Salvador A. Gaudiano v. Commissioner of Internal Revenue

*The Honorable Donald C. Nugent, United States District Judge for
the Northern District of Ohio, sitting by designation.
1
RECOMMENDED FOR FULL-TEXT PUBLICATION
Pursuant to Sixth Circuit Rule 206
ELECTRONIC CITATION: 2000 FED App. 0196P (6th Cir.)
File Name: 00a0196p.06
UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT
_________________
S ALVADOR A. GAUDIANO ,
et al.,
Petitioners-Appellants,
v.
C OMMISSIONER OF INTERNAL
R EVENUE ,
Respondent-Appellee.
;>

1
No. 99-1294
On Appeal from the United States Tax Court.
Nos. 25712-96; 25713-96; 25714-96; 25716-96—
Juan F. Vasquez, Tax Court Judge.
Argued: December 17, 1999
Decided and Filed: June 8, 2000
Before: BOGGS and NORRIS, Circuit Judges; NUGENT,
District Judge.*

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2 Gaudiano, et al. v. Commissioner No. 99-1294
1Kathleen M. Gaudiano and Kathleen R. Edgemon were not
shareholders in Four A Coal Co. They are parties to these actions only
because they filed joint tax returns with their husbands.
_________________
COUNSEL
ARGUED: William C. Myers, Jr., WAGNER, MYERS &
SANGER, Knoxville, Tennessee, for Appellants. Teresa E.
McLaughlin, U.S. DEPARTMENT OF JUSTICE,
APPELLATE SECTION TAX DIVISION, Washington, D.C.,
for Appellee. ON BRIEF: William C. Myers, Jr., Kathleen
M. Flynn, WAGNER, MYERS & SANGER, Knoxville,
Tennessee, for Appellants. Teresa E. McLaughlin, Edward T.
Perelmuter, U.S. DEPARTMENT OF JUSTICE,
APPELLATE SECTION TAX DIVISION, Washington, D.C.,
for Appellee.
_________________
OPINION
_________________
NUGENT, District Judge. The Commissioner of Internal
Revenue (hereinafter the “Commissioner”) assessed tax
deficiencies against Salvador A. and Kathleen M. Gaudiano,
Randy C. and Kathleen R. Edgemon, Gary D. Asher, and
Larry A. Asher (collectively the “Taxpayers”) for the year
1993. The Commissioner determined that the Taxpayers had
improperly utilized discharge of indebtedness income to
increase their bases in the stock of their Subchapter S
corporation Four A Coal Co.1 Each Taxpayer then used the
increase in basis to deduct certain losses. The Commissioner
disallowed the deductions. In his answer to the Taxpayers’
petitions in the Tax Court, the Commissioner asserted
increased deficiencies against Taxpayers Gary Asher and
Larry Asher for their pro rata share of a bad debt deduction
taken by their Subchapter S corporation Appolo Fuels, Inc.,
for loans made to Four A Coal Co. After a trial, the United
No. 99-1294 Gaudiano, et al. v. Commissioner 23
testimony of a witness may “simply disregard it,” the
disregarded testimony is usually not considered sufficient
grounds for drawing the opposite conclusion. Bose Corp. v.
Consumers Union of U.S., Inc., 466 U.S. 485, 512, 104 S. Ct.
1949, 1966, 80 L. Ed.2d 502 (1984).
Absent the testimony of the Taxpayers regarding the
alleged lack of consideration, the Guarantees appear on their
faces to be valid and enforceable. Indeed the testimony of the
Price Waterhouse auditor was compelling on that point.
Accordingly, we do not find clear error in the Tax Court’s
finding that the Continuing Guaranty was valid and
enforceable; and therefore, the Asher Taxpayers’ bad debt
deductions were properly disallowed.
Conclusion
For the reasons stated herein, the Tax Court’s disallowance
of all of the deductions in dispute is AFFIRMED.
Specifically, the Taxpayers were not entitled to deduct their
suspended and ordinary losses for tax year 1993 because those
losses were offset at the corporate level by the COD income
realized by Four A. To the extent that COD income remains
after exhausting the current and suspended losses of Four A
(and its shareholders), such COD income passes through to
the shareholders and increases their basis in their stock. In
addition, the Asher Taxpayers were not entitled to a bad debt
deduction because the debt was guaranteed by the valid and
enforceable Guarantees of the Four A Taxpayers.

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22 Gaudiano, et al. v. Commissioner No. 99-1294
by Mr. Gaudiano or Appolo to include the consideration
language in the Guarantees; and Mr. McGowan, the Price
Waterhouse auditor, “who corroborated the Taxpayers’
testimony that Appolo never made promises to the Four A
shareholders regarding future advances or collection
forbearance and that the Guaranties were respectively
backdated to January 1, 1989, and April 30, 1990, to give the
appearance of enforceability.” Appellant’s Opening Brief at
p. 56. Taxpayers also argue that with Four A hopelessly
insolvent, any threat to foreclose on Four A’s debt by Appolo
would have been meaningless.
The Commissioner counters that Appolo’s promise to
forbear from suit was not meaningless for two reasons. First,
Four A possessed sufficient assets to satisfy at least some of
its indebtedness to Appolo at the time the Continuing
Guaranty was executed. Second, the Guarantees resulted in
a better financial statement for Appolo, from which the
Ashers could benefit.
Moreover, upon review of the record, the non-taxpayer
testimony of Mr. Stites and Mr. McGowan did not do much
to corroborate the Taxpayers’ testimony. Rather, the
testimony simply informed the Court that Mr. Stites and Mr.
McGowan had no idea whether a promise was made or not.
Indeed, Mr. McGowan testified that he believed that the
Guarantees were valid and that he would not have accepted
them if he believed that they were not valid.
Considering the Tax Court’s ability to assess the demeanor
of the witnesses and the credibility of the testimony provided
by the witnesses, and the reasons why the Asher Taxpayers
might have had motive to provide the Guarantees, we cannot
find that the Tax Court clearly erred in disregarding the
Taxpayers’ testimony. A trial court’s findings based on
determinations regarding the credibility of witnesses are
generally entitled to great deference. See Owens-Illinois, Inc.
v. Aetna Cas. & Sur. Co., 990 F.2d 865, 870 (6th Cir. 1993);
In re H.J. Scheirich Co., 982 F.2d 945, 949 (6th Cir. 1993).
Moreover, while a factfinder who does not believe the
No. 99-1294 Gaudiano, et al. v. Commissioner 3
2The Taxpayers do not appeal the Tax Court’s determination
regarding the Taxpayers’ claims for refund for their distributive shares of
the increased § 1231 loss claimed by Four A in an amended Form 1120S
which reported the amount realized on the sale of mining equipment as
$145,430 instead of $445,000 as previously reported in 1993.
3See 26 U.S.C. § 61 (a)(12).
States Tax Court upheld all of the Commissioner’s deficiency
determinations. The Taxpayers filed this timely appeal.2 We
exercise jurisdiction pursuant to 26 U.S.C. § 7482(a)(1) and
AFFIRM for the reasons stated below.
Procedural and Factual Background
I. Discharge of Indebtedness Income
During 1993, and relevant prior years, Taxpayers Salvador
Gaudiano, Gary Asher, Larry Asher, and Randy Edgemon
were each 25% shareholders of Four A Coal Co. (hereinafter
“Four A”), a Kentucky corporation electing to be taxed under
Subchapter S of the Internal Revenue Code (26 U.S.C.
§§ 1361 through 1379). Until February of 1991, Four A
engaged in the business of underground coal mining and
operated as a contract miner for another Subchapter S
corporation, Appolo Fuels, Inc. (hereinafter “Appolo”).
Taxpayers Gary D. Asher and Larry A. Asher were 24%
shareholders in Appolo.
In January, 1993, Four A filed for protection under
Chapter 7 of the Bankruptcy Code and was insolvent within
the meaning of 26 U.S.C. § 108(d)(3). As a result of the
bankruptcy, Appolo wrote off as bad debt the loans it had
made to Four A. Thus, Four A realized $1,289,048 in
discharge of indebtedness income, also known as cancellation
of debt income (hereinafter “COD” income). While gross
income generally includes income from the discharge of
indebtedness3, §108 (a)(1)(B) provides an exclusion of
discharge of indebtedness income from gross income when
the taxpayer is insolvent. Pursuant to 26 U.S.C. § 108

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4 Gaudiano, et al. v. Commissioner No. 99-1294
426 U.S.C. § 1366(a)(1) provides that, in determining an S
corporation shareholder’s tax liability, “there shall be taken into account
the shareholder’s pro rata share of the corporation’s–
(A) items of income (including tax-exempt income) . . . the separate
treatment of which could affect the liability for tax of any shareholder
. . . .”
26 U.S.C. § 1367(a)(1)(A) provides that “the basis of each shareholder’s
stock in an S corporation shall be increased . . . by . . . (A) the items of
income described in subparagraph (A) of section 1366(a)(1).”
(d)(7)(A), the exclusion is determined at the S corporation
level (not the shareholder level) in cases of discharge of S
corporation indebtedness. The exclusion applied to Four A’s
discharge of indebtedness income. Thus, Four A’s discharge
of indebtedness income was excluded from gross income
because Four A was insolvent when the debt was discharged.
Relying on the pass through and basis adjustment
provisions applicable to Subchapter S corporations in 26
U.S.C. §§ 1366 and 1367, the Taxpayers increased their
respective bases in the stock of Four A by $322,262,
representing a 25% share of the discharge of indebtedness
income4. Each Taxpayer then used the increase in basis to
deduct suspended losses from prior tax years as well as
ordinary losses from 1993 which would not have been
deductible without the increase in the shareholders’ bases.
Upon audit, the Commissioner determined that the Taxpayers
were not entitled to increase their adjusted bases in the stock
of Four A by their pro rata shares of the excluded discharge
of indebtedness income. Therefore, the Commissioner denied
the loss deductions claimed by the Taxpayers as a result of the
upward basis adjustments and assessed the deficiencies at
issue here. Taxpayers filed Tax Court petitions contesting the
deficiency determinations.
II. Disallowance of Appolo Bad Debt Deduction
Appolo is an S corporation which began as a surface
mining operation but changed to a coal processing and coal
sales company by 1988. Taxpayers Larry Asher and Gary
Asher were 24% shareholders of Appolo. Appolo purchased
No. 99-1294 Gaudiano, et al. v. Commissioner 21
promised to forbear suing Four A on Four A’s past debt,
Appolo never actually made such a promise. The Tax Court
noted that the only evidence submitted to disprove the
existence of Appolo’s promise was “their own self- serving
testimony,” which the Court, citing Tokarski v.
Commissioner, 87 T.C. 74 (1986), declined to accept.
The Asher Taxpayers contend that the Tax Court
improperly ignored their evidence demonstrating that the
Guarantees lacked valid consideration. They maintain that “it
is inconceivable that Four A’s shareholders would have put
their personal assets on the line in exchange for Appolo’s
collection forbearance of Appolo’s future advances to Four
A.” The Asher Taxpayers assert that Tokarski, and the line of
cases cited therein, which stand for the proposition that the
court need not accept a petitioner’s self-serving testimony
when it is uncorroborated and inconsistent with other facts
and circumstances presented at trial, is distinguishable from
the facts in this case.
In Tokarski, a taxpayer and his mother testified that a bank
deposit by the taxpayer was an inheritance from his father, not
income from working. The taxpayer testified that he had
never worked and that he received funds to live on from his
uncles. The court found it incredible that the taxpayer, who
appeared to be a normal, healthy, 32-year old, had never been
productively employed. The court noted that it weighed
against the taxpayer that he did not offer any corroborative
testimony from his uncles or offer any explanation for not
doing so. The court also questioned the taxpayer’s proffered
reason for waiting 6 weeks to deposit the money. “Under all
the circumstances,” the court held, “we are not required to
accept the self-serving testimony of petitioner or that of his
mother as gospel.” Tokarski, 87 T.C. at 77.
The Taxpayers argue that, unlike the situation in Tokarski,
the testimony of each Taxpayer was internally consistent with
and corroborated by the other Taxpayers’ testimony. They
also point to the testimony of non-taxpayers, Mr. Stites,
Appolo’s legal counsel, who testified that he was not directed

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20 Gaudiano, et al. v. Commissioner No. 99-1294
9Because the Taxpayers’ losses were less than the amount of COD
income realized by Four A, each taxpayer is entitled to increase the basis
of their stock by their share of the excess COD income. Since Four A is
no longer operating, however, it is unlikely that the corporation will incur
future losses.
to the shareholders pursuant to §1366 and increase the
shareholder’s basis pursuant to §1367. The shareholder may
then use his increased basis to deduct any losses that may
accumulate in the future.
In this case Four A realized $1,289,048 in COD income.
Each shareholder deducted $309,914 in suspended and
ordinary losses. The shareholders’ combined losses
($1,239,656) are completely offset by the $1,289,048 in COD
income. Accordingly, the losses were not available to the
Taxpayers to use as deductions on their 1993 returns and the
Tax Court’s disallowance of the deductions is affirmed.9
II. Bad Debt Deduction
The Tax Court held that Appolo was not entitled to a bad
debt deduction under § 166 for amounts advanced to Four A
because the debt was guaranteed by Four A’s shareholders
and the Guarantees were enforceable under Kentucky law.
The Taxpayers contend that the Guarantees were invalid and
unenforceable due to lack of consideration. The question of
whether a contract lacks consideration is a fact question,
subject to review for clear error. See Prichard v. Bank
Josephine, 723 S.W.2d 883, 886 (Ky. Ct. App. 1987); Roach
v. United States, 106 F.3d 720, 723 (6th Cir. 1997).
The Tax Court found that the first guaranty, the
“Continuing Guaranty,” stated that Appolo promised to
forbear suing Four A on Four A’s past debt; thus, the
Continuing Guaranty was supported by adequate and
sufficient consideration and is enforceable. Further, the Court
found that the Four A shareholders were financially capable
of satisfying the Guarantees. The Asher Taxpayers argued
that while the Continuing Guaranty recites that Appolo
No. 99-1294 Gaudiano, et al. v. Commissioner 5
coal from Four A. Between the years 1988 and 1991, Appolo
advanced large sums of money to Four A. Four A ceased
mining operations in February of 1991. In March, 1991, Price
Waterhouse LLP audited Appolo’s 1990 financial statements.
During that audit Price Waterhouse questioned the
collectibility of the Four A debt and raised the question of
whether a bad debt reserve should be established on Appolo’s
books. Appolo, through its chief financial officer Taxpayer
Salvadore Gaudiano, asserted that the debt was collectible
and presented a repayment plan developed by the Four A
shareholders to repay the debt to Appolo over eight years
from equipment rental fees, the residual value of the Four A
mining equipment, and Taxpayer loans to Four A.
Price Waterhouse reviewed the repayment plan and
determined that the loans should have some sort of personal
guarantee of the shareholders. Mr. Gaudiano and Price
Waterhouse agreed that the Four A Taxpayers would execute
guarantees to Appolo for the Four A debt and that Appolo
would not be required to establish a reserve against the Four
A debt. On or about May 13, 1991, the Taxpayers executed
two guaranty agreements (collectively, the Guarantees). The
first guaranty, which is titled “Continuing Guaranty”, was
backdated to January of 1989. The Continuing Guaranty
provides in relevant part:
[Appolo] has from time to time loaned money to Four A
on a demand basis, some of which loans remain
outstanding . . . . [T]he guarantors desire to grant this
Guaranty to Appolo as consideration for Appolo not
demanding immediate payment of its existing loans to
Four A, and as an inducement to Appolo to make future
advances to Four A, without which Guaranty Appolo
would not take such action; . . . Therefore, . . . in
exchange for good and valuable consideration, the receipt
and sufficiency of which all the Guarantors hereby
acknowledge, the Guarantors do hereby absolutely,
unconditionally and irrevocably guaranty to Appolo . . .
[t]he repayment in full (without interest) of all loans and
advances made by Appolo to Four A, including both

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6 Gaudiano, et al. v. Commissioner No. 99-1294
those currently outstanding and those made in the future.
. . .
(Joint Ex. 19-s, JA 356-58). The Continuing Guaranty further
states: “Each of the Guarantors expressly agrees that neither
the bankruptcy, insolvancy [sic], reorganization, liquidation,
dissolution, death or disability of any or all of Four A and the
other Guarantors shall diminish, impair, discharge or release,
or otherwise affect, the obligations and liability of the
Guarantor under this Guaranty. . . .” Id. at JA 357.
The second Guaranty, backdated to April 30, 1990,
guarantees two loans from Appolo to Four A in the amounts
of $500,000 and $170,000. The Guaranty states that “the
Guarantors have previously agreed to guarantee the First Note
and the Guarantors desire to guarantee the Second Note as an
inducement to Appolo to make the loan evidenced thereby,
without which guarantee Appolo would not take such action”.
(Joint Ex. 20-t, JA 359). As in the Continuing Guaranty, the
second Guaranty asserts that the Guaranty is provided in
exchange for “good and valuable consideration, the receipt
and sufficiency of which all the Guarantors hereby
acknowledge” and that “neither the bankruptcy, insolvancy
[sic], reorganization, liquidation, dissolution, death or
disability of any or all of Four A and the other Guarantors
shall diminish, impair, discharge or release, or otherwise
affect, the obligations and liability of the Guarantor under this
Guaranty”. Id. at JA 360.
Four A filed a petition for relief under Chapter 7 of the
Bankruptcy Code in December, 1993. At the time of its
bankruptcy filing, Four A owed $1,106,000 to Appolo.
Appolo determined that the Four A debt was “worthless” and
deducted the $1,106,000 Four A debt as a business bad debt
pursuant to 26 U.S.C. §166 (a) on its 1993 Form 1120S, U.S.
Income Tax Return for an S Corporation. Appolo never
demanded payment from Four A or any of its shareholders.
Taxpayers Larry Asher and Gary Asher, as Appolo
shareholders, each reported an ordinary loss of $80,246 on
No. 99-1294 Gaudiano, et al. v. Commissioner 19
shareholder losses) would never occur since there would be
no income left at the corporate level to apply against the
losses. While § 108(b)(4)(A) provides that the reduction in
attributes shall be made after the determination of the tax
imposed by this chapter for the taxable year of the discharge,
it does not preclude the reduction of certain attributes in the
year of discharge. Specifically, § 108(b)(4)(B) provides that
reductions of net operating loss for the taxable year of
discharge and any net operating loss carryover and any capital
loss carryover shall be made “first in the loss for the taxable
year of discharge.” Thus, the corporation must determine its
net operating losses and suspended operating losses for the
year of discharge and reduce those attributes by the amount of
COD income realized. If the losses exceed the COD income,
then the extra losses pass through to the shareholders.
We disagree with the Tax Court and the Tenth Circuit in
their findings that COD income is not income within the
meaning of § 1366(a)(1)(A) and thus does not pass through to
the shareholders and increase the basis of their shares.
Section 1366 (a)(1)(A) explicitly includes tax-exempt income.
The Tax Court and the Tenth Circuit have determined that
COD income is not really tax-exempt since COD income
reduces suspended losses and thus operates to defer rather
than eliminate taxes. However, as Judge Posner explained in
Witzel, COD income is not always tax deferred; it may be
truly tax exempt if there are no suspended losses to offset the
income. Moreover, § 1366 is not “limited to tax-exempt
income, so if COD income is not ‘really’ tax exempt this
would not take it out of the section.” Witzel, 200 F.3d at 505.
Since COD income falls within § 1366(a)(1)(A), it follows
that pursuant to § 1367(a)(1)(A), COD income increases the
basis of the S corporation shareholder’s stock by the amount
of COD income passed through to the shareholder.
Consequently, we hold that the S corporation must reduce any
existing tax attributes, including shareholder suspended
losses, by the amount of COD income realized by the S
corporation. If any COD income remains after losses and
suspended losses are deducted, that income may flow through

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18 Gaudiano, et al. v. Commissioner No. 99-1294
§108(d)(7)(A), tax attributes [sic] reductions must be
applied at the corporate level with subchapter S
corporations. Taxpayers’ proposal would not give effect
to the attribute reduction scheme. Taxpayers’ approach,
in fact, would thwart the purpose of the net operating loss
tax attribute. . . . As we see it, §108(b)(4)(A) is simply
designed to compute certain tax applications ... before
reducing tax attributes. We do not read the statute as
mandating that attribute reductions be made in the tax
year following the year of the discharge. We concede
that, if §108(b)(4)(A) is read narrowly and in isolation, it
is plausible to conclude Congress intended tax attributes
to be reduced only in the tax year following the taxable
year of the discharge. But we must read the Internal
Revenue Code as a whole. . . . Taxpayers’ interpretation
of §108(b)(4)(A) would negate the effect of the tax
attribution scheme and would give taxpayers an
unwarranted windfall.
Gitlitz, 182 F.3d at 1149. In Witzel, without specifically
addressing the ordering requirements of § 108(b)(4)(A), the
Seventh Circuit determined that the tax attributes must be
reduced before COD income passes through: “if (b)[§108(b)]
is to be applied at the corporate level, the implication . . . is
that the excluded income must be set off against the
suspended losses and the latter reduced accordingly. The
argument is not conclusive; the interpretive question could be
resolved either way; but in these circumstances of dubiety the
sensible result--denying the taxpayers the double windfall--
seems to us the preferable one.” Witzel, 200 F.3d at 503-04.
While this is a very close call, we feel inclined to follow the
reasoning of the Tenth and Seventh Circuits on the ordering
issue. Section 108 (d)(7)(A) clearly requires that the
insolvency determination and the attribute reduction take
place at the corporate level. If the attribute reduction is made
after the COD income passes through then there will be no
attribute reduction at the corporate level. As the
Commissioner notes, the mandated reduction of the
corporation’s net operating losses (which include suspended
No. 99-1294 Gaudiano, et al. v. Commissioner 7
their individual 1993 tax returns based on their distributive
shares of Appolo’s bad debt write-off.
The Commissioner did not disallow the loss deductions
claimed by the Ashers upon audit. Rather, in his answer in
the Larry Asher case, and in an amendment to his answer in
the Gary Asher case, the Commissioner asserted that Appolo
was not entitled to a bad debt deduction for the amounts owed
by Four A because those debts were not worthless in 1993 in
that the debts were guaranteed by the Four A shareholders
who were financially able to make full payment on Four A’s
debts to Appolo. Consequently, the Commissioner requested
that the Tax Court determine that the Ashers were liable for
increased deficiencies for 1993.
The Ashers opposed the Commissioner’s requests for
increased deficiencies, contending that the Guarantees were
not given in exchange for consideration, and thus, were not
enforceable under Kentucky law. During a brief trial before
the Tax Court, the Taxpayers offered testimony that they were
told the Guarantees were for the auditors and that Appolo
never demanded that the Guarantees be executed. Further, the
Taxpayers testified that it was understood by Appolo and the
Taxpayers that Appolo did not require and would never
enforce the Guarantees; the Guarantees were executed solely
to appease the Price Waterhouse auditor. The Taxpayers
asserted that the Guarantees were given to the auditor and that
no copies were kept by the Taxpayers or Appolo. Moreover,
the Taxpayers contended that the consideration language in
the Guarantees was merely form language added by Appolo’s
legal counsel John Stites which Appolo had not requested.
Finally, the Taxpayers testified that Appolo had never
promised to forbear from suing Four A on Four A’s past debt.
The Tax Court held that Appolo was not entitled to a bad
debt deduction for the amounts loaned to Four A; and thus,
the Ashers were not entitled to the ordinary losses they
claimed as their distributive share of Appolo’s deduction.
The Tax Court’s decision was based on its observation that
the Guarantees appeared valid and enforceable on their faces.

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8 Gaudiano, et al. v. Commissioner No. 99-1294
The Tax Court focused on the first Continuing Guaranty,
which stated on its face that consideration was given to the
Four A shareholders in that Appolo promised not to demand
immediate payment on past loans to Four A and to make
future loans to Four A. Noting that forbearance to sue is
sufficient consideration to support a promise, the Tax Court
found that the first Guaranty was supported by sufficient
consideration and held that the Guaranty was valid and
enforceable. In making this finding the Tax Court did not
accept the self-serving testimony of the Taxpayers offered to
prove that Appolo did not give consideration for the
Guarantees. The Tax Court also found that the Taxpayers
were financially able, both in 1993 and at the time of the trial,
to satisfy Four A’s debts to Appolo. Consequently, the Tax
Court concluded that since the first Continuing Guaranty is
enforceable, the debt was not worthless, regardless of whether
the second Guaranty is enforceable.
Analysis
I. Pass Through Issue
The initial issue in this case raises a question of first
impression in this Circuit. Whether the Taxpayers, as the
shareholders of Four A, an S corporation, are entitled to
increase their bases in the stock of Four A by their pro rata
share of discharge of indebtedness income (“COD income”)
realized by Four A, but excluded by Four A pursuant to 26
U.S.C. §108(a)?
There are no facts in dispute, thus the Tax Court’s decision
on this legal issue is a question of law that is reviewed de
novo. Estate of Mueller v. Commissioner, 153 F.3d 302, 304
(6th Cir. 1998).
A. The Tax Court Decision
The Tax Court held that the COD income that Four A
excluded from gross income under § 108 (a) is not a
separately stated item of tax-exempt income for purposes of
§ 1366 (a)(1)(A). Therefore, Taxpayers were not entitled to
No. 99-1294 Gaudiano, et al. v. Commissioner 17
excluded from gross income under § 108(a)(1)(B) shall not
exceed the amount by which the taxpayer is insolvent.
§ 108(a)(3). Further, the amount of COD income excluded
under § 108(a)(1)(B) shall be applied to reduce the tax
attributes of the taxpayer in the order listed in § 108(b)(2)
[Net operating loss, general business credit, minimum tax
credit, capital loss carryovers, basis reduction, Passive activity
loss and credit carryovers, and foreign tax credit carryovers].
§ 108(b)(1). Section 108(b)(4) provides that the reductions
described in § 108(b)(2) shall be made after the determination
of the tax imposed by this chapter for the taxable year of the
discharge. Section 108(d)(7) contains special rules for S
corporations. Section 108(d)(7)(A) provides that in the case
of an S corporation, subsections (a) [exclusion of COD
income if taxpayer is insolvent or is in Title 11], (b)
[reduction of tax attributes] and (g) [qualified farm
indebtedness] shall be applied at the corporate level.
As the Tenth Circuit recognized in Gitlitz, the timing of the
attribute reduction brings § 108(b)(4)(A) into conflict with
§ 108(d)(7)(A). Under the Taxpayers’ position, excluded
COD income does not reduce S corporation losses as required
by § 108(b)’s attribute reduction requirement if the reduction
is made in the year following the year of discharge. Rather,
current and suspended losses are deducted by the shareholders
by virtue of their increased basis, thus offsetting other income
the shareholders may have. In practice, there would be no
income left to offset any tax attributes at the corporate level
in the year following discharge.
The Commissioner argues that § 108(b)(4)(A) does not
require that the reduction of tax attributes be made in the year
following the year of discharge. See § 108(b)(4)(B)
(reductions under § 108(b)(2)(A) & (D)[net operating loss and
capital loss carryover] shall be made first in the loss for the
taxable year of the discharge.) Faced with the same
argument from the taxpayers in Gitlitz, the Tenth Circuit held:
Although a close question, we ultimately conclude the
taxpayers’ theory is not compelling. According to

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16 Gaudiano, et al. v. Commissioner No. 99-1294
8Presumably, the shareholder’s basis in his S corporation stock
would only increase by the amount of the COD income which was not
offset by the existing suspended losses. Thus, the S corporation had $5.4
million in excluded COD income which was offset by approximately $3
million in existing suspended losses leaving approximately $2.4 million
in COD income to pass through to the shareholder to increase the
shareholder’s basis.
losses were completely offset by the amount of the COD
income), the increased basis may enable the taxpayer to
deduct future losses.8 Id. at 505.
C. The Parties’ Arguments
The parties in this case raise the same arguments made by
the parties in Gitlitz, Farley, Witzel, and Hogue. The
Commissioner argues that the only reasonable interpretation
of § 108 is that COD income is recognized only at the
corporate level, does not pass through to the shareholder, does
not raise the shareholder’s basis and instead eliminates
suspended losses at the corporate level. Taxpayers argue that
§ 108(d)(7)(A)-(C) does not override or vary the general S
corporation pass through and basis provisions set forth in
§§ 1366 and 1367, nor does § 108(d)(7)(A) preclude pass
through of COD income under § 1366(a)(1)(A).
As the conflicting decisions of the other courts which have
analyzed this issue demonstrate, interpreting the Internal
Revenue Code is about as easy as swimming through mud.
The sections at issue, 108, 1366, and 1367, while seemingly
clear on their faces, become muddy when they are applied in
conjunction with each other.
The analysis begins with § 108(a)(1)(B) which provides
that gross income does not include any amount which would
be includible in gross income by reason of the discharge of
indebtedness of the taxpayer if the discharge occurs when the
taxpayer is insolvent. In this case the parties agree that Four
A was insolvent at the time that its debt to Appolo
(approximately $2 million) was discharged. The amount
No. 99-1294 Gaudiano, et al. v. Commissioner 9
increase their bases in the Four A stock due to Four A’s COD
income. In reaching this decision, the Tax Court relied, with
little discussion, on its reviewed decision in Nelson v.
Commissioner, 110 T.C. 114 (1998), aff’d, 182 F.3d 1152
(10th Cir. 1999).
In Nelson, the Tax Court held that a taxpayer was not
entitled to increase the basis in his S corporation stock by his
pro rata share of the insolvent corporations’s COD income.
The Nelson court set out the arguments as follows:
The parties’ dispute herein centers on the language in
section 108 (d)(7)(A). Specifically, the parties differ on
the precise meaning of the phrase, “in the case of an S
corporation, * * * [section 108] shall be applied at the
corporate level.” Sec. 108(d)(7)(A). [The
Commissioner] argues that section 108(d)(7)(A)
represents an adjustment and/or exception to the
principles underlying the subchapter provisions that
items of income realized or recognized at the corporate
level are passed through to the shareholders. On the
other hand, [Taxpayer] contends that section
108(d)(7)(A) stands for the proposition that prior to the
determination of an individual shareholder’s income tax
liability, the S corporation must be ascertained to be
insolvent.
[The Taxpayer], in effect, argues that the result of the
interaction between section 108(d)(7)(B) and (b)(2), as
governed by section 108(b)(4), is to apply the attribute
reduction rules of section 108(b)(2) at the shareholder
level. Section 108(b)(4) states that the reduction in tax
attributes will be made “after the determination of the tax
imposed * * * for the taxable year of the discharge.”
(Emphasis added.) Next, [Taxpayer] points out that
“suspended losses” under section 1366(d)(i)-(3) are
deemed to be net operating losses. Sec. 108(b)(2). Such
“suspended losses” are determined at the shareholder
level. Sec. 1366(d)(1). Consequently, [Taxpayer]
extrapolates that the reduction in tax attributes occurs on

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10 Gaudiano, et al. v. Commissioner No. 99-1294
the shareholder level. Similarly, [Taxpayer] reasons that
COD income excluded under section 108(a)(1) passes
through to the shareholder, increases his or her stock
basis, and thus affects his or her “suspended losses”
under section 1366(d). According to [Taxpayer], all of
this occurs at the shareholder level, prior to the reduction
in tax attributes under section 108(b)(2).
Accordingly, in order for [Taxpayer] to prevail in this
matter, the COD income otherwise excluded from gross
income must pass through the corporate form and be
apportioned on a pro rata basis among the subchapter
shareholders. We disagree with [Taxpayer]’s statutory
approach with respect to the COD income exclusion
provision because it is simply not plausible. In this
instance, section 108(d)(7)(A) explicitly provides that the
COD income exclusion operates, for purposes of the
subchapter S regime, on the corporate level.
Nelson, 110 T.C. at 120-21. The court held that the literal
language of §108(d)(7)(A) provides that the reduction in tax
attributes applies at the corporate level. Id. at 121. Further,
§ 1366(b) provides that the character of any item included
under § 1366(a)(1)(A) is determined as if realized directly
from the source from which realized by the corporation, or
incurred in the same manner as incurred by the corporation.
Thus, the court determined that construing § 1366(a)(1)(A) in
combination with § 108(d)(7)(A) meant that COD income
was precluded from recognition at the shareholder level and
could not, therefore, increase the shareholder’s basis. Id. at
122.
In addition, the Tax Court held that § 108(b)(4)(A), which
states that the reduction of tax attributes occurs after the
determination of the tax imposed for the taxable year of the
discharge, requires the S corporation to reduce its tax
attributes by the amount excluded from gross income at the
end of the corporation’s taxable year. Id. at 123. The court
rejected taxpayer’s argument that the income was “tax
exempt” and thus statutorily required to pass through to S
No. 99-1294 Gaudiano, et al. v. Commissioner 15
6Mr. Witzel was the sole shareholder of an S corporation with $5.4
million of COD income and suspended losses of almost $3 million.
7The court noted a recent Treasury Regulation which supports the
Commissioner’s and the Tax Court’s interpretation of § 1366, but
declined to follow the regulation since it is only applicable to tax years
beginning on or after August 18, 1998. The regulation states “‘Tax-
exempt income’ does not include income from discharge of indebtedness
excluded from income under section 108 because such income is not
permanently excludible from income in all circumstances in which section
108 applies.” Treas. Reg. §1.1366-1(a)(2)(viii), 64 Fed. Reg. 71641,
71643 (Dec. 22, 1999). Similarly, this regulation does not apply here
because the tax year at issue is 1993.
section 108(d)(7)(A) requires that COD income of a
subchapter S corporation be offset against any existing
suspended losses arising from the operation of the
corporation.” Id. at 506. Thus, the taxpayer in Witzel was
forbidden to deduct his existing suspended losses because
they were offset at the corporate level by the amount of his
corporation’s COD income.6 The Seventh Circuit noted that
resolving the interpretive question in this way, which denies
the taxpayers the double windfall, seemed to be preferable.
Id. at 504. While Judge Posner did not specifically address
the timing of the attribute reduction as set forth in §108(b)(4),
his holding indicates that he sided with the Gitlitz Court in
finding that attribute reduction precedes pass through.
However, in contrast to Gitlitz, Judge Posner determined
that COD income passes through to the shareholder pursuant
to § 1366(a)(1)(A), which explicitly includes tax exempt
income, and increases the basis of the shareholder’s stock
pursuant to § 1367. The Court was unpersuaded by the Tax
Court’s conclusion that COD income is merely tax deferred,
not really tax exempt, noting that there could be occasions
when COD income is truly tax exempt as opposed to merely
tax deferred. In any event, Judge Posner noted that § 1366 is
not limited to tax-exempt income, so even if COD income
really was not tax exempt it would not take it out of § 1366.7
Thus, while the taxpayer cannot use his increased basis to
deduct existing suspended losses (because in Witzel those

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14 Gaudiano, et al. v. Commissioner No. 99-1294
S corporation shareholders. The court determined that once
COD income is excluded from gross income pursuant to
§ 108(a)(1), it is treated as tax-exempt income pursuant to
§ 1366(a)(1) and is passed through to S corporation
shareholders under that section. Pursuant to § 108(b)(2), the
amount of COD income excluded from gross income is
applied to reduce tax attributes. That reduction of tax
attributes is made after the determination of the tax imposed
by this chapter for the taxable year of the discharge.
§ 108(b)(4)(A). Thus, the court concluded that COD income
passes through to S corporation shareholders in the year that
the debt is discharged and the tax attributes are decreased in
the year following the discharge because the determination of
the tax imposed for the tax year in which the discharge
occurred cannot take place until that tax year ends. Id. at *2-
3. As a result, the S corporation shareholders in Hogue were
allowed to increase shareholder basis in the year of the
discharge and claim suspended losses against the increased
basis. The attribute reduction mandated by § 108(b)(2) would
occur in the year following the year of discharge. The court,
noting that the Tenth Circuit’s decision in Gitlitz was driven
by the court’s desire to avoid allowing the taxpayers to realize
a windfall, stated that “[t]he Internal Revenue Code is too
complicated for courts to strain against the language in an
effort to achieve particular results.” Id. at *3.
Chief Judge Posner, writing for the Seventh Circuit,
addressed this issue in Witzel v. Commissioner of Internal
Revenue, 200 F.3d 496 (7th Cir. 2000), and settled on a result
somewhere in the middle between the Tenth Circuit’s position
in Gitlitz and the positions of the Third Circuit in Farley and
the District Court of Oregon in Hogue. The Seventh Circuit
noted that while the “at the corporate level” language of
§108(d)(7)(A) was not susceptible to conclusive
interpretation, “[i]f (b) [the subsection that reduces tax
attributes by the amount of the excluded COD income] is to
be applied at the corporate level, the implication, as the
government argues, is that the excluded income must be set
off against the suspended losses and the latter reduced
accordingly.” Id. at 503-04. Thus, the Court held “that
No. 99-1294 Gaudiano, et al. v. Commissioner 11
corporation shareholders under § 1366(a)(1)(A). Instead, the
court noted that the exclusion could be subject to taxation in
the future, and therefore was not necessarily tax exempt on a
permanent basis. Id. at 125. After reviewing the “relatively
sparse legislative history,” the court also observed that
allowing taxpayer to increase his basis by using income for
which the creditors, not taxpayer, had borne an economic cost
would produce an unintended windfall for taxpayer. Id. at
127-28.
B. Decisions of other courts on the COD pass through
issue.
In July 1999, the Tenth Circuit, the first circuit to rule on
this issue, affirmed the Nelson decision for the reasons stated
in Gitlitz v. Commissioner of Internal Revenue, 182 F.3d 1143
(10th Cir. 1999). The Tenth Circuit determined that:
The outcome of this case is ultimately determined by the
timing of the pass-through. If the attribute reduction
procedures precede the pass-through, the corporation’s
excluded discharge of indebtedness income is absorbed
before it can pass through to shareholders and compel
basis adjustments. Potential windfalls are thus avoided.
If, on the other hand, attribute reduction takes place after
the pass-through, the taxpayers’ theory must prevail.
Id. at 1148. The court concluded that attribute reduction must
precede the pass through. In reaching this conclusion the
court reviewed § 108(d)(7)(B) which provides that, in
administering the tax attribute reduction scheme, shareholder
losses suspended pursuant to § 1366(d)(1) must be treated as
net operating losses for purposes of § 108(b)(2)(A), “thereby
precluding subchapter S corporation shareholders with
carryover losses from enjoying the tax benefits of ordinary
losses while simultaneously avoiding taxation on discharge of
indebtedness income.” Id. The Court interpreted
§ 108(d)(7)(B) as requiring that shareholder suspended losses
be added to the corporation’s annual net operating losses in
applying the net operating loss tax attribute reduction. The
court conceded that since a subchapter S corporation’s losses

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12 Gaudiano, et al. v. Commissioner No. 99-1294
5The Tenth Circuit set out examples which show how their
interpretation of the interplay between §§ 108 and 1366-1368 operates in
practice. The steps which need to be taken in each calculation are: 1)
corporation computes its COD income and sets this figure aside
temporarily; 2) corporation calculates its net operating loss tax attribute
(net operating loss + shareholder suspended losses); 3) corporation
applies the excluded COD income to reduce its tax attributes. After these
calculations are complete, if any COD income remains it is ignored and
has no tax consequences. If any net operating losses or suspended losses
remain, they flow through to the shareholder and, depending on his basis,
may be used by him to offset his own gross income. 182 F.3d at 1150 n.6.
are normally deductible only by its shareholders, the
corporation itself is not permitted to take a net operating loss
deduction. However, the court noted, “nothing in the Internal
Revenue Code mandates that corporate net operating losses
pass through immediately to shareholders. If pass through
was immediate, “shareholders could secure a windfall by (1)
avoiding tax on corporate discharge of indebtedness income
under § 108(a), and (2) employing the corporation’s passed-
through net operating losses to reduce their own non-
corporate related gross income without having first decreased
the net operating losses by the amount of the corporation’s
discharged debt.” Id.
The Tenth Circuit concluded that “when § 108(a)’s
discharge of indebtedness income exclusion is triggered, a
shareholder’s pro rata share of the corporation’s net operating
losses passes through to him only to the extent such losses are
not absorbed by the shareholder’s pro rata share of the
excluded canceled debt.” Id. Further, should any debt
discharge amount remain after the tax attributes are reduced,
it is disregarded and has no tax consequences; it does not
increase the shareholder’s basis.5
Two other circuit courts and one district court have also
recently addressed this issue and have come to different
conclusions. In United States v. Farley, No. 99-3209, 2000
WL 72087 (3rd Cir. Jan. 27, 2000), the taxpayers obtained
refunds after adjusting the basis of their S corporation stock
upward to account for excluded COD income. By increasing
No. 99-1294 Gaudiano, et al. v. Commissioner 13
the basis of their stock, the taxpayers were able to deduct
previously suspended losses. The Court noted that the key to
unraveling the case was determining how sections 1366,
1367, and 108 interact. As in Gitlitz, the Third Circuit noted
that the timing of the pass through, which is controlled by
§ 108(b)(4)(A), determines the outcome of the case. Unlike
the Tenth Circuit in Gitlitz, the Third Circuit held that:
“[t]he language in section 108(b)(4)(A) clearly indicates
that tax attributes are reduced on the first day of the tax
year following the year of the discharge of indebtedness.
The statutory language is straight forward. Discharge of
indebtedness income, considered income under section
61(a)(12), is excluded from gross income pursuant to
section 108(a)(1)(B) if, as in this case, the S corporation
is insolvent. This solvency determination is made at the
corporate level rather than the individual shareholder
level pursuant to section 108(d)(7)(A). Discharge of
indebtedness income excluded from gross income under
section 108(a)(1)(B) then passes through to the S
corporation’s shareholders pursuant to section
1366(a)(1)(A). Upon passing through to the S
corporation’s shareholders, the discharge of indebtedness
income causes an upward adjustment in the basis of the
shareholder’ S corporation stock pursuant to section
1367(a)(1)(A), thus allowing deductions for losses
previously suspended because the corporation’s stock
lacked adequate basis. Finally, the tax attribute reduction
required by section 108(b) takes place on the first day of
the tax year following the year of the discharge of
indebtedness, as mandated by section 108(b)(4)(A).
Farley, 2000 WL 72087 at *8. Accordingly, the Third Circuit
determined that the taxpayers in Farley were entitled not only
to increase the basis of their S corporation stock but also to
take deductions for their current and suspended losses. Id.
Similarly, in Hogue v. United States, No. 99-302-KI, 2000
WL 2651 (D. Or. Jan. 3, 2000), the court noted that § 108 is
silent with respect to whether COD income passes through to

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