Academic journal article Journal of Corporation Law

The Power of "Except as Otherwise Provided": Carry Forward of Passive Activity Losses from a Closely Held C Corporation to an S Corporation

Academic journal article Journal of Corporation Law

The Power of "Except as Otherwise Provided": Carry Forward of Passive Activity Losses from a Closely Held C Corporation to an S Corporation

Article excerpt


When St. Charles Investment Co. (SCI) elected S corporation status, it disposed of rental properties at a loss and deducted related suspended passive activity losses (PALs) it previously incurred as a C corporation.2 In deducting the PALs, SCI relied on I.R.C. [sec] 469, part of Title V of the Tax Reform Act of 1986,3 which allows deduction of suspended PALs upon disposal of passive activities.4 However, the Tax Commissioner disallowed the deduction based on I.R.C. [sec] 1371, part of the Subchapter S Revision Act of 1982.5 Section 1371 disallows "carryforward" or "carryback" from a C to an S year.6

This Note examines the conflict between [sec] 469 and [sec] 1371, including the background and congressional objectives of PAL restrictions and S corporation taxation. It argues that the Tenth Circuit's decision allowing the taxpayer to deduct passive activity losses after S corporation election was incorrect. The Tenth Circuit's regrettable decision was largely based on the seven words, "[e]xcept as otherwise provided in this section." This Note explains and critiques the economic, structural, and tortious statutory arguments both for and against the Tenth Circuit's decision. The Note evaluates the quality of these arguments and concludes that the Tenth Circuit has dishonored Congress's intent for both the S corporation taxing regime and the PAL restrictions. In addition, this Note recommends legislative clarification of [sec] 469 so that it more closely reflects Congress's intent.


A. St. Charles Investment Co.'s Deduction of Passive Activity Losses as an S Corporation

SCI operated rental real estate as a closely held C corporation.7 From 1988 to 1990, SCI's passive real estate operation created PALs because its deductions exceeded income.8 PALs9 may not offset any other nonpassive income, such as salaries or investment income.10 Taxpayers may utilize the "suspended" PALs in following years only when sufficient offsetting passive activity income is present.11 SCI, as a C corporation, accumulated $4,879,852 in suspended PALs between 1988 and 1990.12

In an exception to the general rule, I.R.C. [sec] 469(g) allows PALs to offset nonpassive income when the taxpayer sells the entire passive activity to an unrelated party.13 In 1991, SCI elected S corporation status14 and disposed of seven rental properties at a net loss of $9,231,591.15 Additionally, SCI, as an S corporation, deducted the $4,879,852 in suspended PALs related to these properties.16 The Commissioner disallowed the deduction because I.R.C. [sec] 1371(b)(1) prohibits a corporation from using in an S corporation year any "carryforward" or "carryback" arising in a C corporation year.17

Depreciation deductions had reduced SCI's basis in the sold real estate properties.18 Of the $4,879,852 in suspended PALs, $2,564,607 was attributable to depreciation that had reduced the basis in the sold properties.19 When the Commissioner disallowed the suspended PALs, the tax benefits of the depreciation that caused the basis deductions were eliminated.20 From SCI's standpoint, because the suspended PAL deductions were disallowed, the basis in the properties was understated and the resulting losses should have been larger.21

1. The Tax Court's Disallowance of Suspended PAL Carryforward

The tax court concluded that [sec] 1371's intended scope includes PALs, preventing their carryover from a C corporation to an S corporation.22 Section 1371 prohibits "carryforward" or "carryback" but does not define these words.23 The tax court decided the word "carryforward" encompasses PALs24 and upheld the Commissioner's disallowance of SCI's suspended PAL deduction.25

The tax court also held that SCI could not adjust its basis in properties for disallowed PALs attributable to depreciation.26 The tax court reasoned that PALs should be treated similarly to net operating losses (NOLs),27 which are not allowed as a deduction unless offsetting income is present. …

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