Deducting suspended losses on disposition of S stock.

• Author: Ellentuck, Albert B.
• Position: Tax planning for S Corporations

Editor's Note: This case study has been adapted from "PPC Tax Planning Guide--S Corporations," 14th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2000.

Facts: Roger Johnson, a single taxpayer, has a $10,000 suspended loss from the ABC Corporation and a $5,000 suspended loss from the 123 Corporation carried over from the previous year. Both companies are S corporations. * On July 1 of the current year, Roger sold all his ABC stock to an unrelated party. The sale generated a $14,000 long-term capital gain. In addition, the Schedule K-1 from ABC showed a $1,500 ordinary loss. The 123 Schedule K-1 reported a $3,000 ordinary loss. Roger also has wages of $85,000 and portfolio income of $15,000. He asks his tax adviser which losses can be deducted currently and which losses will remain suspended. Issues: When can Roger deduct his suspended losses from ABC? How does the long-term capital gain affect the recognition of passive losses? How are the current and suspended losses from ABC reported?

Analysis

If a taxpayer has unused passive losses due to the Sec. 469 limit, they are "suspended" and carried forward to future years, until the taxpayer generates net passive activity income or disposes of the activity. The taxpayer can use the suspended loss due to such disposition as long as the disposition is a fully taxable (as opposed to tax-deferred) transaction in which he disposes of his entire interest in the activity. When passive activity losses (PALs) for a year exceed passive income, the taxpayer must allocate the excess passive loss to specific passive activities and maintain a carryforward record of the suspended PALs from each activity. Worksheets 3 and 4 found in the instructions for Form 8582, Passive Activity Loss Limitations, are available for this purpose. Alternatively, a taxpayer can maintain free-form schedules of suspended PAL carryforwards.

When a taxpayer sells an entire interest in a passive activity to an unrelated party, both current and suspended losses generated by that activity (as well as any loss on the disposition) can be deducted. To determine the deduction, suspended losses from the disposed of activity are combined with (1) the activity's current-year income or loss and (2) gain or loss on disposition of the activity. Overall losses from the activity are then applied against the income and gains (net of losses) from the taxpayer's passive activities...