Tax Legal Services · Primary-source case analysis

Gitlitz: Excluded Cancellation-of-Debt Income Increased S-Corporation Basis

By Aneeta Mishra and Timothy Chan

Published April 27, 2026

Gitlitz illustrates how statutory sequencing controlled basis and loss deductions even when cancellation-of-debt income was excluded at the corporate level.

An insolvent S corporation had debt discharged

The corporation excluded cancellation-of-debt income under section 108. Its shareholders argued that the income nevertheless passed through under Subchapter S, increased their bases, and allowed previously suspended losses.

Excluded income remained an item of income

The Court read the statutory text to treat discharge income as income even though section 108 excluded it from gross income. Subchapter S passed that item through to shareholders.

Basis adjustment preceded attribute reduction

Under the sequencing provisions then applicable, pass-through and basis adjustment occurred before reduction of the corporation’s tax attributes. The shareholders therefore obtained basis sufficient to deduct suspended losses.

Disposition

The Court reversed and accepted the shareholders’ interpretation of the then-current Code. Congress later amended the statute, so the holding must not be applied without checking the governing tax year.

Key takeaways

• Identify the tax year before relying on the sequencing rule.
• Separate income characterization from gross-income exclusion.
• Trace pass-through, basis, loss, and attribute steps in order.
• Check subsequent statutory amendments.