Nathel v. Commissioner

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09-1955-ag Nathel v. Commissioner 1 UNITED STATES COURT OF APPEALS 2 3 FOR THE SECOND CIRCUIT 4 5 ____________________________________ 6 7 August Term, 2009 8 9 (Argued: February 3, 2010 Decided: June 2, 2010) 10 11 Docket No. 09-1955-ag 12 ____________________________________ 13 14 IRA NATHEL, TRACY NATHEL, SHELDON NATHEL, ANN M. NATHEL, 15 16 Petitioners-Appellants, 17 18 —v.— 19 20 COMMISSIONER OF INTERNAL REVENUE, 21 22 Respondent-Appellee. 23 24 ____________________________________ 25 26 Before: KATZMANN and RAGGI, Circuit Judges, and KOELTL, District 27 Judge.* 28 ____________________________________ 29 30 The petitioners appeal a decision of the United States Tax 31 Court (Stephen J. Swift, Judge) finding that capital 32 contributions they made to two S corporations could not be 33 treated as “tax-exempt income” to the corporations for the 34 purpose of increasing, pursuant to 26 U.S.C. § 1367(b)(2)(B), 35 the petitioners’ bases in loans they made to the corporations. 36 The Tax Court also found that the petitioners could not deduct * The Honorable John G. Koeltl, of the United States District Court for the Southern District of New York, sitting by designation. 1 their capital contributions as ordinary losses incurred in a 2 trade or business pursuant to 26 U.S.C. § 165(c)(1) or incurred 3 in a transaction entered into for profit pursuant to 4 § 165(c)(2). We affirm. 5 _________________________ 6 7 HUGH JANOW, Pearl River, NY, for Petitioners- 8 Appellants. 9 10 TERESA T. MILTON, Attorney (John A. DiCicco, 11 Acting Assistant Attorney General, 12 Steven Parks, Attorney, on the brief), 13 Tax Division, United States Department 14 of Justice, Washington, DC, for 15 Respondent-Appellee. 16 17 _________________________ -2- 1 JOHN G. KOELTL, District Judge: 2 The petitioners, Ira and Tracy Nathel and Sheldon and Ann 3 M. Nathel, appeal a decision of the United States Tax Court 4 (Stephen J. Swift, Judge) upholding tax deficiencies assessed 5 by the Commissioner of Internal Revenue (the “Commissioner”). 6 On appeal, the petitioners argue that certain capital 7 contributions they made to two S corporations, of which they 8 were shareholders, should be treated as items of “tax-exempt 9 income” to the corporations for the purpose of restoring, 10 pursuant to 26 U.S.C. § 1367(b)(2)(B), the petitioners’ 11 previously reduced bases in loans they made to the 12 corporations. The petitioners contend that as a result of 13 their restored bases, they received no ordinary income when 14 the S corporations repaid the petitioners’ loans. 15 Alternatively, the petitioners argue that because they made 16 the capital contributions to obtain releases from personal 17 loan guarantees made to one of the corporations, the capital 18 contributions should be deductible as ordinary losses incurred 19 in a transaction entered into for profit pursuant to 26 U.S.C. 20 § 165(c)(2). 21 We conclude that the petitioners’ capital contributions 22 do not constitute “tax-exempt income” to the S corporations 23 and, therefore, that the petitioners are not entitled to 24 increase their bases in their loans. We also conclude that -3- 1 because the petitioners have not met their burden of showing 2 that the primary purpose of their capital contributions was to 3 obtain releases from their loan guarantees, the petitioners 4 are not entitled to deductions from ordinary income pursuant 5 to § 165(c)(2). Therefore, we affirm the Tax Court’s 6 decision. 7 BACKGROUND 8 The following facts are based on stipulated facts that 9 the parties submitted to the Tax Court. 10 Ira and Sheldon Nathel1 (the “Nathels”) are brothers who, 11 along with Gary Wishnatzki, organized three corporations that 12 elected to be taxed under Subchapter S of the Internal Revenue 13 Code (the “Code”), 26 U.S.C. §§ 1361–1379. “Subchapter S 14 allows shareholders of qualified corporations to elect a 15 ‘pass-through’ taxation system under which income is subjected 16 to only one level of taxation.” Gitlitz v. Comm’r, 531 U.S. 17 206, 209 (2001) (citing Bufferd v. Comm’r, 506 U.S. 523, 525 18 (1993)). S corporation profits are not taxed on the corporate 19 level; instead, they are passed through as taxable income to 20 shareholders on a pro rata basis. 26 U.S.C. § 1366(a)(1)(A); 21 see also Gitlitz, 531 U.S. at 209. 22 In addition to profits, an S corporation shareholder is 23 also taxed on any gain from the shareholder’s sale of 1 Ira and Sheldon Nathel filed joint tax returns with their wives, who are also petitioners in this case. -4- 1 S corporation stock, which gain is calculated as the amount 2 realized from the sale in excess of the shareholder’s basis in 3 the stock. See 26 U.S.C. § 1001(a); Craven v. United States, 4 215 F.3d 1201, 1204 (11th Cir. 2000). A shareholder’s basis 5 in stock is generally the price paid for the stock if 6 purchased from a third party or the amount of the 7 shareholder’s capital contributions if the stock is received 8 in exchange for capital contributions. 26 U.S.C. § 1012; 9 Treas. Reg. § 1.118–1 (1960). 10 Because S corporation profits are passed on to 11 shareholders to be taxed at the individual level, to avoid the 12 double taxation of a corporation’s profits, the Code permits 13 shareholders to increase their bases in a corporation’s stock 14 when the corporation receives certain “items of income 15 described” in § 1366(a)(1)(A). § 1367(a)(1)(A); Gitlitz, 531 16 U.S. at 209. Similarly, any losses or deductions that are 17 passed through from an S corporation to shareholders reduce 18 the shareholders’ bases in stock in order to prevent the 19 double deduction of those items. § 1367(a)(2)(B); Gitlitz, 20 531 U.S. at 209. If the deductions passed through by the 21 corporation to a shareholder exceed a given shareholder’s 22 remaining basis in stock in any tax year, the excess 23 deductions are applied to reduce the shareholder’s basis in 24 any indebtedness owed by the S corporation to the -5- 1 shareholder.2 § 1367(b)(2)(A). If the shareholder’s basis in 2 indebtedness was so reduced, any net increase in basis in a 3 subsequent tax year, as determined pursuant to 4 §§ 1367(a)(1)(A) and 1366(a)(1)(A), is first applied to 5 restore the shareholder’s basis in indebtedness before it is 6 applied to restore the shareholder’s basis in stock. 7 § 1367(b)(2)(B). 8 The three S corporations in this case, Wishnatzki & 9 Nathel, Inc. (“W & N New York”), G & D Farms, Inc. (“G & D 10 Farms”), and Wishnatzki & Nathel of California, Inc. (“W & N 11 California”), were organized to operate food distribution 12 businesses in New York, Florida, and California. The Nathels 13 each owned twenty-five percent of the corporations and Mr. 14 Wishnatzki owned fifty percent. 15 In June 1999, the Nathels and Mr. Wishnatzki personally 16 guaranteed $2.5 million in loans made by two banks to G & D 17 Farms. In December 2000, Ira and Sheldon Nathel each made 18 personal loans in the amount of $649,775 to G & D Farms. 19 As of December 31, 2000, the Nathels each had a zero basis in 20 their G & D Farms and W & N California stock. They each had a 2 An S corporation shareholder typically would not be entitled to a deduction upon making a loan to an S corporation and would not include in income any repayment of the principal by the corporation to the extent it is less than or equal to the shareholder’s basis in the loan. See Nat’l Bank of Commerce of Seattle v. Comm’r, 115 F.2d 875, 876 (9th Cir. 1940) (finding that repayment of money lent is not income). The shareholder’s basis in the loan would equal the amount of the original principal, subject to any subsequent adjustments to basis. See § 1012; § 1366(d)(1)(B). -6- 1 basis of $112,547 in loans they made to G & D Farms and a 2 basis of $3,603 in loans made to W & N California. 3 In February 2001, G & D Farms repaid the Nathels’ 4 December 2000 personal loans in the full amount of $649,775 5 each. In August 2001, the Nathels and Mr. Wishnatzki agreed 6 to a plan to liquidate W & N California and to convey full 7 ownership of G & D Farms to Mr. Wishnatzki and full ownership 8 of W & N New York to the Nathels. Prior to its liquidation, 9 W & N California repaid outstanding loans to the Nathels in 10 the amount of $161,250 each. The Nathels then made capital 11 contributions to W & N California in the amount of $181,396 12 each. The Nathels also made capital contributions to G & D 13 Farms in the amount of $537,228 each. In the parties’ 14 stipulation before the Tax Court, they indicated that the 15 capital contributions to G & D Farms “were made by the Nathels 16 to secure the release of their respective guarantees of [G & D 17 Farms’] debts to the Banks and to obtain [Mr. Wishnatzki’s] 18 agreement to the release of the Nathels from their guarantees 19 and to the reorganization plan.” (Stipulation of Facts 20 (“Stip.”) ¶ 34.) The parties also stipulated that “[a]s a 21 condition for releasing Sheldon and Ira from their guarantees 22 of [G & D Farms’] debt, the Banks and [Mr. Wishnatzki] 23 required Sheldon and Ira to each contribute to [G & D Farms] 24 additional capital in the amount of $537,228.00.” (Stip. -7- 1 ¶ 26.) In sum, in 2001, the Nathels received a combined 2 $1,622,050 in loan repayments from the two corporations and 3 made a combined total of $1,437,248 in capital contributions. 4 In calculating their 2001 taxes, the Nathels treated 5 their capital contributions to G & D Farms and W & N 6 California as constituting “tax-exempt income” to the 7 corporations for the purposes of § 1366(a)(1)(A). Therefore, 8 because the Nathels’ bases in their stock previously had been 9 reduced to zero and because their bases in the loans they made 10 to the corporations were also reduced, the Nathels used their 11 capital contributions to restore their bases in the loans 12 pursuant to § 1367(b)(2)(B). Without such an increase in 13 their bases, the petitioners would have been taxed on the 14 ordinary income that would have resulted from the 15 corporations’ repayment of the petitioners’ loans in amounts 16 above the petitioners’ previously reduced bases. 17 The Commissioner rejected the Nathels’ treatment of the 18 capital contributions. The Commissioner determined that the 19 Nathels’ capital contributions could not be used to offset the 20 ordinary income that resulted from the amount of the 21 corporations’ repayment of the Nathels’ loans above the 22 Nathels’ then-existing bases in the loans. Instead, the 23 Commissioner determined that the capital contributions 24 increased the petitioners’ bases in their G & D Farms and -8- 1 W & N California stock. Because the petitioners redeemed 2 their stock as part of the reorganization plan, the 3 Commissioner determined that they were entitled to a long-term 4 capital loss in light of their now-increased bases in the 5 stock. The net effect of the Commissioner’s calculation was 6 an increase in the tax owed by the Nathels in 2001. 7 The Commissioner mailed a notice of deficiency dated June 8 21, 2006, to Ira and Tracy Nathel, indicating that they owed 9 an additional $279,847 in income taxes for 2001. The 10 Commissioner also mailed a notice of deficiency dated June 21, 11 2006, to Sheldon and Ann M. Nathel, indicating that they owed 12 an additional $279,722. Both couples filed a timely petition 13 in the Tax Court for a redetermination of the deficiencies. 14 The Tax Court granted the parties’ joint motion to consolidate 15 the cases. In an opinion dated December 17, 2008, the Tax 16 Court rejected the petitioners’ challenges to the deficiencies 17 determined by the Commissioner.3 Nathel v. Comm’r, 131 T.C. 18 262 (2008). 19 20 21 3 In addition to the arguments raised on appeal, the petitioners argued in the Tax Court that their capital contributions were deductible as ordinary losses incurred in a trade or business pursuant to § 165(c)(1). The Tax Court rejected that argument and the petitioners have abandoned it on appeal. -9- 1 DISCUSSION 2 I 3 We accept the stipulated facts the parties submitted to 4 the Tax Court. We review the Tax Court’s legal conclusions de 5 novo. Reimels v. Comm’r, 436 F.3d 344, 346 (2d Cir. 2006). 6 II 7 The petitioners’ argument that their capital 8 contributions can be used to increase the bases of their loans 9 to the corporations begins with the Code. Section 10 1367(b)(2)(B) allows taxpayers to restore any basis in 11 indebtedness that was reduced in a prior tax year if there is 12 any “net increase” in basis in a subsequent tax year pursuant 13 to § 1367(a)(1)(A). Section 1367(a)(1)(A), in turn, provides 14 that a shareholder’s basis is increased by a corporation’s 15 receipt of “the items of income described in” § 1366(a)(1)(A). 16 Section 1366(a)(1)(A) provides that a shareholder’s pro rata 17 share of a corporation’s “items of income (including tax- 18 exempt income),” among other things, should be taken into 19 account in calculating an S corporation shareholder’s tax. 20 The petitioners make the novel argument that capital 21 contributions constitute “items of income (including tax- 22 exempt income)” for the purposes of § 1366(a)(1)(A). They 23 make this argument despite 26 U.S.C. § 118(a), which provides 24 that “[i]n the case of a corporation, gross income does not -10- 1 include any contribution to the capital of the taxpayer.” 2 They argue that capital contributions are income, although 3 tax-exempt income. 4 We are aware of no case that has decided whether capital 5 contributions constitute “items of income (including tax- 6 exempt income)” for the purposes of § 1366(a)(1)(A). However, 7 while the question whether “income” in § 1366(a)(1)(A) 8 includes capital contributions has not been resolved, courts 9 frequently have addressed the scope of “income” as used in 26 10 U.S.C. § 61(a) and in the Sixteenth Amendment.4 Those cases 11 indicate that capital contributions traditionally are not 12 considered to be “income” and, therefore, should not be 13 considered “items of income” under § 1366(a)(1)(A). 14 In determining whether capital contributions constitute 15 “items of income (including tax-exempt income),” we look first 4 Section 61(a) of the Code states: “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived . . . .” The Sixteenth Amendment allows Congress to “lay and collect Taxes on incomes, from whatever source derived, without apportionment among the several States.” See also U.S. Const. art. I, § 2, cl. 3 (“[D]irect Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers . . . .”); U.S. Const. art. I, § 9, cl. 4 (“No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.”). It should be noted that “gross income” in § 61(a) is at least as broad as the meaning of “incomes” in the Sixteenth Amendment. See Murphy v. IRS, 493 F.3d 170, 176, 178-79 (D.C. Cir. 2007). The petitioners have not suggested that the definition of “income” for purposes of § 1366(a)(1)(A) should be broader than the meaning of “incomes” under the Sixteenth Amendment, and we therefore find cases interpreting both “income” under § 61(a) and “incomes” under the Sixteenth Amendment to be instructive. -11- 1 to the traditional distinction between income and capital. In 2 Eisner v. Macomber, 252 U.S. 189, 219 (1920), the Supreme 3 Court determined that a shareholder’s receipt of a stock 4 distribution was not income to the shareholder and, therefore, 5 Congress’s attempt to tax the stock dividend was not 6 authorized by the Sixteenth Amendment. Rejecting the argument 7 that the shareholder could be taxed on the corporation’s 8 underlying accumulated profits,5 the Court stated that 9 “enrichment through increase in value of capital investment is 10 not income in any proper meaning of the term.” Id. at 214-15. 11 The Court drew a clear distinction between income and capital, 12 defining income as “the gain derived from capital, from labor, 13 or from both combined.” Id. at 207 (internal quotation marks 14 omitted). 15 Consistent with this definition, in Edwards v. Cuba 16 Railroad Co., 268 U.S. 628, 632-33 (1925), the Supreme Court 17 found that subsidy payments from the Cuban government to the 18 defendant railroad company were reimbursements for “capital 19 expenditures” and were not profits or gains to the 20 corporation, and, therefore, were not income for purposes of 21 the Sixteenth Amendment. An early case by this Court 5 The Court noted that a shareholder’s share of a corporation’s accumulated profits could be taxed, but such taxation would be the taxation of property because of ownership, not income, and would require apportionment under Article I, section 2, clause 3 and Article I, section 9, clause 4 of the Constitution. Macomber, 252 U.S. at 217; see also n. 4, supra. -12- 1 similarly distinguished income from capital. In United States 2 v. Oregon-Washington Railroad & Navigation Co., 251 F. 211, 3 213 (2d Cir. 1918), Judge Learned Hand noted that the Code’s 4 use of “income” “unquestionably imports . . . the current 5 distinction between what is commonly treated as the increase 6 or increment from the exercise of some economically productive 7 power . . . and the power itself.”6 Judge Hand stated that 8 “income” “should not include such wealth as is honestly 9 appropriated to what would customarily be regarded as the 10 capital of the corporation taxed.” Id. 11 Macomber’s limited definition of income was expanded in 12 United States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931) 13 (finding that discharge of indebtedness caused the corporation 14 taxpayer to realize an “accession to income” and was taxable 15 under the Code). Subsequently, in Commissioner v. Glenshaw 16 Glass Co., 348 U.S. 426, 431 (1955), the Supreme Court adopted 17 a broad definition of income as “instances of undeniable 18 accessions to wealth, clearly realized, and over which the 19 taxpayers have complete dominion.” In Glenshaw Glass, the 20 Supreme Court held that a punitive damages award was taxable 6 Oregon-Washington’s holding, that discharge of indebtedness that was “a means of contribution to [the corporation’s] capital account” did not constitute taxable income to the corporation, Oregon-Washington, 251 F. at 213, was later abrogated by 26 U.S.C. § 108(e)(6), which provides a mechanism for taxing discharge of indebtedness that was acquired by a corporation from a shareholder as a capital contribution. We address the petitioners’ argument that § 108(e)(6) demonstrates that capital contributions constitute “items of income” for the purposes of § 1366(a)(1)(A) below. -13- 1 because it was included in the definition of “gross income” 2 under the Code. Id. at 432-33. The Court found that through 3 its then-existing definition of gross income as “income 4 derived from any source whatever,” Congress intended “to exert 5 in this field ‘the full measure of its taxing power’” and thus 6 to tax “all gains except those specifically exempted” by the 7 Code. Id. at 429-30 (quoting Helvering v. Clifford, 309 U.S. 8 331, 334 (1940)); see also Collins v. Comm’r, 3 F.3d 625, 630 9 (2d Cir. 1993). The Court distinguished the narrow definition 10 of income in Macomber, but in doing so, it was careful to 11 maintain the distinction between capital and income: 12 Nor can we accept respondents’ 13 contention that a narrower reading of [the 14 predecessor of § 61(a)] is required by the 15 Court’s characterization of income in 16 [Macomber], as “the gain derived from 17 capital, from labor, or from both 18 combined.” The Court was there 19 endeavoring to determine whether the 20 distribution of a corporate stock dividend 21 constituted a realized gain to the 22 shareholder, or changed ‘only the form, 23 not the essence,’ of his capital 24 investment. It was held that the taxpayer 25 had ‘received nothing out of the company’s 26 assets for his separate use and benefit.’ 27 The distribution, therefore, was held not 28 a taxable event. In that context— 29 distinguishing gain from capital—the 30 definition served a useful purpose. But 31 it was not meant to provide a touchstone 32 to all future gross income questions. 33 34 Glenshaw Glass, 348 U.S. at 430-31 (emphasis added) (citations 35 omitted). -14- 1 Congress has specifically recognized that capital 2 contributions are not income. In 1954, Congress enacted 3 § 118(a) of the Code, which provides that, “[i]n the case of a 4 corporation, gross income does not include any contribution to 5 the capital of the taxpayer.” Internal Revenue Code of 1954, 6 Pub. L. No. 83-591, ch. 736, § 118(a), 68A Stat. 3, 39. The 7 legislative history of § 118(a) indicates that the purpose of 8 that section was to codify pre-1954 court decisions holding 9 that certain payments to corporations by nonshareholders 10 should be treated as capital contributions and not as income 11 to the corporations, just as shareholder contributions were 12 not treated as income to the corporations. See H.R. Rep. No. 13 83-1337, at 17 (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 14 4042 (noting that § 118(a) “in effect places in the [C]ode the 15 court decisions” on the subject of contributions from 16 “individuals having no proprietary interest in the 17 corporation”); S. Rep. No. 83-1622, at 18 (1954), reprinted in 18 1954 U.S.C.C.A.N. 4621, 4648 (same). While not explicitly 19 listed, the legislative history most likely referred to 20 several Supreme Court cases delineating the boundaries of 21 capital contributions as distinguished from taxable income. 22 Compare Brown Shoe Co. v. Comm’r, 339 U.S. 583, 591 (1950) 23 (holding that payments to entice the location of a 24 corporation’s factories in certain communities were nontaxable -15- 1 capital contributions), with Detroit Edison Co. v. Comm’r, 319 2 U.S. 98, 102-03 (1943) (holding that payments from an electric 3 company’s customers were not contributions to capital) and 4 Texas & Pac. Ry. Co. v. United States, 286 U.S. 285, 289-90 5 (1932) (finding that government subsidies to guarantee a 6 railroad a minimum revenue were not contributions to capital). 7 In 1960, the Internal Revenue Service (“I.R.S.”) 8 promulgated Treasury Regulation section 1.118-1, which notes 9 that § 118(a) applies to capital contributions from both 10 shareholders and nonshareholders. The Regulation provides 11 that “voluntary pro rata payments” to a corporation from its 12 shareholders for the purposes of providing “additional funds 13 for conducting [the corporation’s] business . . . do not 14 constitute income” to the corporation. Treas. Reg. § 1.118-1. 15 This Regulation is entitled to deference by this Court and is 16 fatal to the petitioners’ position. See McNamee v. Dep’t of 17 Treasury, 488 F.3d 100, 106 (2d Cir. 2007) (“Because Congress 18 has delegated to the Commissioner the power to promulgate all 19 needful rules and regulations for the enforcement of [the 20 Code], we must defer to his regulatory interpretations of the 21 Code so long as they are reasonable.” (internal quotation 22 marks and citation omitted)); United States v. Mazza-Alaluf, 23 607 F. Supp. 2d 484, 496 (S.D.N.Y. 2009) (“Chevron deference -16- 1 is warranted for Treasury regulations passed under the 2 authority delegated to it by Congress.”). 3 The petitioners’ argument that capital contributions 4 constitute “tax-exempt income,” despite the traditional 5 treatment of capital contributions as distinct from income, is 6 centered on the relatively recent Gitlitz case. In Gitlitz, 7 the petitioners were shareholders of an insolvent 8 S corporation that realized a discharge of indebtedness. 531 9 U.S. at 210. The S corporation excluded the discharge of 10 indebtedness amount from taxable income pursuant to 26 U.S.C. 11 § 108(a)(1)(B) and (d)(7)(A), which excludes discharge of 12 indebtedness from gross income if the taxpayer is insolvent. 13 Id. The petitioners then increased their bases in the 14 corporation’s stock by their pro rata share of the discharge 15 of indebtedness under the theory that it was an “item of 16 income [including tax-exempt income],” to the corporation 17 pursuant to § 1366(a)(1)(A). Id. The Commissioner contended 18 that the Code’s exclusion of discharge of indebtedness from 19 the gross income of insolvent taxpayers meant that the 20 discharge of indebtedness at issue was no longer an “item of 21 income” for the purposes of § 1366(a)(1)(A) and could not be 22 used to increase the petitioners’ bases. Id. at 213. 23 The Supreme Court upheld the taxpayers’ treatment of the 24 discharge of indebtedness, holding that § 108(a)’s exclusion -17- 1 of certain discharge of indebtedness income from gross income 2 does not change its fundamental character as an “item of 3 income.”7 Id. at 214. The Court noted that § 61(a)(12) 4 explicitly provides that discharge of indebtedness generally 5 is included in gross income. Id. at 213. The Court reasoned 6 that while §§ 101 through 136 exclude certain items from gross 7 income, the “mere exclusion of an amount from gross income 8 does not imply that the amount ceases to be an item of 9 income.” Id. The Court also stated that “[i]f discharge of 10 indebtedness of insolvent entities were not actually ‘income,’ 11 there would be no need to provide an exception to its 12 inclusion in gross income.” Id. at 214. 13 The petitioners argue that, based on the reasoning in 14 Gitlitz, there would be no need to exclude capital 15 contributions from gross income, as § 118(a) does, if capital 16 contributions were not already included in gross income 17 pursuant to § 61(a). The petitioners argue that, therefore, 18 capital contributions are fundamentally income and constitute 7 The Supreme Court acknowledged that the result of Gitlitz would be to allow shareholders a “double windfall”: The corporation’s discharge of indebtedness income would be excluded and not passed through as taxable income and the shareholders would be able to increase their bases in stock. Gitlitz, 531 U.S. at 219-20. However, the Court found that the result was required by the “plain text” of the Code. Id. at 220. After Gitlitz was decided, Congress added language to § 108(d)(7)(A) barring the pass-through of excluded discharge of indebtedness income to the shareholders of S corporations and eliminating the resulting increase in basis: “In the case of an S corporation, subsections (a), (b), (c), and (g) shall be applied at the corporate level, including by not taking into account under section 1366(a) any amount excluded under subsection (a) of this section.” Job Creation and Worker Assistance Act of 2002, Pub. L. No. 107-147, § 402(a), 116 Stat. 21, 40. -18- 1 “items of income (including tax-exempt income)” for the 2 purposes of § 1366(a)(1)(A). This argument ignores the 3 critical difference between Gitlitz and this case: Gitlitz 4 addressed payments that explicitly were included in gross 5 income under § 61(a). See § 61(a)(12) (“[G]ross income means 6 all income . . . including (but not limited to) . . . (12) 7 [i]ncome from discharge of indebtedness . . . .”). While the 8 petitioners are correct that the list of items of income in 9 § 61(a) is not exclusive, the petitioners cannot rely on 10 Gitlitz alone to overcome the long-standing treatment of 11 capital contributions as distinct from income. Gitlitz did 12 not create any new items of income. Gitlitz only held that 13 the nature of discharge of indebtedness as income was not 14 changed by the exclusion in § 108(a). 15 Unlike this case, the Commissioner in Gitlitz admitted 16 that the item at issue—discharge of indebtedness—generally was 17 included in gross income, but argued that the exclusion of 18 discharge of indebtedness of insolvent entities in § 108(a) 19 altered the character of that item. It was only in rejecting 20 this argument that Gitlitz noted that it would be unnecessary 21 to exclude discharge of indebtedness of insolvent entities 22 from gross income if discharge of indebtedness in general were 23 not already income. In this case, capital contributions 24 traditionally have not been included in gross income in the -19- 1 first instance and the fact that § 118(a) explicitly excludes 2 them does not transform them into “items of income” for the 3 purposes of § 1366(a)(1)(A). 4 The petitioners’ view of the superfluous nature of 5 § 118(a) is belied by the legislative history of that section. 6 The legislative history of § 118(a) shows that, unlike 7 discharge of indebtedness, Congress did not consider 8 shareholder capital contributions to be generally includible 9 in gross income when it created the exclusion. See State Farm 10 Road Corp. v. Comm’r, 65 T.C. 217, 227 (1975) (noting that 11 § 118 was “intended as an incorporation of existing decisional 12 law”). As discussed above, § 118(a)’s exclusion of “any 13 contribution to the capital of the taxpayer” (emphasis added) 14 was intended to codify certain cases finding that 15 nonshareholder, in addition to shareholder, capital 16 contributions were not income. Treasury Regulation section 17 1.118-1 underscores this understanding of § 118(a) by 18 explicitly stating that both shareholder and nonshareholder 19 capital contributions “do not constitute income” to a 20 corporation. 21 In addition to their argument based on Gitlitz and § 118, 22 the petitioners argue that § 108(e)(6) demonstrates that 23 capital contributions constitute income. Section 108(e)(6) 24 provides a mechanism for taxing the discharge of any -20- 1 indebtedness that was acquired by a corporation as a capital 2 contribution. Section 108(e)(6) provides that 3 for purposes of determining income of the debtor 4 from discharge of indebtedness, if a debtor 5 corporation acquires its indebtedness from a 6 shareholder as a contribution to capital— 7 (A) section 118 shall not apply, but 8 (B) such corporation shall be treated as having 9 satisfied the indebtedness with an amount of money 10 equal to the shareholder’s adjusted basis in the 11 indebtedness. 12 13 The petitioners argue that because § 108(e)(6) allows for 14 discharge of indebtedness acquired as a capital contribution 15 to be taxed as income to the corporation, capital 16 contributions must be “items of income” for the purposes of 17 § 1366(a)(1)(A). However, discharge of indebtedness is 18 explicitly included in gross income in § 61(a)(12) and, under 19 Gitlitz, is an “item of income” for the purposes of 20 § 1366(a)(1)(A) even when it is exempt from taxation. The 21 fact that Congress chose, when confronted with the confluence 22 of discharge of indebtedness, which is income, and capital 23 contributions, which traditionally have not been considered 24 income, to subject discharge of indebtedness acquired as a 25 capital contribution to taxation does not mean that capital 26 contributions that are not discharge of indebtedness -21- 1 constitute “items of income (including tax-exempt income)” for 2 the purposes of § 1366(a)(1)(A).8 3 We are not aware of any case that has held that capital 4 contributions are “income” under § 1366(a)(1)(A) or any other 5 provision of the Code. On the contrary, the Supreme Court and 6 this Court have repeatedly emphasized the distinction between 7 capital and income. See, e.g., Macomber, 252 U.S. at 214-15; 8 Cuba R.R., 268 U.S. at 632-33; Oregon-Washington, 251 F. at 9 213. The petitioners argue that Glenshaw Glass has overruled 10 the earlier cases’ treatment of capital as distinct from 11 income because it rejected Macomber’s definition of income as 12 “‘the gain derived from capital, from labor, or from both 13 combined.’” Glenshaw Glass, 348 U.S. at 430-31 (quoting 14 Macomber, 252 U.S. at 207). However, the decision in Glenshaw 15 Glass was founded on “the intention of Congress to tax all 16 gains except those specifically exempted.” Glenshaw Glass, 17 348 U.S. at 430. In deciding that the punitive damages at 18 issue in that case were a taxable gain, even though not 19 derived from capital or labor, Glenshaw Glass did not overrule 20 the previous cases’ distinction between capital and income. 8 The legislative history of § 108(e)(6) indicates that it was enacted to override the decision of the Court of Appeals for the Fifth Circuit in Putoma Corp. v. Commissioner, 601 F.2d 734, 751 (5th Cir. 1979), which held that a shareholder’s discharge of indebtedness acquired by the corporation as a capital contribution was not taxable income to the corporation because it was a capital contribution. S. Rep. No. 96-1035, at 18-19, 56 n.24 (1980), reprinted in 1980 U.S.C.C.A.N. 7017, 7033-34, 7068 n.24. -22- 1 On the contrary, Glenshaw Glass recognized that Macomber’s 2 definition of income was “useful” in that case precisely 3 because it “distinguish[ed] gain from capital.” Id. at 431. 4 Capital contributions are not gains to a corporation. Rather, 5 they “represent an additional price paid for[] the shares of 6 stock held by the individual shareholders” of a corporation, 7 and are treated as a part of the operating capital of the 8 company. Treas. Reg. § 1.118-1. 9 In arguing that Glenshaw Glass erased the traditional 10 distinction between capital contributions and income, the 11 petitioners also rely on an I.R.S. General Counsel Memorandum 12 dated December 21, 1977 (the “Memorandum”), which addressed 13 whether certain nonshareholder contributions made to a public 14 utility constituted excludable capital contributions under 15 § 118(a) or constituted taxable income to the utility. The 16 Memorandum concluded that because the contributions were 17 motivated by the nonshareholder’s desire to obtain a more 18 reliable source of electric power, the amounts were taxable 19 income, not contributions to capital. In providing a history 20 of the taxation of nonshareholder capital contributions, the 21 Memorandum noted that “the constitutional basis” of Cuba 22 Railroad “seems to have been considerably weakened” by 23 Glenshaw Glass and its progeny. I.R.S. Gen. Couns. Mem. 24 37,354 (Dec. 21, 1977) (citing State Farm Road Corp., 65 T.C. -23- 1 at 227). The Memorandum explained that payments like those 2 made by the Cuban government to the railroad “can no longer be 3 characterized as falling outside the scope of gross income 4 within the meaning of Code § 61.” I.R.S. Gen. Couns. Mem. 5 37,354 (Dec. 21, 1977). Rather, according to the Memorandum, 6 those payments would be part of a “new class of tax-exempt 7 transactions, called contributions to capital, that was 8 codified in 1954 as Code § 118.” Id. 9 I.R.S. General Counsel Memoranda are informal documents 10 written by the I.R.S. Chief Counsel’s office. They provide 11 the Chief Counsel’s opinion on particular tax matters before 12 other I.R.S. officials. The Memorandum at issue in this case 13 includes a disclaimer that it is “not to be relied upon or 14 otherwise cited as precedent by taxpayers.” Id. As a result, 15 the Memorandum is not entitled to deference under Chevron 16 U.S.A. Inc. v. National Resources Defense Council, Inc., 467 17 U.S. 837 (1984), because it is an informal letter that itself 18 renounces any force-of-law effect.9 See United States v. Mead 9 In Morganbesser v. United States, 984 F.2d 560, 563 (2d Cir. 1993) (quoting Herrmann v. E.W. Wylie Corp., 766 F. Supp. 800, 802-03 (D.N.D. 1991)), this Court noted that “[General Counsel Memoranda] are helpful in interpreting the Tax Code when ‘faced with an almost total absence of case law.’” The Court, therefore, found it “arguably permissible” to use General Counsel Memoranda (“GCMs”) to “instruct the court on how the [I.R.S.] itself” defines “labor organization,” because they were “the only real guidance as to what the [I.R.S.] considers a labor organization for the purposes” of the Code. Id. Courts of Appeals in other circuits have declined to rely on GCMs. See Tupper v. United States, 134 F.3d 444, 448 & n.5 (1st Cir. 1998) (“GCMs . . . are not authority in this court.”); Stichting Pensioenfonds Voor de Gezondheid v. United States, 129 F.3d 195, -24- 1 Corp., 533 U.S. 218, 226-27 (2001) (holding that Chevron 2 deference is appropriate “when it appears that Congress 3 delegated authority to the agency generally to make rules 4 carrying the force of law, and that the agency interpretation 5 claiming deference was promulgated in the exercise of that 6 authority”); Christensen v. Harris County, 529 U.S. 576, 587- 7 88 (2000) (holding that agency interpretations contained in 8 informal opinion letters are not entitled to Chevron 9 deference). Any “respect” afforded to the Memorandum would 10 only be proportional to its “power to persuade” pursuant to 11 Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944). 12 Christensen, 529 U.S. at 587. 13 In this case, we decline to rely on the Memorandum 14 because it disclaims precedential effect and is not entitled 15 to deference under Chevron. Furthermore, the persuasiveness 16 of the Memorandum is limited in light of the fact that the 17 Memorandum does not address the question whether capital 18 contributions such as those in this case constitute “tax- 19 exempt income” for the purposes of § 1366(a)(1)(A). The 20 Memorandum, like Cuba Railroad, deals only with nonshareholder 21 capital contributions, the scope of which has been clarified 22 by several Supreme Court decisions following Cuba Railroad. 200 (D.C. Cir. 1997) (“These ‘GCMs,’ however, have no precedential value.”); Disabled Am. Veterans v. Comm’r, 942 F.2d 309, 315 n.5 (6th Cir. 1991) (“Such informal, unpublished opinions of attorneys within the [I.R.S.] are of no precedential value . . . .”). -25- 1 See, e.g., Brown Shoe Co., 339 U.S. at 591-93; Detroit Edison 2 Co., 319 U.S. at 103. 3 Finally, the petitioners point to two cases from Courts 4 of Appeals in other circuits that allegedly show that capital 5 contributions constitute income. In one case, the Court of 6 Appeals for the Seventh Circuit referred to “tax-exempt 7 capital contributions.” Am. Med. Ass’n v. United States, 887 8 F.2d 760, 774 (7th Cir. 1989). In the other, the Court of 9 Appeals for the Ninth Circuit addressed whether certain 10 payments were “exempt from federal income tax as contributions 11 to capital.” Washington Athletic Club v. United States, 614 12 F.2d 670, 671 (9th Cir. 1980). The petitioners argue that 13 because the above cases referred to capital contributions as 14 being “exempt” from income, these cases demonstrate that 15 capital contributions are “tax-exempt income” for the purposes 16 of § 1366(a)(1)(A). However, these cases did not hold that 17 capital contributions constitute income. Rather, they 18 discussed, among other things, whether certain membership fees 19 paid to associations constituted capital contributions or 20 taxable income. The fact that these cases may have used 21 imprecise language to express the fact that capital 22 contributions are not subject to taxation does not mean that -26- 1 capital contributions are income.10 In fact, American Medical 2 Association explicitly recognized the distinction between 3 capital contributions and income when it noted that if the 4 plaintiff in that case argued that certain funds it received 5 “should be likened to capital contributions, it would argue 6 that those monies should never be considered income.” Am. 7 Med. Ass’n, 887 F.2d at 774 n.15. 8 Therefore, for all of these reasons, we find that the 9 petitioners’ capital contributions do not constitute “items of 10 income (including tax-exempt income)” under § 1366(a)(1)(A) 11 and cannot be used to restore their bases in indebtedness 12 pursuant to § 1367(b)(2)(B). 13 III 14 As an alternative to using their capital contributions to 15 increase their loan bases and thereby reduce their taxable 16 income, the petitioners argue that they should be allowed to 17 deduct their capital contributions to G & D Farms as losses 18 incurred in a transaction entered into for profit pursuant to 19 § 165(c)(2). The petitioners do not argue that their capital 20 contributions to W & N California should be deductible. 10 It is difficult to place too much emphasis on the specific language in those decisions. In calculating taxable income, in most circumstances, there is no difference between the case where an item is included in gross income pursuant to § 61(a) and then excluded from gross income by another Code section and the case where the item is not includible under § 61(a) at all. -27- 1 Section 165(c)(2) provides that individuals are allowed a 2 deduction from taxable income for “losses incurred in any 3 transaction entered into for profit, though not connected with 4 a trade or business.” In general, a negotiated payment to 5 secure a release from conditional liability under a loan 6 guarantee is deductible as a loss incurred in a transaction 7 entered into for profit. See, e.g., Duke v. United States, 8 No. 75 Civ. 5122, 1977 WL 1082, at *2 (S.D.N.Y. Jan. 31, 9 1977); Shea v. Comm’r, 36 T.C. 577, 582 (1961), aff’d, 327 10 F.2d 1002 (5th Cir. 1964); Lloyd-Smith v. Comm’r, 40 B.T.A. 11 214, 223 (1939), aff’d on other grounds, 116 F.2d 642 (2d Cir. 12 1941). 13 “This court has repeatedly held that, in determining the 14 deductibility of a loss, the primary motive must be 15 ascertained and given effect.” Austin v. Comm’r, 298 F.2d 16 583, 584 (2d Cir. 1962); see also Helvering v. Nat’l Grocery 17 Co., 304 U.S. 282, 289 n.5 (1938) (“[T]he deductibility of 18 losses under [the predecessor of § 165(c)] may depend upon 19 whether the taxpayer’s motive in entering into the transaction 20 was primarily profit.”); Ewing v. Comm’r, 213 F.2d 438, 439 21 (2d Cir. 1954). The burden of proving the requisite motive is 22 on the petitioners. Cf. Sutton v. Comm’r, 84 T.C. 210, 221 23 (1985), aff’d, 788 F.2d 695 (11th Cir. 1986). -28- 1 Instead of looking to the “primary motive,” some courts 2 have attempted to ascertain whether the “sole purpose” of a 3 taxpayer’s payment was to secure a release from a loan 4 guarantee before allowing the taxpayer to take a deduction 5 pursuant to § 165(c)(2). See Duke, 1977 WL 1082, at *2; Shea, 6 36 T.C. at 582; Lloyd-Smith, 40 B.T.A. at 223. In Duke, the 7 court denied the taxpayers’ motion for summary judgment 8 because it could not determine if their payment was for the 9 “sole purpose” of securing a release from a guarantee or 10 rather was the purchase price of a capital asset. Duke, 1977 11 WL 1082, at *2. 12 In this case, the Tax Court found that the petitioners 13 “clearly had multiple purposes in making the[ir] capital 14 contributions,” and, therefore, distinguished this case from 15 those that allowed deductions upon finding that payments were 16 made for the “sole purpose” of obtaining releases from loan 17 guarantees. Nathel, 131 T.C. at 274. The Tax Court noted 18 that the parties stipulated that the Nathels made the 19 contributions in connection with the banks’ release of the 20 petitioners’ guarantees, in connection with Mr. Wishnatzki’s 21 assumption of responsibility as a guarantor, and to obtain Mr. 22 Wishnatzki’s agreement to the reorganization plan. Id. The 23 Tax Court found that, therefore, the petitioners did not make 24 the contributions for the “sole purpose of being released from -29- 1 their guarantees on the bank loans” and, as a result, it found 2 that the contributions were not deductible pursuant to 3 § 165(c)(2). Id. at 274-75. 4 To the extent the Tax Court required the capital 5 contributions to be for the sole purpose of obtaining releases 6 from the loan guarantees, the Tax Court required too much. 7 The capital contributions need only have been made for the 8 primary purpose of obtaining the releases in order to be 9 deductible as losses incurred in a transaction entered into 10 for profit. However, the Tax Court’s error was harmless 11 because the petitioners did not meet their burden of showing 12 that the primary purpose of the contributions was to obtain 13 the releases from the guarantees. 14 The petitioners argue that the parties’ stipulation 15 before the Tax Court proves that the capital contributions 16 were made for the primary purpose of obtaining the releases. 17 The petitioners point to paragraph 26 of the stipulation, 18 which provides that “[a]s a condition for releasing [the 19 Nathels] from their guarantees of [G & D Farms’] debt, the 20 Banks and [Mr. Wishnatzki] required [the Nathels] to each 21 contribute to [G & D Farms] additional capital in the amount 22 of $537,228.00.” (Stip. ¶ 26.) The petitioners also rely on 23 paragraph 34 of the stipulation, which provides that the 24 Nathels’ capital contributions to G & D Farms “were made -30- 1 . . . to secure the release of their respective guarantees of 2 [G & D Farms’] debts to the Banks and to obtain [Mr. 3 Wishnatzki’s] agreement to the release of the Nathels from 4 their guarantees and to the reorganization plan.” (Stip. ¶ 34 5 (emphasis added).) 6 While paragraph 26 of the stipulation states that the 7 capital contributions were a condition of the petitioners’ 8 release from their loan guarantees, there is no stipulation 9 that the primary purpose of the contributions was to obtain 10 that release. Paragraph 34 of the stipulation provides that 11 the capital contributions were made for three purposes: (1) 12 to secure the petitioners’ release from the guarantees of 13 G & D Farms’ debts, (2) to obtain Mr. Wishnatzki’s agreement 14 to the release of the Nathels from the guarantees, and (3) to 15 obtain Mr. Wishnatzki’s agreement to the reorganization plan. 16 The stipulation, therefore, suggests that the capital 17 contributions were made to achieve multiple purposes, without 18 indicating which, if any, was the primary purpose. 19 The petitioners point to several cases that demonstrate 20 that payments can have multiple purposes and still be 21 deductible under § 165(c)(2). The petitioners argue that 22 these cases show that the capital contributions here are 23 deductible. The petitioners read too much into these cases. 24 In Rushing v. Comm’r, 58 T.C. 996, 1000-01, 1005 (1972), the -31- 1 Tax Court distinguished between two payments the taxpayers 2 attempted to deduct: legal expenses connected with the 3 petitioners’ personal guarantee of a corporation’s debt, which 4 the court found to be deductible, and other fees related to 5 the sale of the corporation’s assets, which it found to be not 6 deductible. Rushing simply demonstrates that if a court can 7 determine that the principal purpose of any one of a number of 8 payments was in connection with a transaction entered into for 9 profit, then the payment may be deducted pursuant to 10 § 165(c)(2). In this case, it cannot be determined what 11 portion of petitioners’ capital contributions, if any, was 12 principally made to obtain the petitioners’ release from the 13 guarantees. 14 The petitioners also point to a case from another 15 circuit, Commissioner v. Condit, 333 F.2d 585, 587-88 (10th 16 Cir. 1964), in which the court found that the taxpayer 17 “attained three objectives” through making a certain payment, 18 including obtaining a release on a loan guarantee, settling a 19 debt with the payee, and transferring the responsibility for 20 winding up a business. The court found that the taxpayer’s 21 payment “was not the payment of a debt within the purview of 22 [26 U.S.C.] § 166(d) but rather a loss incurred in a 23 transaction for profit.” Id. at 588. To the extent that the 24 court in Condit found that the payment had no primary purpose, -32- 1 but nevertheless was deductible pursuant to § 165(c)(2), it is 2 inconsistent with prior decisions of this Court and we decline 3 to follow it. 4 In addition to relying on the parties’ stipulations 5 regarding the purposes of the capital contributions, the 6 petitioners argue that the fact that G & D Farms and W & N New 7 York “were sold for each corporation’s fair market value” to 8 Mr. Wishnatzki and the Nathels, respectively (Stip. ¶ 46), 9 illustrates that the petitioners’ capital contributions to 10 G & D Farms could not have been part of the price the Nathels 11 paid to obtain Mr. Wishnatzki’s agreement to the sale of the 12 companies. The petitioners argue that, therefore, the primary 13 purpose of the capital contributions was to obtain the 14 petitioners’ release from the loan guarantees. However, there 15 is no reason to believe that the petitioners’ capital 16 contributions were not part of the “fair market value” price 17 for which the corporations were sold as part of the 18 reorganization plan. 19 In their reply brief, the petitioners argue for the first 20 time that their capital contributions were made in connection 21 with a transaction entered into for profit because, as 22 shareholders of both G & D Farms and W & N New York at the 23 time, they signed their personal guarantees of G & D Farms’ 24 loans in order to improve the financial position of both -33- 1 corporations, in light of the fact that W & N New York’s 2 business allegedly was dependent on receiving produce from 3 G & D Farms. However, the Commissioner does not contest that 4 the Nathels’ personal guarantees of G & D Farms’ loans 5 constituted a transaction entered into for profit. The 6 question is whether the primary purpose of the Nathels’ 7 subsequent capital contributions was to obtain releases from 8 the loan guarantees. The fact that the Nathels expected the 9 guarantees to benefit G & D Farms and W & N New York does not 10 establish the primary purpose of the Nathels’ capital 11 contributions. 12 The petitioners did not meet their burden of showing that 13 the capital contributions were primarily motivated by a desire 14 to obtain releases from the loan guarantees. Therefore, the 15 capital contributions are not deductible as losses incurred in 16 a transaction entered into for profit pursuant to § 165(c)(2). 17 CONCLUSION 18 For all of the reasons explained above, we AFFIRM the Tax 19 Court’s decision. -34-