S corporation can deduct suspended PALs incurred while a C corporation.
Sec. 469(a) disallows PALs incurred by individuals, estates, trusts and personal service corporations. PALs cannot be deducted against active or portfolio income. The PAL rules also apply to closely held C corporations. Closely held C corporations can deduct PALs from active, but not portfolio, income. A C corporation is closely held for purposes of the PAL rules if, at any time during the tax year, more than 50% of the value of its outstanding stock is owned, directly or indirectly, by five or fewer individuals.
Under Sec. 469(b), PALs disallowed under Sec. 469(a) are treated as deductions or credits allocable to the activity in the next tax year. The disallowed losses are suspended until they can be used against passive income (passive or active income in the case of a closely held C corporation). However, under Sec. 469(g)(1), disallowed losses can be used in full when the passive activity to which they apply is disposed of in a taxable transaction. On disposition, suspended PALs are first used against income from the activity, then against income from other passive activities. If any suspended PALs remain, they are treated as nonpassive and can be offset against other income.
The taxpayer in St. Charles Investment Co. was a closely held C corporation subject to the PAL rules. It operated several rental real estate properties during 1988, 1989 and 1990, which produced several million dollars of PALs. The PALs attributable to each of the taxpayer's rental activities were disallowed under Sec. 469(a) and treated, under Sec. 469(b), as allocable to the activities in the next tax year.
The taxpayer elected S status effective Jan. 1, 1991. It sold several of its rental activities in 1991. On its 1991 S return, the taxpayer deducted suspended PALs allocable to the activities sold under Sec. 469(g)(1). On audit, the Service disallowed these deductions, based on Sec. 1371(b)(1), which provides that "[n]o carryforward, and no carryback, arising for a taxable year for which a corporation is a C corporation may be carried to a taxable year for which such corporation is an S corporation."
The Tax Court upheld the IRS's position. The Tax Court reviewed the legislative history of Secs. 469 and 1371, and held PALs were carryforwards within the meaning of Sec. 1371(b)(1) and therefore could not be used in an S year. Because it found that the legislative history of Sec. 1371(b) supports a broad interpretation of the term "carryforward," the Tax Court held that carryforward (as used in Sec. 1371(b)) means the same as "shall be treated as a deduction ... allocable to such activity in the next taxable year" (as used in Sec. 469(b)).
The Tax Court also held that the taxpayer could not increase the basis of the sold properties by the depreciation portion of the suspended PALs. The fact that the PALs were disallowed was irrelevant.
The Tenth Circuit viewed the issue as one of statutory construction and held that Sec. 469 precludes application of Sec. 1371(b)(1) to the suspended PALs. Therefore, the suspended PALs generated while the taxpayer was a C corporation were deductible on its S return. Because they ruled in the taxpayer's favor, the court did not address the issue of whether the taxpayer could increase the basis of the sold properties by the depreciation portion of the Suspended PALs.
The court's analysis began (and ended) with the plain meaning of the statute. The court used Sec. 469(.b) and the general rule of statutory construction followed in Goldbaum, 879 F2d 811 (10th Cir. 1989); under this rule, if a statute specifies exceptions to its general application, other exceptions not specifically mentioned are excluded. Under Sec. 469(b),"[E]xcept as otherwise provided in this section, any loss or credit from an activity which is disallowed under subsection (a) shall be treated as a deduction or credit allocable to such activity in the next taxable year." (Emphasis added.) Because Sec. 469(b) states that the only exceptions to its general rule are those enumerated in Sec. 469, Sec. 1371(b)(1)'s restriction on carryforwards has no effect. It was not enumerated in Sec. 469. The suspended losses are treated, under Sec. 469(b), as a deduction allocable to the activity in the next tax year, and are deductible in the year the property is disposed of under Sec. 469(g)(1).
The Court cited a previous application of this rule in a tax context in support of its position. In O'Gilvie, 66 F3d 1550 (10th Cir. 1995), the "except as otherwise provided in this subtitle" language of Sec. 61 was held to preclude exceptions from gross income for items not specifically appearing in the subtitle. Applying this rule to Sec. 469, the prohibition of carryforwards from a C to an S year does not apply to suspended PALs, because it does not appear in Sec. 469.
The court also relied on Sec. 469(f)(2) in reaching its decision. Under this section, if a taxpayer ceases to be a closely held C corporation, Sec. 469 shall continue to apply to losses and credits to which it applied for any preceding tax year in the same manner as if the taxpayer continued to be a closely held C corporation. Because of Sec. 469(f)(2), Sec. 469 applies to the suspended PALs in 1991 as if the taxpayer had continued its C status. The PALs are deductible subject only to Sec. 469's limits.
Although the Tenth Circuit rejected the Service's argument that the language of Sec. 1371(b)(1) was broad enough to cover suspended PALs, it acknowledged its concern that the result reached creates a windfall by allowing one taxpayer (the shareholder) to offset his income with losses of another taxpayer (the corporation). The court found, however, that the statutory language of Sec. 469 unequivocally requires the result reached.
S corporations now have authority to deduct suspended PALs incurred while a C corporation. Practitioners, especially those with clients in the Tenth Circuit, should consider the impact of this decision. If suspended PALs were not deducted when the activity was disposed of (perhaps because of the Tax Court's 1998 decision), an amended return may be appropriate. If an amended S return is filed, amended returns for all shareholders with sufficient basis in their S stock to use the losses on their individual returns should also be filed.
The Tenth Circuit's decision in St. Charles Investment Co. also makes it possible for the owners of closely held C corporations engaged in passive activities to transfer suspended PALs to themselves by electing S status and disposing of the properties to which the suspended PALs are allocable. The restriction limiting the deduction of losses to a shareholder's basis in his S stock, however, has to be considered. In addition, the issue may not be completely settled. The Tenth Circuit is the only circuit to rule on this issue. The Service has not yet acquiesced in the decision, and may well pursue the issue in other circuits.
FROM TIMOTHY R. KOSKI, PH.D., CPA, LL.M., UNIVERSITY OF SOUTHERN INDIANA, EVANSVILLE, IN (NOT AFFILIATED WITH SUMMIT INTERNATIONAL ASSOCIATES, INC.)
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|Publication:||The Tax Adviser|
|Date:||Aug 1, 2001|
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