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Suspended PALs from C years could be deducted in S election year.

Before 1991, the T Corporation was a closely held C corporation. During 1988-1990, T had been engaged in the real estate rental business. During these years, T had passive activity losses (PALs) that were nondeductible under Sec. 469(a).

T made an S election in 1991. T also sold several of its rental properties for which there were suspended PALs. On its 1991 return, T claimed a deduction for the PALs that had been suspended.

The IRS disallowed these deductions, citing Sec. 1371(b)(1). The Tax Court held for the Service, but the Court of Appeals (opinion Tacha, J.) reverses; Sec. 1371(b)(1) does not preclude T's deduction of suspended PALs incurred when T was a closely held C corporation.

Congress made Sec. 1371 (b) a part of subchapter S in 1982 to prevent corporate losses incurred prior to electing S status from benefiting the corporation's shareholders after an S election. Four years later, Congress enacted Sec. 469 out of concern that taxpayers were "front-loading" deductions arising from activities in which they did not participate (passive activities) and using those deductions to reduce other income. Sec. 469, therefore, is a comprehensive, "cradle-to-the-grave" statutory scheme governing gain and loss from passive activities. Sec. 469 allows taxpayers to deduct PALs only to the extent they have passive activity gains. Any remaining PAL is suspended and carried over to the next year, again becoming available to offset passive activity gains. Only on the disposition of the passive activity does the entire PAL (including the suspended PALs from previous years) become available as a deduction against both passive activity gains and other, ordinary income.

The dispute centers on the conflict between Secs. 469(b) and 1371(b)(1). Sec. 469(b) states "[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." Sec. 1371(b)(1), on the other hand, 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." Which section governs the treatment of suspended PALs after a corporate changeover from a C to an S year? Either the language of Sec. 469(b) functions as a statutory "traffic cop," preventing any provision of the Code outside of Sec. 469 from negating the general rule of Sec. 469(b), or Sec. 1371 (b) (1)'s clear prohibition on carryovers effectively trumps the general rules of Sec. 469.

Sec. 469(b) sets forth the general rule that PALs nondeductible pursuant to Sec. 469(a) shall be "suspended" and treated as deductions in the following year. The only exceptions to this general rule are those enumerated in Sec. 469--namely, the limitation on deductibility found in Sec. 469(a).We hold that the "except as otherwise provided in this section" language of Sec. 469(b) prevents the application of unenumerated exceptions to the statute's general rule. Because Sec. 1371's restrictions on carryforwards from a C to an S year are not enumerated in Sec. 469, they have no effect on the operation of Sec. 469(b); T's suspended PALs from 1988-1990 are deductible in 1991, subject only to Sec. 469.

Evidence that Congress intended this result can be found in Sec. 469(f) (2), which states "[i]f a taxpayer ceases for any taxable year to be a closely held C corporation or personal service corporation, this section shall continue to apply to losses and credits to which this section applied for any preceding taxable year in the same manner as if such taxpayer continued to be a closely held C corporation or personal service corporation, whichever is applicable." Thus, Sec. 469 applies to T's suspended PALs in 1991 as if T had continued in its C status.

There is nothing in the statutory language to support the Service's assertion that Sec. 469(f)(2) was not intended to apply to a C corporation that later becomes an S corporation. When a corporation goes from a closely held C to an S corporation, it has "cease[d] ... to be a closely held C corporation" within the meaning of Sec. 469(f)(2), and Sec. 469 shall apply to its PALs as if it remained a closely held C corporation. The language of Sec. 469(b) (which seals off its general rule from exceptions outside Sec. 469), along with the provisions of Sec. 469(f)(2) (which allows the application of Sec. 469 to a corporation's PALs even after it ceases to be a closely held C corporation), gives ample reason to conclude that T's suspended PALs did carry over to 1991 and were deductible subject only to the limits contained in Sec. 469.

The IRS argues that, even if Sec. 469(b) restricts the application of Sec. 1371(b)(1), Sec. 469(g)(1)(a) transforms a PAL into a net operating loss (NOL) on the disposition of the passive activity, thus removing the loss from the ambit of Sec. 469. Sec. 469 (g) (1) (A) provides:

If all gain or loss realized on such disposition is recognized, the excess of (i) any loss from such activity for such taxable year (determined after the application of subsection (b)), over (ii) any net income or gain for such taxable year from all other passive activities (determined after the application of subsection (b)), shall be treated as a loss which is not from a passive activity.

Thus, the Service urges that once the loss becomes nonpassive, it can only be an NOL, which is not governed by Sec. 469. Therefore, there is nothing to prevent it from being subject to the restrictions of Sec. 1371 (b) (1). It is clear that Sec. 1371(b)(1) does prohibit the carryover of NOLs from a C to an S year. T responds that, on disposition, the excess of the PAL overall passive activity gain does not become an NOL merely by virtue of it becoming nonpassive. T argues that the nonpassive loss contemplated by Sec. 469(g)(1)(A) is more akin to an accounting device used to govern the timing of deductions.

The focus of the parties on whether Sec. 469(g)(1)(A) creates an NOL misses the point. First, the language "shall be treated as a loss which is not from a passive activity" was not intended to create an NOL. Should Congress have wished to create an NOL, it knew how to do so explicitly. More importantly, however, the IRS's argument ignores the fundamental issue of timing. Even if we were to agree with the Service that, on the application of Sec. 469 (g) (1) (A), an NOL was created, the prohibition of Sec. 1371(b)(1) against carrying forward an NOL still would not apply. Sec. 469(g)(1)(A), by its own language, does not take effect until after the application of Sec. 469(b). This is the key point. Thus, at the time the loss is "carried over," it is still passive. It is only after the PAL arrives in the current tax year that it becomes nonpassive under Sec. 469(g)(1)(A). Once the suspended PALs have cleared the carryover hurdle of Sec. 1371(b)(1) via Sec. 469(b), there remains nothing in subchapter S to prevent their deduction as nonpassive losses--regardless of whether they are characterized as NOLs or something else entirely.

T's suspended PALs from 1988-1990 are carried over to 1991 under Sec. 469(b) and (f)(2). Further, those suspended PALs associated with the activities disposed of in 1991 are fully deductible under Sec. 469(g)(1)(A).

ST. CHARLES INVESTMENT CO., 10TH CIR., 11/14/00, REV'G 110TC 46 (1998)
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Article Details
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Title Annotation:passive activity losses; C and S corporations
Author:Fiore, Nicholas J.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jan 1, 2001
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