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Media Alerts - R Ball for R Ball III by Appt v. Commissioner of IRS - Third Circuit
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February 21, 2014
  R Ball for R Ball III by Appt v. Commissioner of IRS - Third Circuit
Headline: Third Circuit Affirms tax court Decision on Tax Implications of Qsub Designation

Area of Law: Internal Revenue Code

Issue(s) Presented: Whether Qsub designation qualifies as an item of income under the Internal Revenue Code?

Brief Summary: Ten Trusts for the benefit of the Ball family sold their interests in a corporation to a third party and claimed a loss on their 2003 tax returns. The IRS determined that the sale resulted in a capital gain, as the Trusts had increased the basis of their stock in the company by electing to treat its subsidiary as a "qualified subchapter S subsidiary" (Qsub) under the Internal Revenue Code. The IRS found that the Qsub election did not give rise to an item of income under I.R.C. § 1366(a)(1)(A) and sent deficiency notices to the Trusts. The Trusts filed petitions with the United States tax court seeking a redetermination, which held that the Qsub does not create an item of income. The Trusts appealed to the Third Circuit, which affirmed the decision in the tax court.

Extended Summary: This appeal arose out of nine consolidated cases before the United States tax court regarding the tax implications of an S Corporation's election to treat its subsidiary as a "qualified subchapter S subsidiary" (Qsub) under Internal Revenue Code § 1361. An S corporation ("S Corp.") is a small business corporation that is permitted to have its corporate income, losses, deductions, and credits attributed to its shareholders.

In June 1997, ten Trusts for the benefit of the Ball family acquired direct ownership of all shares of American Insurance Service, Inc. (AIS) with an aggregate basis in AIS stock totaling $5,612,555. In 1999, the Trusts created Wind River Investment Corporation (Wind River), and the Trusts contributed their shares in AIS in exchange for all shares of Wind River so that Wind River owned all of the shares of AIS. Wind River then designated itself an S Corp. and treated AIS as a Qsub under § 1361(b)(3). Before the Qsub election, the Trusts' aggregate adjusted basis in the Wind River stock was $15,246,099. Following the Qsub election, the Trusts increased their basis to $242,481,544.

In 2003, the Trust sold their interests in Wind River to a third party, Fox Paine. The sale yielded $230,111,857 in cash and securities in exchange for all of the Wind River stock. Despite this amount, the Trusts claimed a loss of $12,247,229, calculated as the difference between the amount received for the sale and the new basis in the Wind River stock. The Trusts 2003 tax returns were filed citing this capital loss.

The Internal Revenue Service (IRS) determined that the Wind River stock should not have been increased to $242,481,544 following the Qsub election. The IRS instead determined that the sale to Fox Paine resulted in a $214 million capital gain, and therefore there was a tax deficiency of $33,747,858. The Trusts received deficiency notices which stated that the Qsub election did not give rise to an item of income under I.R.C. § 1366(a)(1)(A) and therefore the Trusts could not increase the basis of their Wind River stock under I.R.C. § 1367(a)(1)(A).

The Trusts filed petitions with the United States Tax Court seeking a redetermination and the cases were consolidated and submitted for decision on stipulated facts. The parties disagreed as to whether the Qsub election and subsequent sale of the S Corp. parent creates an "item of income" for the parent company under § 1366(a)(1)(A) and therefore requires the parties who hold stock in the parent S Corp to adjust their bases in stock under § 1367(a)(1)(A). The Trusts argued that the election resulted in a gain derived from dealings in property and therefore created an item of income under § 61(a). The tax court found the increase in stock basis and declared loss to be improper. The tax court reasoned that a gain from a Qsub election is "realized" and calculated under § 1001, but is not "recognized." Under §1366, when a gain is unrecognized it "does not rise to the level of income" and is not an "item of income for tax purposes."

On appeal to the Third Circuit, the Court affirmed the order of the tax court. First, the Court determined the definition of an "item of income," as the term is not defined in the Internal Revenue Code. The Court held that while an "item of income" is not defined, "gross income" has been defined as "gains derived from dealings in property." The Supreme Court has also defined "gross income" as "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." Because the Qsub election did not add wealth, just changed the tax treatment of the income flowing from the Qsub, there was no "accession to wealth" for the corporation and therefore could not create "income" for the Trusts.

Next, the court considered the Trusts' argument that the tax court erred in its determination that "unrecognized gain does not rise to the level of income." The Trusts argued that an "item of income" may be defined as gross income under one provision of the Internal Revenue Code, but not recognized under another provision and still remain an "item of income." The Trusts relied on the Supreme Court's decision in Gitlitz v. Commissioner and the Third Circuit's decision in United States v. Farley to support their arguments. In Gitlitz, the Supreme Court held that § 1366 is worded broadly enough to include any item of income, even tax-deferred income, which could affect the tax liability of any shareholder. The Third Circuit came to a similar decision in Farley. However, the Court reasoned that the crucial difference in Gitlitz was that the case addressed payments that explicitly were included in gross income under §61(a). After Gitlitz, Congress also made changes to the statute. The Third Circuit explained that the regulations demonstrate that the gain is not recognized and is not income, and, therefore, the S Corp. shareholders could not increase their bases under § 1367.

The full opinion can be found at http://www2.ca3.uscourts.gov/opinarch/132247p.pdf

Panel: Circuit Judges Jordan, Vanaskie, and Van Antwerpen

Argument Date: 12/17/2013

Argument Location: Philadelphia

Date of Issued Opinion: 02/12/2014

Docket Number: No. 13-2247

Decided: Affirmed

Case Alert Author: Larissa Staszkiw

Counsel: Nancy Winkelman, Esq. & Timothy K. Lewis, Esq., Schnader Harrison Segal & Lewis LLP, Attorneys for Appellants; Francesca Ugolini, Esq., Richard Farber, Esq.
& Kathryn Keneally, Esq., United States Department of Justice, Attorneys for Appellee.

Author of Opinion: Judge Van Antwerpen

Circuit: 3rd Circuit

Case Alert Circuit Supervisor: Professor Mary E. Levy

    Posted By: Susan DeJarnatt @ 02/21/2014 11:46 AM     3rd Circuit  

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