Recent Judicial Decisions Guide Valuation Analysts
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."
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.
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.
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.