S Corporation Suspended Losses Allowed Against C Corporation Basis Following Merger

An S shareholder is precluded from using S flowthrough losses to the extent that the shareholder does not have basis in either the corporation's stock or debt sufficient to offset such losses (Sec. 1366(d)(1)). However, if the losses are not currently deductible, under Sec. 1366(d)(2), the shareholder can carry them forward indefinitely to succeeding S years. In Field Service Advice (FSA) 200223052, the IRS gave a taxpayer-friendly answer to the question of what happens to suspended losses on a merger of commonly owned S and C corporations.

In the FSA, shareholder A owned stock in S corporation X, with a zero basis and $150 of losses suspended under Sec. 1366(d)(1). X merged into C corporation Y in an A reorganization. In such a transaction, Y acquired all X's assets and liabilities, and X ceased to exist. Prior to the merger, A also owned Y stock with a $100 basis. After the merger, A owned two blocks of Y stock, a portion with a $100 basis that he historically owned and a portion with a zero basis that he acquired as part of the merger.

The FSA addressed whether A can use the $100 basis that he had in Y stock to free the suspended losses arising from now nonexistent X.

In determining the ability to use the historical C basis, the first issue is how to treat a suspended loss when an S corporation is terminated. Sec. 1366(d)(3) provides a special rule for suspended loss carryovers when an S election is terminated. Under Sec. 1366(d)(3)(A), if losses have been disallowed in the last tax year for which a corporation is an S corporation, the losses will be "treated as incurred by the shareholder on the last day of any post-termination transition period" (PTTP). For this purpose, a PTTP is defined in Sec. 1377(b)(1) as beginning on the day after the last day of the corporation's last S tax year and ending on the later of (1) one year after the last day of the last S year or (2) the due date for filing the return for the last S year.

Regs. Sec. 1.1377-2(b) further clarifies the treatment of a transaction in which a C corporation acquires an S corporation in an A, C, D, F or G reorganization. The regulation provides that the PTTP begins the day after the S corporation is in existence before acquisition by the C corporation. The Senate Finance Committee Report on the Subchapter S Revision Act of 1982 provides that suspended losses can be taken during the PTTP, as long as the shareholder experiences a restoration in basis within the later of PTTP or 120 days after a determination that the S election is terminated. Thus, a basis restoration after the termination of S status can result in a deduction of a suspended loss as long as the restoration occurs within the applicable time limits.

Clearly, the suspended loss does not disappear immediately on merger. The next consideration is whether the loss can be used against basis in the historical C stock held by A in Y. A's investment in the Y stock had nothing to do with his investment in X at the time it was made. The question is whether the Service would allow the economic outlay made as an investment in Y to be transferred to X if the two corporations merge. Regs. Sec. 1.1366-2(c)(1) provides that an S shareholder who is also a shareholder in the successor C corporation after a merger may use basis in the C successor to offset any suspended S losses.

This language seems to contemplate a situation in which a shareholder gains shares in the successor in exchange for his S shares as part of a merger. It does not, however, appear to contemplate whether basis historically attached to the pre-merger C corporation can be used to offset suspended S losses.

In FSA 200223052, the IRS interprets Congressional intent by ruling that the historical C basis can be used to offset the carried-over suspended S losses. It holds that, "[t]he purpose of section 1366(d)(1) is to prevent shareholders from using losses that are not related to any corresponding economic outlay. Here, however, A has made economic outlays in the form of A's investment in the acquiring C corporation."

The Service concluded that A should be allowed to take the suspended losses incurred by X prior to the merger, even though the new basis was originally created through the purchase of Y stock. A can deduct $100 of the $150 in suspended losses. The remaining $50 of suspended losses will be permanently disallowed under the current facts, because sufficient basis does not exist to take these losses by the end of the PTTP. A will reduce his basis in Y stock accordingly, so that his basis is zero.

This taxpayer-friendly ruling may provide a planning possibility in the right circumstances. An individual who is unable to take advantage of flow-through losses from an S corporation might rely on this ruling affirmatively if there is a commonly owned C corporation with sufficient basis to offset such losses.

A merger of an S corporation into a C corporation may allow freeing of otherwise unusable losses. The businesses can probably continue to operate autonomously through the use of a single-member limited liability company. Further, any ongoing losses incurred by the historical S corporation can serve to reduce taxes on C profits. While many non-tax issues should be considered before effecting such a merger, the FSA certainly gives a green light to consider such a possibility.

From Louis J. Miller, CPA, South Bend, IN