The Supreme Court’s decision in Gitlitz v. Commissioner1 is an irresponsible decision disrupting the logic of tax for the benefit only of abuse.2 In Gitlitz the Supreme Court gave the equivalent of a double deduction, both an appropriate exclusion of cancellation of indebtedness income for an insolvent Subchapter S corporation and also an inappropriate increase in shareholder basis. The combination of the exclusion and shareholder basis generated a tax loss that had no economic substance, a loss that in Judge Posner’s wonderful phrase “did not impinge on the world.”3
Congress is sovereign and the courts may not overturn congressional policy decisions, even bad ones. Still, there is a bright-line distinction between a policy decision and an unintended mistake, an absurdity like that involved in Gitlitz. For the tax system to work well, the Treasury and courts need to be faithful servants in applying the law, correcting mistakes not seen nor intended by Congress. Congress can in turn correct the courts or administration if they get it wrong.
Congress leaves a great deal of evidence behind when it deliberates policy. Gitlitz involves no policy decision. No lobbyists asked for this absurd result, and no legislative history or outside stories support that this was an intended loophole enacted, for instance, to subsidize some activity. Congress and its staff did not see that the language in the provisions could be read to create a windfall loophole exploitable by sophisticated tax advisers. The Gitlitz result is a simple violation of the logic of tax, more akin to a cashier giving back too much change or akin to adding 2 plus 2 and reaching 5, but not akin to a policy choice.
The approach in Gitlitz allowing an absurd tax deduction shows a hostility to the tax system that is inappropriate for a court in its role as a faithful servant. There are fundamental principles underlying the tax law, including antagonism to double deductions and deduction of phantom losses. The Supreme Court has a duty to interpret tax law in favor of coherent principle, and Gitlitz violates fundamental principle.
I. Facts of Gitlitz
In 1991, David Gitlitz owned half of the stock of an insolvent S corporation which received approximately $2 million4 of cancellation of debt (COD) income. Since the S corporation was insolvent, the COD freed no assets for the debtor corporation: accordingly, the COD was excluded from income, notwithstanding the general rule (subject to exceptions) that COD is ordinary income. Gitlitz claimed that his $1 million share of the excluded COD income should nonetheless increase his basis in his S corporation stock because it was “tax-exempt income” within the meaning of section 1366, which triggered an increase in Gitlitz’ basis in his stock under section 1367. The extra $1 million basis would have allowed Gitlitz to take a $1 million capital loss if he had sold his worthless stock. Without a sale, the increased basis in fact allowed Gitlitz to take prior losses generated by the S corporation from never-paid debt. Section 1366(d) limits a shareholder’s use of S corporation tax losses to the shareholder’s adjusted basis, and Gilitz had reduced his basis to zero by prior deductions passed through to him. The section 1367 increase in basis allowed Gitlitz to deduct those tax losses generated in prior years by the S corporation’s never-paid debt, which losses Gitliz never suffered. His interpretation allowed him a windfall in the form of a phantom loss that had no economic reality for him.
The Tax Court and the Court of Appeals for the Tenth Circuit both upheld the Commissioner’s deficiency notice in the case, accepting in modified forms the Commissioner’s interpretation of the interplay of the insolvency provision and the S corporation provisions.5 The Supreme Court, however, in an opinion written by Justice Thomas with only one justice, Breyer, in dissent, reversed the lower court to allow Gitlitz his claimed tax loss.
In response to the Gitlitz decision, Congress amended the statute to take away the basis increase at issue in Gitlitz. Congress amended section 108(d)(7) to provide that the rules for COD income and attribute reduction for S corporations would be applied without treating excluded COD income as an “item of income.”6 The Conference Committee described the Gitlitz error in explaining the legislative reversal.
To illustrate these rules, assume that a sole shareholder of an S corporation has zero basis in its stock of the corporation. The S corporation borrows $100 from a third party and loses the entire $100. Because the shareholder has no basis in its stock, the $100 loss is “suspended” at the corporate level. If the $100 debt is forgiven when the corporation is in bankruptcy or is insolvent, the $100 income from the discharge of indebtedness is excluded from income, and the $100 “suspended” loss should be eliminated in order to achieve a tax result that is consistent with the economics of the transactions in that the shareholder has no economic gain or loss from these transactions.
Notwithstanding the economics of the overall transaction, the United States Supreme Court ruled in the case of Gitlitz v. Commissioner that, under present law, income from the discharge of indebtedness of an S corporation that is excluded from income is treated as an item of income which increases the basis of a shareholder’s stock in the S corporation and allows the suspended corporate loss to pass thru to a shareholder. Thus, under the decision, an S corporation shareholder is allowed to deduct a loss for tax purposes that it did not economically incur.7
II. The Logic of Basis
The increase in basis originally allowed in Gitlitz was an error. In the case that Congress was thinking of, the increase in shareholder basis provided by section 1367 represents an appropriate adjustment. An S corporation receives $100 of municipal bond income. An S corporation is a pass-through entity, and accordingly the exemption for municipal bond income of the corporation is intended to be preserved for shareholders. (By contrast, a C corporation does not pass through the exemption to shareholders: the corporation’s $100 from municipal bond interest is earnings and profits taxed to the shareholder as a dividend when distributed.8)For an S corporation, the mechanism of increase of shareholder basis allows the shareholder to get an exclusion as well. Under section 1367, the shareholders increase basis by the amount of the excluded $100 municipal interest. The shareholder may thus sell the stock and the extra $100 undistributed income will not be reflected as gain on the sale. The S corporation may also distribute the $100. An S corporation shareholder pays no tax by reason of a distribution until all basis in the shares is recovered. Adding basis to shareholder stock is the mechanism by which the corporate level exclusion is preserved as a shareholder exclusion as well.
Other exclusions do not get basis increase. Basis increase is denied as a matter of tax logic without anything said about it in the statutory language. Unrealized increases in value, for instance, are economic income because they represent an increase in net worth and command over real resources, but unrealized income is generally excluded from tax. If my property increases by $50, do I get both an exclusion and increase of basis of $50? Not under the logic of tax. The exemption is only temporary. The $50 gain is taxed when the property is sold. An increase in basis at either shareholder or corporation level would inappropriately exempt the gain forever. Unrealized appreciation is not the kind of exclusion that gets a basis increase. It goes without saying.
So too, good friendship and good sex are invaluable benefits worth many dollars if we could even translate them into dollars. Both benefits are excluded from tax. Does that mean taxpayers get basis for the excluded benefits? No, they are not that kind of exclusion. The denial of basis increase for the excluded benefits has no statutory basis; it just goes without saying.
So too, in Gitlitz forgiveness of debt that leaves the S corporation still under water is not taxed, but it also is not the kind of exclusion for which a shareholder can get basis under the logic of tax. The exclusion makes sense because you can drown just as thoroughly under 6 feet of water as at 140 feet down before the forgiveness. No assets are freed up for other use by the COD of an S corporation that is insolvent after the cancellation. There are no assets available to the corporation in the COD that leaves the corporation still insolvent, nor any assets available to the shareholders. Thus, the shareholders automatically get an exclusion of the COD, because there is nothing the shareholders get that could be taxable. The appropriate exclusion on the shareholder level occurs without saying anything. An inappropriate section 1367 basis increase in that circumstance then generates a second deduction, used to shelter unrelated shareholder income, a loss that has no economic substance. The exclusion of COD of a still insolvent corporate debtor is just not the kind of exclusion for which a basis increase is either necessary or appropriate. It goes without saying.
III. Identifying Absurd Results
We are in era that gives increasing respect to strict construction of the text. Still, even the strictest forms of interpretation do not justify absurd results. For instance, in the 1658 case of James v. Morgan,9 one Morgan agreed to buy a horse from one James for the stated consideration of one grain of barley, with the grains to be paid doubled for every nail in the horse’s hooves. The contract price was stated with mathematical precision. The horse turned out to have thirty-two nails: that translated to 232 or over four billion grains of barley–roughly 8000 bushels. The court directed Morgan to pay for the horse, but only at fair value. A court properly avoids absurdity. The Gitlitz holding in the Supreme Court produced a worse absurdity than the James contract would have produced. Using rough internet figures and modern dollars, the double-for-every-nail contract would have required Morgan to pay $40,000 for a $5,000 horse. Gitlitz produced tax losses not correlated with the real world of perhaps as much as a billion dollars per shelter, at no cost.
We can distinguish bad policy that Congress has mandated from errors of math or logic that everyone needs to correct, in the context of the facts. Courts must defer to Congress on all policy decisions, including bad policy decisions or decisions the judge would make differently. That is not what Gitlitz is about. Policy decisions leave behind evidences that the sovereign’s mind was engaged in the problem. Some rationale for the result will appear in the debates. Gitlitz is on the unintended side of the line, an absurd result like James v. Morgan, which nobody can or has ever tried to defend on the merits. Correctable absurdity is easy to distinguish from congressional policy.
Justice Breyer’s dissent in the Supreme Court would not have allowed a construction attributed to lawmakers that was so contrary to the logic of tax. The Code should not be interpreted to allow respondent “the practical equivalent of double deduction,” “absent a clear declaration of intent by Congress.”10 Congress is sovereign and can mandate error, but when the results are so contrary to the logic and descriptive accuracy of tax, the orders need to be written more clearly than this.
The courts need to interpret the statutory words with common sense avoiding absurdities. Consider Wittgenstein’s example.11 I ask my babysitter to teach my children some games, but I come back to find the sitter has taught them strip poker and craps. The sitter points to the instructions and notes that dice games and sex games are, in fact, listed within the category of “games.” To which the clear rebuttal is that in context, dice games and sex games are not games to be taught to children. I did not mean those kinds of games. It goes without saying. Do I need a full inventory of all “games” including dice games, knife games, and sex games in order to instruct my sitter “to teach my children some games?” I didn’t think of all references—nobody can, and I didn’t need to. Thus, “teach my children some games” is a perfectly fine instruction in ordinary language in that context to a faithful servant observant of the context. Still I do need to have a sitter who uses common sense and interprets the words in context and who is not trying to harm my children! The Gitlitz court, in contrast, was perfectly willing to harm the tax system it was interpreting by focusing on an interpretation that gave absurd results in context.
Similarly, a court should not take a “nanny nanny boo, you didn’t say it right” attitude in its role as faithful servant. For example, in Commissioner v. Tufts,12 the Supreme Court held that nonrecourse liability included in basis at acquisition must also be included in amount realized at disposition. Treating a nonrecourse liability as if it were a payment up front (in advance of actual payment) without correcting that payment assumption at disposition when it turns out to be wrong is not a coherent system. It would generate fake losses. Nevertheless, Fifth Circuit Judge Williams would have limited Tufts’ amount realized to the modest fair market value of the collateral. Williams had been a professor at my Texas Law School and when my tax colleague accosted him at a social occasion, his reply was “I know what the Congress was trying to do, but they did not say it right.” That is not an appropriate judicial attitude. The role of the court as a faithful servant is to try to get the answer right, especially in the context of the Crane doctrine which was itself a product of judicial analysis. A faithful interpretation does not try to get the answer wrong, harmful to the tax system, and blame Congress, because Congress was inarticulate or had not considered some possible interpretations of the text.
The truly faithful servant will in fact make many hard decisions. In 1942, General Eisenhower sent the Queen Mary loaded with 15,000 American troops to Australia through submarine-infested waters without telling his immediate superior General George Marshall. Eisenhower considered that he need not give Marshall the anxiety that he was suffering. Marshall was most pleased.
“Eisenhower,” he said, “the department is filled with able men who analyze their problems well but feel compelled always to bring them to me for final solution. I must have assistants who will solve their own problems and tell me later what they have done.”13
Congress needs intelligent application of the tax law by Treasury and the courts because it cannot think of all the problems that will arise and solve the problems on its own. Congress will be grateful that its faithful servants are trying to solve its problems correctly in the application. Gitlitz does not qualify as intelligent application, worthy of Eisenhower, to reach a rational result.
Congress is, of course, sovereign and can overturn court results it does not like regarding statutory interpretation (rather than constitutional interpretation). In fact, it simply works better as a matter of political process for the courts, in case of doubt in tax cases, to lean toward the fair logical result that is pro-government. In criminal law, words are construed against the government: the government wins only when the government makes its case beyond a reasonable doubt. Tax law is an area of civil law where “more likely than not” is sufficient for a government victory. When it is the taxpayer asking for the benefit of a loophole, ambiguities are appropriately construed against the taxpayer. Legislative tax increases get stuck in the muddle of political process, but tax relief is much loved and much more easily enacted. The courts should accordingly lean toward decisions protecting the tax base because it is easier for Congress to reduce tax than it is to correct the result by increasing tax. Errors against the government—i.e., against protecting the tax base—are hard to correct, and those court opinions that leave it to Congress to fix thus leave the tax base just one more step closer to tatters.
Congress does need to improve its craftsmanship in drafting the Code. It should not act so swiftly that it does not have the opportunity to consider the loopholes it may create in the interstices of the language provided. It should specify when exemptions create added basis and when exclusions do not. Regrettably, those in Congress seem uninclined to devote time and energy to meticulous drafting: they apparently do not get elected to pour over the drafting to catch potential ambiguities or absurdities. Treasury and the courts have roles to play in this setting: they need to fill in with interpretations that fit the language but acknowledge the principles underlying the language.
The Supreme Court in shifting the blame for the Gitlitz problem onto Congress mandates a congressional omniscience well beyond what any group of mortals can satisfy, at a cost of having bad law reign for whatever period it may take for Congress to overrule the court decision through legislation. In these days of partisan paralysis in Congress, the administration and courts need to get the issue right, because Congress will not be able to fix it, even for clear error.
Words stating general principles, even good principles of law, also need to be applied with intelligence. Common law judges know when they see the facts that the outcome apparently required by a principle of law is just not what they meant, and they make a distinction. Even in civil law systems, which pretend that only legislative rules are binding, the judges increasingly know that they need to act like common law judges, relying on precedents and the same process of analogy and distinctions by which the common law reaches decisions.14 The general rule simply cannot capture every game that comes before the courts. General laws need to be interpreted with good common sense knowing the unstated assumptions arising in context.
When the Supreme Court took certiorari in Gitlitz, the Chief of Staff of the Joint Committee on Taxation asked the staff member responsible for the area what should be done? The Tax Court15 and Tenth Circuit16 had decided the issue correctly in favor of the government and certiorari often suggests a will to reverse. “Nothing” was the reply. “No court can ultimately get the case wrong, there is no defense for sabotaging a coherent system.” No responsible tax lawyer could have anticipated the Gitlitz result. A purpose so opposed to the logic of tax and fair treatment should not be attributed to lawmakers. The staff of those lawmakers knew that.
IV. Congress Generally Respects Courts’ Purposive Interpretation of Statutes
Congress has shown itself to be generally accepting of courts capturing the intended meaning of statutes by generally codifying court forays that are far more adventuresome than the logic of the basis system in Gitlitz. In Helvering v. Gregory, for instance, Judge Learned Hand found a distribution was not a true “reorganization” that Congress intended to qualify for tax-free distributions.17 The Ways and Means Committee reacted by praising the courts for “a commendable tendency to look through the mere form of the transaction into its substance.”18 When Congress adopted section 355 in 1951, it added to the requirements for tax-free distributions conditions of genuine business and business purpose that are best understood as codifications of Judge Hand’s opinion in Gregory.
Similarly, section 7701(o) codifies the economic substance doctrine by which myriad courts and decisions denied taxpayers’ claims of tax losses relying on hyperliteral interpretations of statutory text, because those claimed losses did not represent genuine economic losses. As one court said, a transaction that is “devoid of economic substance ... simply is not recognized for federal taxation purposes.”19 Without that court-created economic substance doctrine (now incorporated into legislation), the land would be overrun by shelters churned out by the shelter factories of highly paid, sophisticated tax accountants and lawyers.20 The people who find loopholes are much more highly motivated than Congress and better trained, maybe even smarter. The loss generators will shred the tax base, even more than it has been shredded, if the tax base is not defended in its application.
Economic substance is embedded now in the heart of the tax law. Every capable tax lawyer and accountant knows that a tax scheme not only must pass technical muster, but also must not be devoid of substance. The whole house of cards of documents may well fall, no matter what their technical merit, if the loss is not genuine. This is not some kind of surprise. Tax law has had the economic substance doctrine since at least 1934, and practitioners have had plenty of notice. Any capable tax attorney has grown up knowing that economic substance is part of our law. None of the cases denying the taxpayer a tax loss where there is no loss in substance are wrongly decided, in retrospect, and on reflection. The insistence that we have a tax law insisting on substance is a proud part of our law.
The general rule for basis is that improper basis results should be fixed by the courts without the need for statutory changes to spell it out, because of the importance of the concept of basis to the operation of the entire tax system. In the Gitlitz case, Congress did act to overturn the result, albeit with a band-aid that covered only the exclusion of underwater debt21 without a comprehensive solution for all the other situations where an increase in basis when income is excluded would not be appropriate. The statute still requires the courts to interpret basis in statutory contexts by denying creation of basis when appropriate, even after Congress supposedly fixed this issue.
In the process of addressing the Gitlitz result, Congress essentially told the courts to shape up their bad attitude. The Conference Committee explaining the legislation that reversed Gitlitz provided instructions that the Supreme Court needs faithfully to follow.
As a general matter, the Committee believes that where, as in the case of the present statute under section 108, the plain text of a provision of the Internal Revenue Code produces an ambiguity, the provision should be read as closing, not maintaining, a loophole that would result in an inappropriate reduction of tax liability.22
These are instructions that appear to treat the Gitlitz court as an unruly child, strictly admonished and sent to the corner. These are, however, wise instructions which the Court should feel compelled to follow. Congress is, after all, sovereign. Had Congress told my babysitter to teach my children a game, it would be up to the executive through regulations or the courts to take strip poker and craps out of the authorized games. It goes without saying. ■