TENTH CIRCUIT COURT OF APPEALS SUPPORTS PALS.
The court reversed a decision involving the collision of IRC section 1371, which effectively prohibits losses incurred by C corporations that later convert to S status, and IRC section 469, which suspends the utilization of passive losses until they are either netted against passive income or allowable in the year of disposition of the passive activity.
Before 1991, St. Charles Investment Co. was a closely held C corporation engaged in a rental real estate business that constituted a passive activity within the meaning of IRC section 469(c). Since IRC section 469(b) provides for the carryforward of suspended losses generated from years in which expenses exceed income, St. Charles did so with the intention of utilizing them either when income was generated or when a complete disposition was triggered, whichever came first.
Effective January 1991, St. Charles elected S status. During the year, the corporation sold several rental properties with suspended passive activity losses (PALs). On its 1991 income tax return, St. Charles identifled the suspended PALs and deducted them in full under IRC section 469(g)(1)(A) It also deducted the appropriate suspended alternative minimum tax passive activity losses. The IRS issued a determination disallowing all losses incurred during the corporation's C period, citing IRC section 1371(b)(l). The Tax Court agreed with the IRS, but the 10th Circuit decided that IRC section 469(b) takes precedence over IRC section 1371(b)(1). The language and reasoning of the decision acknowledged that the issue before them "in so far as we can determine, has not been addressed in any other circuit."
Holding and Reasoning
The appeals court reasoned that the crux of the dispute was the conflict between the carryforward provisions of IRC sections 1371(b)(l) and 469(b). IRC section 469(b) states that "except 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." IRC section 1371(b)(1), on the other hand, provides that "no 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 court held that the plain language of IRC section 469 acts to prevent any other provision of the tax code from negating its appropriate application. As such, it distinguished the "except as otherwise provided in this section" language to mean that the provisions of IRC section 469(b) prevent the application of unenumerated exceptions to the general rule of the statute. This reasoning resulted in a reversal of the Tax Court's decision.
Corporations that elected S status on or after January 1, 1997, and had unused passive losses during prior C years are excellent candidates for filing amended returns. In many cases, this decision could reduce Federal taxes by as much as 39.6%, if the carryfoward losses were ordinary. In addition, C corps with passive loss carryforwards should consider electing S status. While it was previously thought that IRC section 1371 prohibited the use of such losses, St. Charles gives ample reason to reconsider.
EXAMPLE OF ST CHARLESS IMPACT Nicole is a majority shareholder in a closely held C corporation. The business owns real estate and uses a small portion in its operations. The remainder of the property is rental real estate. The corporation has suspended passive losses of $1 million from its rental real estate activities. These operations were sold in January 2001. The following analysis contrasts the results for a C and S corporation: C Corporation S Corporation Net operating income $2,000,000 $2,000,000 Net loss from rental real estate (100,000) (100,000) Capital gain from real estate sale 1,500,000 1,500,000 Section 469 passive loss carryforward 1,000,000 1,000,000 Taxable income $2,400,000 $2,400,000 Federal tax $816,000 [a] $325,000 [c] 633,600 [b] $360,000 [d] 490,000 [e] Total tax $1,449,600 $1,175,000 (a) $2,400,000 at 34% ordinary corporate income tax (b) ($2,400,000 - 816,000) at 40% tax on dividend (c) Tax on capital gain: $1,000,000 at 20%, $500,000 at 25% (d) Tax on ordinary income: ($2,000,000 - 100,000 - 1,000,000) at 40% (e) Tax on built-in gains: $1,400,000 at 35%