Gitlitz v. Commissioner, 531 U.S. 206, 11 (2001)

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216

GITLITZ v. COMMISSIONER

Opinion of the Court

"[i]ncome is not realized." The regulation says nothing about whether discharge of indebtedness is income subject to pass-through under 1366.

Second, the Commissioner argues that excluded discharge of indebtedness is not " tax-exempt" income under 1366(a)(1)(A), but rather "tax-deferred" income. According to the Commissioner, because the taxpayer is required to reduce tax attributes that could have provided future tax benefits, the taxpayer will pay taxes on future income that otherwise would have been absorbed by the forfeited tax attributes. Implicit in the Commissioner's labeling of such income as "tax-deferred," however, is the erroneous assumption that 1366(a)(1)(A) does not include "tax-deferred" income. Section 1366 applies to "items of income." This section expressly includes "tax-exempt" income, but this inclusion does not mean that the statute must therefore exclude "tax-deferred" income. The 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." 1366(a)(1)(A). Thus, none of the Commissioner's contentions alters our conclusion that discharge of indebtedness of an insolvent S corporation is an item of income for purposes of 1366(a)(1)(A).

III

Having concluded that excluded discharge of indebtedness is an "item of income" and is therefore subject to pass-through to shareholders under 1366, we must resolve the sequencing question addressed by the Court of Appeals— whether pass-through is performed before or after the reduction of the S corporation's tax attributes under 108(b). Section 108(b)(1) provides that "[t]he amount excluded from gross income under [ 108(a)] shall be applied to reduce the tax attributes of the taxpayer as provided [in this section]." Section 108(b)(2) then lists the various tax attributes to be reduced in the order of reduction. The first tax attribute to

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