRS contested the close corporation stock valuation used for the husband's estate tax
return. Ultimately, the representatives of Mr. McMorris's estate reached an agreement
with the IRS to value the stock at $2.5 million per share. This $2.5 million
per share amount became the new basis of the transferred stock to Mrs. McMorris at
the time of her husband's death.
Based on this 1994 revaluation of the transferred stock, Mrs. McMorris's estate
applied for refunds of some of the 1991 federal and state income tax that she had
paid. These federal and state income tax refunds were ultimately received by Mrs.
McMorris's estate in 1997.
The IRS Position
The IRS filed a notice of deficiency against Mrs. McMorris's estate, claiming that
the estate's deductions for the full amount of 1991 federal and state income tax
paid by Mrs. McMorris should be adjusted to reflect the income tax refunds that the
decedent's estate received on her behalf in 1997. The IRS adjusted the Mrs.
McMorris estate value for this subsequent income tax refund event even though the estate
could not have anticipated the 1997 refund as of the 1991 date of death.
The Tax Court Position
When the estate tax case reached the U.S. Tax Court, it ruled in favor of the
IRS's determination. The tax court decided that Mrs. McMorris's estate deduction for
federal income taxes paid should be reduced by the amount of the federal income tax
refund her estate ultimately received. Accordingly, the tax court ruled that Mrs.
McMorris's estate must pay an additional estate tax on the 1997 income tax refund.
The Court of Appeals Decision
The Tenth Circuit reversed the tax court decision. The appeals court ruled that
the date-of-death valuation rule announced by the U.S. Supreme Court in Ithaca
Trust Co., 279 U.S. 151 (1929), should be applied to a deduction for
a claim against the estate under Internal Revenue Code §2053(a)(2).
In Ithaca Trust, the Supreme Court ruled that the value of a charitable
deduction taken by a decedent's estate for transfers to a charitable remainder trust
had to be calculated based on the beneficiary's life expectancy as of the date of
death. The charitable deduction could not be affected by the beneficiary's
earlier-than-expected actual date of death. This is because the beneficiary's actual
date of death could not be known or knowable as of the relevant valuation date—in
that case, the date of the charitable contribution.
According to this Tenth Circuit decision, applying the date-of-death valuation rule
to deductions taken under §2053(a)(2) "provides a bright-line rule which
alleviates the uncertainty and delay in estate administration which may result if events
occurring months or even years after a decedent's death could be considered in valuing
a claim against the estate." This means that if a subsequent event (e.g., a
decedent's income tax refund) could not be reasonably expected as of the valuation
date, it should not be included in the estate valuation.
Case Summary
Even though the McMorris case is not related to a bankruptcy issue, the decision
should be instructive to bankruptcy practitioners and especially valuation
practitioners. This is because the McMorris case reinforces a fundamental valuation
principle that has relevance to valuations performed for various purposes—and not just
for estate tax purposes.
Conclusion
Valuation analysts consider professional guidance from various sources, including
the decisions of the bankruptcy courts. Sometimes, judicial decisions in
non-bankruptcy cases (especially federal appeals courts and the U.S. Supreme
Court) establish or reinforce valuation principles that are also applicable in the
bankruptcy area. The above cases should be generally informative to valuation
analysts who practice in that discipline.
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