Recognizing suspended passive losses when S stock is transferred to a family member.

• Author: Ellentuck, Albert B.

Facts: Nick owns stock in Klippers, an S corporation in which he does not materially participate. His daughter Nora is 16 years old and will start college in three years. She has some funds set aside for college but will be short of the amount she needs. Nick's stock basis is $10,000 and he has $25,000 of suspended losses from Klippers. Nick believes that the corporation will generate profits starting next year, and he expects the stock to appreciate in value. Nora will be in the 15% tax bracket, while Nick will pay tax at 36%. Nick's tax adviser recommends that Nick sell the shares to Nora, at their fair market value (FMV) of $14,000, which Nick does. For each of the next three years, Nora's share of Klippers' income is $15,000, and she receives distributions of that amount. At the end of the three years, Nora sells the shares for $34,000 and recognizes a $20,000 gain. During the three years, Nick receives passive activity income totaling $5,000 from other sources. Issue: Will the disposition of an interest in an S corporation to a family member allow a taxpayer to deduct suspended losses?

Analysis

The disposition of a taxpayer's interest in a passive activity normally triggers deductibility of suspended losses. However, passive losses are not deductible against nonpassive income when the interest is transferred to a family member or other entity whose relationship would disallow losses on a sale or exchange.

When a taxpayer transfers an interest in a passive activity to a family member, the transferor continues to carry forward suspended losses that he can deduct against income from other passive activities he holds. If the losses remain suspended, the taxpayer can deduct them against his nonpassive income when the transferee family member disposes of the property (e.g., stock) in a fully taxable transaction with an unrelated party.

Conclusion

Nick recognized a $4,000 gain from the sale of the shares to Nora. Gain from the sale of passive activity property is passive activity income, so Nick can offset $4,000 of the suspended loss against the gain from the sale. He carries forward the unused portion ($21,000) of the suspended losses, even though the shares were sold to Nora. During the next three years, he will offset $5,000 of the suspended losses against the passive activity income he receives from other sources during those, years. When Nora disposes of the shares, Nick deducts the remainder of the suspended losses, $16,000 ($25,000 --...