S corporation can deduct suspended PALs incurred while a C corporation.

• Author: Bakale, Anthony

In St. Charles Investment Co., 232 F3d 773 (2000), rev'g 110 TC 46 (1998), the Tenth Circuit reversed the Tax Court and held that an S corporation can deduct suspended passive activity losses (PALs) incurred while it was a C corporation. The Tenth Circuit is the first Court of Appeals to rule on this issue. The decision creates planning opportunities for closely held C corporations engaged in passive activities.

Background

Sec. 469(a) disallows PALs incurred by individuals, estates, trusts and personal service corporations. PALs cannot be deducted against active or portfolio income. The PAL rules also apply to closely held C corporations. Closely held C corporations can deduct PALs from active, but not portfolio, income. A C corporation is closely held for purposes of the PAL rules if, at any time during the tax year, more than 50% of the value of its outstanding stock is owned, directly or indirectly, by five or fewer individuals.

Under Sec. 469(b), PALs disallowed under Sec. 469(a) are treated as deductions or credits allocable to the activity in the next tax year. The disallowed losses are suspended until they can be used against passive income (passive or active income in the case of a closely held C corporation). However, under Sec. 469(g)(1), disallowed losses can be used in full when the passive activity to which they apply is disposed of in a taxable transaction. On disposition, suspended PALs are first used against income from the activity, then against income from other passive activities. If any suspended PALs remain, they are treated as nonpassive and can be offset against other income.

Facts

The taxpayer in St. Charles Investment Co. was a closely held C corporation subject to the PAL rules. It operated several rental real estate properties during 1988, 1989 and 1990, which produced several million dollars of PALs. The PALs attributable to each of the taxpayer's rental activities were disallowed under Sec. 469(a) and treated, under Sec. 469(b), as allocable to the activities in the next tax year.

The taxpayer elected S status effective Jan. 1, 1991. It sold several of its rental activities in 1991. On its 1991 S return, the taxpayer deducted suspended PALs allocable to the activities sold under Sec. 469(g)(1). On audit, the Service disallowed these deductions, based on Sec. 1371(b)(1), which provides that "[n]o carryforward, and no carryback, arising for a taxable year for which a corporation is a C corporation may be carried...