IRS approves use of S corporation suspended losses in reorganization.

• Author: Romanelli, Russell L.

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...