Suspended PALs from C years could be deducted in S election year.

• Author: Fiore, Nicholas J.
• Position: Passive activity losses; C and S corporations

Before 1991, the T Corporation was a closely held C corporation. During 1988-1990, T had been engaged in the real estate rental business. During these years, T had passive activity losses (PALs) that were nondeductible under Sec. 469(a).

T made an S election in 1991. T also sold several of its rental properties for which there were suspended PALs. On its 1991 return, T claimed a deduction for the PALs that had been suspended.

The IRS disallowed these deductions, citing Sec. 1371(b)(1). The Tax Court held for the Service, but the Court of Appeals (opinion Tacha, J.) reverses; Sec. 1371(b)(1) does not preclude T's deduction of suspended PALs incurred when T was a closely held C corporation.

Congress made Sec. 1371 (b) a part of subchapter S in 1982 to prevent corporate losses incurred prior to electing S status from benefiting the corporation's shareholders after an S election. Four years later, Congress enacted Sec. 469 out of concern that taxpayers were "front-loading" deductions arising from activities in which they did not participate (passive activities) and using those deductions to reduce other income. Sec. 469, therefore, is a comprehensive, "cradle-to-the-grave" statutory scheme governing gain and loss from passive activities. Sec. 469 allows taxpayers to deduct PALs only to the extent they have passive activity gains. Any remaining PAL is suspended and carried over to the next year, again becoming available to offset passive activity gains. Only on the disposition of the passive activity does the entire PAL (including the suspended PALs from previous years) become available as a deduction against both passive activity gains and other, ordinary income.

The dispute centers on the conflict between Secs. 469(b) and 1371(b)(1). Sec. 469(b) states "[e]xcept as otherwise provided in this section, any loss or credit from an activity which is disallowed under subsection (a) shall be treated as a deduction or credit allocable to such activity in the next taxable year." Sec. 1371(b)(1), on the other hand, provides that "[n]o carryforward, and no carryback, arising for a taxable year for which a corporation is a C corporation may be carried to a taxable year for which such corporation is an S corporation." Which section governs the treatment of suspended PALs after a corporate changeover from a C to an S year? Either the language of Sec. 469(b) functions as a statutory "traffic cop," preventing any provision of the Code outside of Sec. 469 from...