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Supreme Court to settle business tax dispute

May 3, 1999Washington — The Supreme Court Monday agreed to resolve a split among the nation’s federal appeals courts over how to calculate taxes owed by shareholders of insolvent small businesses classified as “S corporations.”The court will use a Colorado case to decide how federal tax collectors must view forgiven debts of S corporations, created under Subchapter S of the Internal Revenue Code as pass-through entities that offer favorable tax treatment for owners of closely held businesses.David Gitlitz and Philip Winn each owned a 50 percent interest in PDW & A Inc., a Colorado-based S corporation that belonged to a real estate partnership.In 1991, the partnership had a $4.1 million debt forgiven. PDW & A’s share was just over $2 million. But because the S corporation was insolvent at the time, it incurred no tax liability.Gitlitz and Winn, in submitting tax returns for the relevant years, sought to claim their share of the forgiven debt as income to increase their basis in PDW & A stock. An increased basis raises the number of deductions a shareholder-taxpayer can claim for prior losses.After an Internal Revenue Service audit, the agency’s commissioner disallowed those deductions claimed in the amounts equal to the two men’s allocable share of the forgiven debt.The IRS said Gitlitz owed $251,192 in additional taxes, and Winn $242,555.They challenged the tax agency’s determination, but lost in the U.S. Tax Court and the Denver-based 10th U.S. Circuit Court of Appeals.The appeals court ruled that allowing shareholders in insolvent S corporations to avoid tax liability for forgiven debts by not treating such amounts as income means the forgiven debts cannot be counted toward increasing a shareholder’s basis in the corporation.To do otherwise, the appeals court said, would be to give taxpayers an inappropriate double benefit.In the appeal acted on Monday, lawyers for Gitlitz and Winn said the appeals court ruling “is contrary to the plain language of the statutes.”Government lawyers told the justices that the 10th Circuit court ruled correctly, but said the appeal should be granted because the Philadelphia-based 3rd U.S. Circuit Court of Appeals has issued a ruling that favors taxpayers in the same situation.Dozens of cases raising the same tax issue are pending in lower courts, the justices were told.The case is Gitlitz vs. Commissioner of Internal Revenue, 99-1295.

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