Deducting Suspended Losses on Disposition of S Stock

Editor:

Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from "PPC Tax Planning Guide—S Corporations," 14th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2000.

Facts: Roger Johnson, a single taxpayer, has a $10,000 suspended loss from the ABC Corporation and a $5,000 suspended loss from the 123 Corporation carried over from the previous year. Both companies are S corporations. • On July 1 of the current year, Roger sold all his ABC stock to an unrelated party. The sale generated a $14,000 long-term capital gain. In addition, the Schedule K-1 from ABC showed a $1,500 ordinary loss. The 123 Schedule K-1 reported a $3,000 ordinary loss. Roger also has wages of $85,000 and portfolio income of $15,000. He asks his tax adviser which losses can be deducted currently and which losses will remain suspended.Issues: When can Roger deduct his suspended losses from ABC? How does the long-term capital gain affect the recognition of passive losses? How are the current and suspended losses from ABC reported?

Analysis

If a taxpayer has unused passive losses due to the Sec. 469 limit, they are "suspended" and carried forward to future years, until the taxpayer generates net passive activity income or disposes of the activity. The taxpayer can use the suspended loss due to such disposition as long as the disposition is a fully taxable (as opposed to tax-deferred) transaction in which he disposes of his entire interest in the activity. When passive activity losses (PALs) for a year exceed passive income, the taxpayer must allocate the excess passive loss to specific passive activities and maintain a carryforward record of the suspended PALs from each activity. Worksheets 3 and 4 found in the instructions for Form 8582, Passive Activity Loss Limitations, are available for this purpose. Alternatively, a taxpayer can maintain free-form schedules of suspended PAL carryforwards.

When a taxpayer sells an entire interest in a passive activity to an unrelated party, both current and suspended losses generated by that activity (as well as any loss on the disposition) can be deducted. To determine the deduction, suspended losses from the disposed of activity are combined with (1) the activity's current-year income or loss and (2) gain or loss on disposition of the activity. Overall losses from the activity are then applied against the income and gains (net of losses) from the taxpayer's passive activities other than the one that was disposed of. Finally, any remaining loss from the disposed-of activity is treated as a nonpassive loss (i.e., it is deductible without limit against the taxpayer's active and portfolio income).

The current-year income or loss from the activity is combined with prior-year suspended losses from the activity and also with the gain or loss generated on disposition. If the net result is a loss, Form 8582 is bypassed and the various components are reported on the forms usually used (e.g., Schedule E or D). If the net result is an overall gain and the taxpayer has other passive activities, the income and losses are posted to Worksheet 1 or 2 of Form 8582. If the net result is an overall gain and there are no other passive activities, Form 8582 is bypassed and the gains and losses are reported on the schedules and forms otherwise used.

If the activity is disposed of using the installment-sale method, the suspended losses from the activity are deductible over the term of the payments in proportion to the gain recognized.

Under the facts of this case study, Roger's adjusted gross income (AGI) is calculated as follows:

The $5,500 unused loss from 123 ($5,000 + $3,000 – $2,500) is suspended and carries over to the following year. The $14,000 long-term capital gain from the sale of ABC stock is reported on Schedule D, Form 1040. The interaction with the passive losses is not reflected on Schedule D.

Conclusion

On complete disposition of the ABC stock, Roger can deduct current and suspended losses generated by ABC.

Under Regs. Sec. 1.469-4(g), the disposition of "substantially all" of an activity (rather than the "entire interest" in an activity, as required by the Code) may be treated as a complete disposition on which suspended losses are allowed. Unfortunately, the regulation does not define or provide examples of the disposition of "substantially all" of an activity.

The only additional guidance provided is that, to treat part of an activity as disposed of, the taxpayer must establish with reasonable certainty (1) the deduction and credits allocable to that part of the activity for the tax year under Regs. Sec. 1.469-1(f)(4) (relating to carryover of disallowed deductions and credits) and (2) the gross income and any other deductions and credits allocable to that part of the activity for the tax year.

Form 8582 must be used, as Roger has an overall gain from ABC and also has other passive activities. The long-term capital gain is netted against the passive losses on Form 8582 (and worksheets), but reported independently of the passive losses on Schedule D. In this case, Roger would report the income and losses as follows:

Some taxpayers may be subject to deduction limits because of basis and at-risk rules, as well as the PAL rules. The limits are applied first to basis limits, then to at-risk limits, and finally to the PAL rules (Temp. Regs. Sec. 1.469-2T(d)(6)).

Variation

Capital loss limit. Assuming the sale resulted in a $14,000 capital loss instead of a capital gain, how would this affect the deductibility of the PALs?

If the disposition results in a capital loss, the $3,000 capital loss limit applies. Resulting capital loss carryovers are not subject to the passive loss rules in years following the disposition year. If the sale generated a $14,000 capital loss (rather than a $14,000 capital gain), this loss would still be reported on Schedule D and, if there were no other capital gains, would be limited to the $3,000 capital loss limit. The suspended and current passive ordinary losses from ABC, however, would be deductible against nonpassive income in the disposition year. No portion of the current or suspended loss from 123 would be deductible.