PALs Carried Forward from C to S Corporation

When converting from a C to an S corporation, a taxpayer cannot carry forward or back any net operating losses (NOLs) arising when the taxpayer was a C corporation to a tax year for which such taxpayer is an S corporation (Sec. 1371(b)(1)). Under Sec. 469(b), however, a closely held C corporation treats a suspended passive activity loss (PAL) as a deduction allocable to such activity in the next subsequent year.

In St. Charles Investment Co., 10th Cir, 11/14/00, a C corporation had suspended PALs from real estate during the years 1988–1990. In 1991, the corporation elected S status, selling its real estate activity and recognizing the PALs suspended in the prior years. The IRS disallowed the deduction of the suspended losses, claiming that Sec. 1371(b)(1) prohibits an S corporation from claiming any carryforward from a year in which it was a C corporation to a year in which it elected S status.

St. Charles argued that it was not claiming a carryforward loss, but following Sec. 469(b), which provides that a taxpayer must treat disallowed PALs as a deduction allowable to the activity for the next year. Sec. 469(f)(2) specifically provides that if a corporation ceases to be a closely held C corporation, the passive-loss rules apply in the same manner as if such taxpayer continued to be a closely held C corporation.

The Tenth Circuit, in reversing the Tax Court, ruled that Sec. 469(f)(2) precludes application of Sec. 1371(b)(1), and the treatment of suspended PALs does not change when a corporation becomes an S corporation. Sec. 469(b) does not create an NOL, but limits the deduction in the current year. The court pointed out that the suspended-loss rule states that suspended losses carry forward "except as provided in this section." In other words, no other section can negate its rules. When the corporation disposed of its interest in the passive activity, the suspended PALs became deductible as an offset against current-year income, and gain from the activity and the excess losses were treated as nonpassive loss (Sec. 469(g)(1)).

Based on the result in this case, closely held C corporations with suspended PALs may consider electing S status, so that the losses may pass through to the shareholders on the sale of the activity.

From James Ng, CPA, New York, NY