IRS Approves Use of S Corporation Suspended Losses in Reorganization

Field Service Advice (FSA) 200223052 concluded that in a merger of an S corporation and a C corporation, an S shareholder could deduct suspended losses, using the stock basis held in the merged C corporation. The ruling bases its conclusion on the Sec. 1366(d)(3) post-termination transition-period (PTTP) rules.

Example: Entrepreneur E has for years operated and run a very successful C corporation manufacturing business that he inherited from his father. The inheritance created a large basis step-up of the corporation's stock. E wants to develop and market an Internet retailing website and will incur substantial initial expenses. Using an S corporation, he separates the Internet business from the successful family business. After a few years of operation, the dot-com industry implodes and E has substantial suspended losses. E would like to maximize use of such losses.

An S shareholder's loss deduction is limited to the amount of basis in stock and loans made directly to the corporation. Losses disallowed due to these provisions are carried forward indefinitely, until they are either used, or the corporation terminates its S election or goes out of existence–at which time the losses may be permanently lost.

However, Sec. 1366(d) provides that if an S election is terminated while a shareholder maintains suspended loss carryovers due to basis limits, the loss are treated as incurred by the shareholder on the last day of any PTTP. The suspended-loss deductions are limited to the shareholder's adjusted basis in the corporation's stock, determined on the PTTP's last day. Any losses not used during a PTTP are permanently disallowed.

Under Sec. 1366, if an S corporation's final year ends as a result of a statutory merger, any loss disallowed as a result of basis limits will be available to the shareholder as a shareholder of an acquiring corporation. If the acquirer is a C corporation, the PTTP arises the day after the last day the S corporation was in existence.

Sec. 1367(a)(1) states that a shareholder's stock basis is increased by the sum of items of income described in Sec. 1366(a)(1)(A) and any nonseperately computed income under Sec. 1366(a)(1)(B). Note: The PTTP rules allow for increases only to stock basis, not loan basis.

Because the shareholder can no longer adjust basis via passthrough income, he or she can only increase basis by making a capital contribution to the C corporation after the merger. Accordingly, the shareholder can use suspended losses by making additional capital contributions during the PTTP period.

The Service has historically restricted the use of losses to limit basis. However, FSA 200223052 allows the use of basis under those facts because of the economic-outlay doctrine. The ruling rationalizes that the statute and legislative history clearly allow a shareholder to obtain additional basis via capital contributions. It states "[t]here does not appear to be a compelling reason for reaching a different conclusion if the shareholder has historic C basis in the acquiring corporation. The purpose of Sec. 1366(d)(1) is to prevent shareholders from using losses that are not related to any corresponding economic outlay." (Emphasis added.) Clearly, in a merger setting, the shareholder has made an additional investment in the S corporation and its activities.

The IRS has allowed the use of the suspended loss without an additional transfer of funds. In the example, E will merge the S corporation into the C corporation (assuming no potential liability problems) and use his inherited stepped-up basis in his C stock. E will be able to deduct the suspended loss up to the amount of his stepped-up basis in his inherited stock.

From Russell L. Romanelli, CPA, MST, Wolf & Company LLP, Chicago, IL