Recognizing Suspended Passive Losses when S Stock Is Transferred to a Family Member

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," 15th edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2001 ((800) 323-8724; www.ppcnet.com).

Facts: Nick owns stock in Klippers, an S corporation in which he does not materially participate. His daughter Nora is 16 years old and will start college in three years. She has some funds set aside for college but will be short of the amount she needs. Nick's stock basis is $10,000 and he has $25,000 of suspended losses from Klippers. Nick believes that the corporation will generate profits starting next year, and he expects the stock to appreciate in value. Nora will be in the 15% tax bracket, while Nick will pay tax at 36%. Nick's tax adviser recommends that Nick sell the shares to Nora, at their fair market value (FMV) of $14,000, which Nick does. For each of the next three years, Nora's share of Klippers' income is $15,000, and she receives distributions of that amount. At the end of the three years, Nora sells the shares for $34,000 and recognizes a $20,000 gain. During the three years, Nick receives passive activity income totaling $5,000 from other sources. Issue: Will the disposition of an interest in an S corporation to a family member allow a taxpayer to deduct suspended losses?

Analysis

The disposition of a taxpayer's interest in a passive activity normally triggers deductibility of suspended losses. However, passive losses are not deductible against nonpassive income when the interest is transferred to a family member or other entity whose relationship would disallow losses on a sale or exchange.

When a taxpayer transfers an interest in a passive activity to a family member, the transferor continues to carry forward suspended losses that he can deduct against income from other passive activities he holds. If the losses remain suspended, the taxpayer can deduct them against his nonpassive income when the transferee family member disposes of the property (e.g., stock) in a fully taxable transaction with an unrelated party.

Conclusion

Nick recognized a $4,000 gain from the sale of the shares to Nora. Gain from the sale of passive activity property is passive activity income, so Nick can offset $4,000 of the suspended loss against the gain from the sale. He carries forward the unused portion ($21,000) of the suspended losses, even though the shares were sold to Nora. During the next three years, he will offset $5,000 of the suspended losses against the passive activity income he receives from other sources during those years. When Nora disposes of the shares, Nick deducts the remainder of the suspended losses, $16,000 ($25,000 – $4,000 – $5,000), against nonpassive income.

Nora is taxed on the $20,000 gain on the sale. Ultimately, $65,000 of income is shifted from Nick to Nora, resulting in tax savings of $13,650.

The sale of passive-activity S stock to a family member transfers tax on future appreciation to the purchaser, while leaving the suspended losses with the seller. Income from the S corporation is also shifted. (Note: The purchaser must be over 13 years old for income-shifting to be effective.)

This case study assumes that Nora sells the stock in a relatively short time. If that does not happen and Nick does not have passive income from other sources, the loss would remain suspended until someone outside the family acquired Nora's shares.

Variation—Gift of Stock in a Passive Activity

In this scenario, Nick gives the stock to Nora instead of selling it to her. His stock basis when he makes the gift is $14,000.

Generally, when an interest in a passive activity is transferred by gift, suspended losses increase the basis of the interest; they are no longer available to offset passive income. The increase in basis is deemed to take place immediately before the gift.

Nora's stock basis is $39,000 (Nick's $14,000 basis + $25,000 suspended losses). The suspended losses are no longer deductible either by Nick or Nora, but in effect will reduce any gain when the stock is sold. For purposes of determining the donee's loss on the disposition of the shares, the basis of property received by gift is limited to its FMV at the time of the gift. This rule can cause the passive losses to disappear, with neither the donor nor the donee receiving tax deductions.

If the stock's FMV on the date of the gift is $15,000, and Nora sells it for that amount, her basis in the shares would be computed under the general rule, resulting in a $24,000 loss (i.e., $15,000 sales price – $39,000 basis). However, because of the FMV limitation, she recognizes no gain or loss from the sale, calculated as follows:

Thus, if Nora sells the shares for less than $15,000, her basis for computing the loss would be $15,000. If she sells at $15,000$39,000, there would be no gain or loss. If she sells the stock for more than $39,000, her basis for calculating the gain would be $39,000.

Under this scenario, the tax adviser would undoubtedly recommend that Nick not give the shares to Nora, but consider other alternatives. For example, Nick can sell the shares to an outsider to trigger loss recognition. Conversely, the S corporation can dispose of the activity that generated the losses, so the losses can be recognized before the shares are transferred.

The tax adviser will have to perform "what if" calculations to determine whether selling the stock or making a gift of the stock provides the best tax result. A sale would generally be preferable if the taxpayer expects to have passive income from other sources against which to deduct the suspended losses. However, if the transferor cannot reasonably hope to deduct the suspended losses, the best answer for income-shifting purposes might be to transfer the stock as a gift.

Under Regs. Sec. 1.1366-2(a)(6), the basis of S stock received by gift is limited to the stock's FMV at the date of the gift for purposes of determining the deductibility of losses passed through to a shareholder. This provision, however, does not affect Nora in this case study, because Klippers is passing through income rather than losses.