Owing too much money is bad. Being relieved from owing too much money is good. Paying tax on being relieved from owing too much money is bad. Being exempt from paying tax on being relieved from owing too much money would be very good - and it was too good for the Tax Court, which denied such an extra benefit in Nelson vs. Commissioner (February 19, 1998).

Mel Nelson tried to take advantage of the interaction between two sets of tax rules - those governing income from the discharge of indebtedness (commonly called "COD," for "cancellation of debt") and those governing the taxation of S corporations. The basic rules governing the tax treatment of COD are familiar to many readers. COD is generally included in a taxpayer's income. However, some taxpayers are permitted to exclude COD from income; one important example of such an exclusion is that available to taxpayers who are "insolvent" at the time of a cancellation. Although an insolvent taxpayer may be required to reduce certain favorable tax attributes as the price for excluding COD from income, this is not always the case. In particular, if the taxpayer does not have any of these tax attributes, the COD is still excluded from income and the taxpayer obtains what is, in effect, a "freebie."

The basic rules governing the taxation of a corporation are also well known. S corporations are generally not themselves subject to Federal income tax. Rather, the income and loss of an S corporation "flows through" to its shareholder(s). A shareholder's basis is increased by any income inclusions and decreased by distributions from the S corporation to the shareholder; distributions that exceed a shareholder's basis give rise to taxable gain. A shareholder's basis is also increased by any tax-exempt income of the S corporation that flows through to the shareholder; this basis increase is necessary in order to prevent the shareholder(s) from losing the benefit of the exempt nature of the income through the creation of a taxable distribution.

Prior to 1982, the Internal Revenue Code did not contain any explicit provision to govern the interaction of the COD rules with the S corporation rules. The Subchapter S Revision Act of 1982 provided that the rule allowing insolvent taxpayers to exclude COD from their income was to be applied at the shareholder level; if an S corporation realized COD, any insolvent shareholders would be permitted to exclude their shares of that income (but would have to reduce any available personal tax attributes), while those shareholders who were not insolvent would have to include the COD in their income. By analogy to the rules that have governed COD realized by a partnership since 1980, it was moderately clear that all shareholders - solvent and insolvent - increased their bases by the amount of the COD. The solvency or insolvency of the S corporation was not relevant.

This regime envisioned by the 1982 Act was changed by the Tax Reform Act of 1984, effective retroactively back to the original effective date of the 1982 Act. The application of the "insolvency exception" is now determined at the S corporation itself. If an S corporation realizing COD itself is insolvent, all of the shareholders are entitled to exclude that COD from income, regardless of whether they themselves are solvent or insolvent. Moreover, it is the favorable tax attributes of the corporation itself which are subject to reduction, as the price exacted for the benefit of the insolvency exclusion. The 1984 Act left some questions unanswered, though, including the one at the heart of the Nelson case: May an S corporation shareholder still increase his basis by the amount of COD that would have been passed through to the shareholder if the insolvency exclusion had not been available?

The facts in Nelson were quite simple. Mel Nelson was the sole shareholder of an S corporation, "MAI." During 1991, MAI realized over $1.3 million of COD. Since MAI was insolvent to at least that extent, it excluded that amount from gross income and Nelson was not taxed on it. Later in 1991, Nelson sold his MAI stock and claimed a loss based, in part, on an asserted increase to his basis by reason of the pass-through of COD. To illustrate, assume that Nelson made no equity investment in MAI and had never received any distributions, or allocations of income or loss, from the corporation; under these circumstances his basis in his MAI stock would have been $0 immediately before the discharge of indebtedness. Assume also that Nelson received proceeds of $100,000 from the ultimate sale of his stock. In Nelson's view, his basis in his stock was increased by $1.3 million at the time of the debt discharge, so that he realized a $1.2 million loss on the stock sale, even though, in economic terms, his overall investment in MAI could be said to have yielded an economic profit of $100,000.

All 19 judges of the Tax Court agreed that Nelson was wrong. An opinion in which 12 judges joined went through a variety of arguments for denying to Nelson the benefit of the basis increase that he sought. One argument that these judges found particularly persuasive was grounded in a inconsistency between the basis increase that Nelson sought and the perceived congressional intent that the insolvency exclusion generally creates only a deferral of income, rather than an exclusion of income; by contrast, the rules governing, for example, municipal bonds are generally intended to work a permanent exclusion from taxable income.

In order to understand the court's argument better, it is helpful to consider what would have happened had Nelson sold his stock for $1.3 million. Under Nelson's view, he would have realized no taxable income at all, at any time, with respect to his MAI stock - in fact, he would have realized a $100,000 loss - even though he had an economic profit of $1.2 million from his overall investment; this absence of taxable income would have resulted from the asserted basic increase arising from the excluded COD, a result that the court viewed as inconsistent with the congressional intent.

The discharge of indebtedness has long been a transaction fraught with sometimes unanticipated tax consequences, both favorable and unfavorable. This case adds an element of certainty to what is still a very confusing picture.

Code section 198:

* Provision allows taxpayers to elect to treat certain environmental remediation costs that otherwise would be required to be capitalized as deductible in the year paid or incurred.

*Limited benefits because it applies only to qualified environmental remediation expenses incurred with respect to geographical tracts or zones and does not apply to building-specific expenditures.

Revenue Procedure 98-17:

* This provides a procedure for requesting written guidance on the tax treatment of environmental cleanup costs incurred in projects that may span several years.

* It is currently available for a two-year trial period which began on Feb. 2.