Disposing of an activity to release suspended passive losses.

• Author: Ellentuck, Albert B.
• Position: Case Study

The passive, activity loss (PAL) rules were originally enacted to address abusive tax shelters and restrict taxpayers ability to reduce their tax liability through the use of loss deductions or credits. In many cases, any amount of loss from passive activities exceeding income from passive activities in a given year is not deductible and must be carried forward to succeeding tax years or until the activity is disposed of in a taxable transaction.

Unused PALs are suspended and carried forward to future years until the taxpayer (1) disposes of the particular activity that generated the losses, (2) generates net passive activity income in the case of a personal service corporation (PSC), or (3) generates net passive activity income or net active income in the case of a closely held corporation (CHC). A disposition generally occurs if the taxpayer's entire interest in the activity is disposed of in a fully taxable transaction to an unrelated party (Sec. 469(g)(1)).

Example 1: A, Inc., is a PSC that owns two passive activities, a leased office building and a book unit. The building lease activity has no suspended losses and a current-year income of $10,000. The book unit has $50,000 in suspended losses and a current-year loss of $10,000. A has always treated the activities as two separate activities. A has active income of $100,000 in the current year.

A has decided that the book unit will never be profitable. Therefore, it plans to sell most of the assets involved with the book unit activity on December 30 of the current year. The assets to be sold have a fair market value (FMV) of $20,000 and a basis of $5,000. A plans to retain the book unit's office equipment in its active business operations rather than sell it. That office equipment has an FMV of $1,000 and a basis of $500. Can A use the $50,000 of suspended losses from the book unit in the current year?

It would appear from the facts that A will dispose of substantially all of the book unit activity in the current year. A must be able to correctly account for the gross income, deductions, and credits that are allocable to that activity for the current tax year. As a result, A should be able to offset the $10,000 income from the building rental, the $15,000 gain from the sale of the book unit, and $35,000 of its active income with the $50,000 suspended loss and the $10,000 current-year loss from the book unit activity.

Sale of Entire Interest to an Unrelated Party

When an entire interest in a passive activity is sold to an unrelated party, current and suspended losses related to the activity may be used according to the following rules...