110 T.C. No. 6
UNITED STATES TAX COURT
ST. CHARLES INVESTMENT CO., BURTON C. BOOTHBY, TAX MATTERS PERSON, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5793-96. Filed February 5, 1998.
Prior to Jan. 1, 1991, X was a closely held C corporation, which incurred passive activity losses (PAL's) giving rise to suspended PAL's pursuant to sec. 469, I.R.C. A portion of the suspended PAL's was attributable to depreciation. X reduced the bases of the properties used in the passive activities by the amounts of such depreciation. X elected S corporation status as of Jan. 1, 1991. During 1991, it disposed of several of the passive activities and calculated the gain (loss) from those dispositions using the bases of the properties involved as reduced by the depreciation. X used suspended PAL's allocable to the sold activities which had arisen prior to 1991, in calculating its taxable income for 1991. Held, sec. 1371(b)(1), I.R.C., precludes X from using its suspended PAL's in 1991, an S corporation year. Held, further, X may not recompute the bases of the sold properties to include amounts representing the portions of the suspended PAL's attributable to depreciation. - 2 -
Darrell D. Hallett, Larry N. Johnson, Robert J. Chicoine,
and John M. Colvin, for petitioner.
Cathy A. Goodson and William A. McCarthy, for respondent.
OPINION
TANNENWALD, Judge: This case comes before us on cross-
motions for partial summary judgment by the parties under Rule
121.1 The issues for decision are:
(1) Whether suspended passive activity losses (PAL's)
incurred by a closely held C corporation that later elects to be
an S corporation may be deducted by the then S corporation in the
year the corporation disposes of its entire interest in the
activity generating the losses, and if not,
(2) whether the basis of the assets used in the activity may
be recomputed to restore amounts for portions of the suspended
PAL's attributable to depreciation (and the gain or loss from the
disposition commensurately recalculated).
Summary judgment as to those issues is appropriate in this
case because there is no genuine issue of fact, and a decision
can be made as a matter of law. Rule 121(b); Northern Ind. Pub.
Serv. Co. v. Commissioner, 101 T.C. 294, 295 (1993).
1 Unless otherwise indicated, all statutory references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. - 3 -
Background
At the time the petition was filed, Burton C. Boothby
(petitioner) resided in Denver, Colorado, and St. Charles
Investment Company (St. Charles) had its principal place of
business in Englewood, Colorado. St. Charles filed its 1991 U.S.
Income Tax Return as an S corporation with the Internal Revenue
Service at Odgen, Utah.
Prior to 1991, St. Charles was a closely held C corporation
as defined under section 469(j)(1). St. Charles operated rental
real estate giving rise to PAL's under section 469 in 1988, 1989,
and 1990. St. Charles elected S corporation status effective
January 1, 1991. Immediately prior to the effective date of the
S corporation election, St. Charles had suspended PAL's from its
real estate activities.
During 1991, St. Charles disposed of certain of the rental
properties (the properties). St. Charles reported the sales of
the properties and deducted the suspended PAL's arising from the
properties on its 1991 S corporation tax return. Six of the
seven properties sold produced losses of $9,237,752; the seventh
produced a gain of $6,161.
A portion of the suspended PAL's was attributable to
depreciation for which St. Charles had adjusted the bases of the
properties. St. Charles used these adjusted bases in calculating
its gain or loss from the sales of the properties. - 4 -
Effective March 30, 1995, St. Charles elected to terminate
its S corporation status and reverted to C corporation status.
Discussion
The parties have locked horns on the impact of sections
469(b) and 1371(b)(1). St. Charles contends that section 469
governs and that section 1371(b) has no application under the
circumstances herein. Respondent takes a diametrically opposed
position and contends that section 1371(b) controls and that
therefore section 469 is inapplicable.
Section 469(a) disallows the PAL for the taxable year to any
individual, estate or trust, any closely held C corporation, and
any personal service corporation. The term "passive activity
loss" generally means the amount by which the aggregate losses
from all passive activities for the taxable year exceed the
aggregate income from all passive activities for such year. Sec.
469(d)(1). However, a closely held C corporation, unlike the
other taxpayers to whom section 469 applies, also may use its PAL
for a taxable year to offset net active income for such year, and
the amount so used will not be disallowed under section 469(a).
Sec. 469(e)(2). The term "passive activity" includes any rental
activity, with exceptions not relevant herein. Sec. 469(c)(2).
Although section 469(a) disallows PAL's, section 469(b) provides:
"Except as otherwise provided in this section, any loss or credit
from an activity which is disallowed under subsection (a) shall - 5 -
be treated as a deduction or credit allocable to such activity in
the next taxable year."
Section 469(f)(2) provides:
(2) Change in status of closely held C corporation or personal corporation.--If a taxpayer ceases for any taxable year to be a closely held C corporation or personal service corporation, this section shall continue to apply to losses and credits to which this section applied for any preceding taxable year in the same manner as if such taxpayer continued to be a closely held C corporation or personal service corporation, whichever is applicable.
Section 469(g)(1)(A) provides that, in the taxable year in
which a taxpayer disposes of his entire interest in any passive
activity in a transaction where all the gain or loss realized on
such disposition is recognized, then generally, the excess of--
(i) any loss from such activity for such taxable year (determined after the application of subsection (b)), over
(ii) any net income or gain for such taxable year from all other passive activities (determined after the application of subsection (b)),
shall be treated as a loss which is not from a passive activity.
Thus, the usual result upon a taxable disposition of a passive
activity is that the taxpayer may use any remaining suspended PAL
allocated to that activity first against passive income from the
same activity, then against net passive income from other passive
activities, and then as a nonpassive loss. - 6 -
The effect of making an election to be an S corporation is
that, generally, an S corporation is not subject to income tax;2
instead, the shareholders are taxed on their respective shares of
the items constituting the S corporation's taxable income. Secs.
1363, 1366. Section 1371(b)(1) provides that "No 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."3 On the basis
of this provision, respondent disallowed the deduction of the
suspended PAL's.
Before proceeding to discuss the specific arguments of the
parties, we think it important to recognize the purposes which
underlay the enactment of sections 469 and 1371 and the overall
context applicable to those sections. Section 469 was enacted in
1986 by section 501(a) of the Tax Reform Act of 1986, Pub. L. 99-
514, 100 Stat. 2233, in response to legislative concern that
certain categories of taxpayers were engaging in activities which
generated losses and using those losses to shelter income from
other activities. See Schaefer v. Commissioner, 105 T.C. 227,
230 (1995). It is essentially a transactional provision, i.e.,
it deals with the tax treatment of particular activities. In
2 The exceptions are the taxes imposed on built-in gains under sec. 1374 and on excess net passive income under sec. 1375. 3 See infra pp. 20-22 for a discussion of the impact of other provisions of sec. 1371(b). - 7 -
determining the existence of a PAL, section 469 treats each
activity separately.
Section 1371 was enacted in 1982 by section 2 of the
Subchapter S Revision Act of 1982, Pub. L. 97-354, 96 Stat. 1669,
as part of a continuing effort by the Congress to provide a
statutory framework whereby shareholders of closely held
corporations could obtain substantially the same tax treatment as
they would have received if they had conducted their activities
as a partnership without being required to accept the personal
liability attaching to a partner. Thus, subchapter S, of which
section 1371 was a part, dealt with the status of a taxpayer by
permitting a corporation to continue as the same corporate entity
but treating its income and deductions as those of its
shareholders and taxing them accordingly. As we observed in
Frederick v. Commissioner, 101 T.C. 35, 43 (1993):
conversion from a C corporation to an S corporation does not create a new taxpayer or otherwise involve a transfer of assets and liabilities from one entity to another. Following its S corporation election, Quanta is still the same taxpayer; Quanta merely has subjected its income and expenses to a new taxing regime for Federal income tax purposes. * * *
This structural difference, i.e., transactional versus
taxpayer status, is a significant element in synthesizing the
application of sections 469(b) and 1371(b)(1). It facilitates
our ability to take into account the objectives of Congress,
namely, (1) including section 469(b) to ease the restrictive
thrust of section 469 generally by limiting, but not necessarily - 8 -
eliminating, use of PAL's, and (2) including section 1371(b)(1)
to narrow the liberalizing thrust of subchapter S generally, and
to prevent abuse by limiting, but not necessarily eliminating,
the ability of a corporation to utilize subchapter S status to
pass on its C status losses to its shareholders, see Rosenberg v.
Commissioner, 96 T.C. 451, 455 (1991).
Respondent's position is straightforward. Respondent
maintains that section 1371(b)(1) is clear on its face and that
the word "carryforward" in that section is not limited and
encompasses PAL's. Respondent argues that nothing in the
legislative history of either section 1371(b)(1) or 469 casts
doubt on respondent's position and that petitioner's attempts to
accord a narrow interpretation to the word "carryforward", both
directly and by interpolating section 469, are unavailing.
Petitioner's arguments fall into two categories: (1)
Suspended PAL's are not "carryforwards" within the meaning of
section 1371(b)(1), because the PAL rules, set forth in section
469, constitute an accounting method which St. Charles should
continue to use after its conversion to an S corporation; and (2)
pursuant to principles of statutory construction, the specific
language of section 469, particularly subsections (f)(2) and
(g)(1)(A), precludes the application of section 1371(b)(1).
Petitioner asserts that, unless it is permitted to utilize the
suspended PAL's in the year of disposition of the activities - 9 -
giving rise to them, its right to use those PAL's will be lost
forever.
We deal first with petitioner's position in respect of the
proper interpretation of section 1371(b)(1). Clearly, Congress
could not have had PAL's specifically in mind when it enacted
section 1371(b)(1) in 1982, since section 469 was not enacted
until 1986. But even petitioner does not suggest that this
factor, in and of itself, is determinative. Rather, petitioner
goes on to argue that the word "carryforward" was intended to
refer only to those items which are specifically so described in
other provisions of the Code.4 We disagree.
In construing the meaning of a statute, we seek the plain
meaning of its language, assuming that Congress uses common words
in their popular meaning, and relying on the words as generally
understood. Norfolk S. Corp. v. Commissioner, 104 T.C. 13, 36-37
(1995) and cases cited thereat, modified 104 T.C. 417 (1995).
The language of section 1371(b) ("No carryforward, and no
carryback") is broad, unlike that of other sections which specify
certain types of carryforwards and carrybacks. See supra note 4.
The legislative history of section 1371(b) supports a broad
4 See, e.g., sec. 170(d)(1) and (2) (charitable contributions); sec. 38(a) (business credit carryforwards and carrybacks); sec. 172 (net operating loss carryovers and carrybacks); sec. 904(c) (foreign tax credit); sec. 1212 (capital loss carrybacks and carryovers); sec. 1374(b)(2) and (3) (net operating loss carryforward, capital loss carryforward, and business credit carryforwards). - 10 -
interpretation in that the prohibition reflected in this
provision appears in similar terms and follows a list of specific
examples of passthrough items. S. Rept. 97-640 (1982), 1982-2
C.B. 718, 725; H. Rept. 97-826 (1982), 1982-2 C.B. 730, 737.
Although section 469(b) does not use the term "carryforward", we
think the phrase "shall be treated as a deduction * * * allocable
to such activity in the next taxable year" has the same meaning.
We think this is particularly true in the case of a closely held
C corporation where passive losses are available as deductions
against active losses. Our view in this respect is reinforced by
that fact that the Senate Finance Committee report, accompanying
the enactment of section 469, states that "Suspended passive
activity losses for the year are carried forward indefinitely,
but are not carried back" (emphasis added). S. Rept. 99-313
(1986), 1986-3 C.B. (Vol. 3) 1, 722; see also H. Conf. Rept. 99-
841 (Vol. II) (1986), 1986-3 C.B. (Vol. 4) 1, 137, describing the
Senate version of section 469 (there was no House of
Representatives version) as providing that "Disallowed losses and
credits are carried forward" (emphasis added). Moreover, while
we recognize that the use of captions is limited, see section
7806(a), we think it not amiss, in the context of this case, to
note that section 469(b) is entitled "Disallowed Loss or Credit
Carried to Next Year" (emphasis added).
Petitioner points to Congress' placement of section 469
within subchapter E, part II of the Code, entitled "Methods of - 11 -
Accounting". Petitioner argues that the PAL rules, like other
methods of accounting, such as basis and depreciation, are to be
continued after a C corporation becomes an S corporation. As the
subject of an accounting method, petitioner argues, PAL's are not
carryovers within the meaning of section 1371(b)(1).
"The term 'method of accounting' includes not only the over-
all method of accounting of the taxpayer but also the accounting
treatment of any item." Sec. 1.446-1(a)(1), Income Tax Regs. A
material item, for purposes of a method of accounting, is any
item which involves the proper time for the inclusion of the item
in income or the taking of a deduction. Sec. 1.446-1(e)(2)(ii),
Income Tax Regs. The legislative history of section 469
expresses concern over the mismatching of deductions and income
from passive activities which leads to the sheltering of other
income. S. Rept. 99-313, supra, 1986-3 C.B. (Vol. 3) at 716-717.
An accounting method addresses the timing of the deduction
of an item, it does not provide for any deduction per se. Sec.
1.446-1(a)(1), Income Tax Regs., states: "These methods of
accounting for special items include the accounting treatment
prescribed for research and experimental expenditures, soil and
water conservation expenditures, depreciation, net operating
losses, etc." Section 1371(b)(1) clearly precludes the carryover
of net operating losses (NOL's). Rosenberg v. Commissioner, - 12 -
supra; cf. sec. 1374(b)(2)5 (allowing NOL carryforward
"Notwithstanding section 1371(b)(1)"). Similarly, it appears
Congress intended section 1371(b)(1) to apply to carryover of
research and other business credits. See sec. 1374(b)(3)(B)
(allowing business credit carryforwards "Notwithstanding section
1371(b)(1)"). In short, Congress evinced an intention to
recognize specific exceptions, rather than a general exception to
the application of section 1371(b)(1). It does not follow, as
petitioner suggests, from the fact that the statute specifies
certain items to be excluded from the application of section
1371(b) for one purpose, namely built-in gains under section
1374, that other items are excluded from the application of
section 1371(b) for other purposes.
Thus, even if section 469 is treated as an accounting
method, we are still left with the question whether section
1371(b)(1) applies to a particular item, in this case, PAL's.
Moreover, we note that, although Congress placed section 469 in a
part of the Code entitled "Methods of Accounting", the
legislative history indicates that such treatment is not as
significant as petitioner would have us believe. The statute
itself and the legislative history treat section 469 separately
5 Sec. 1374(b) provides limited exceptions for the purpose of calculating the tax on built-in gains, a tax imposed on the S corporation resulting from a subchapter S election by a C corporation which at the time of the election has unrealized gains on its properties. See supra note 2. The instant case does not involve the tax on built-in gains. - 13 -
from the provisions dealing with accounting matters. Compare
title V entitled "Tax Shelter Limitations; Interest Limitations",
which includes the provisions of section 469, with title VIII
"Accounting Provisions" of the Tax Reform Act of 1986, Pub. L.
99-514, 100 Stat. 2085, 2233-2249, 2345-2375; H. Conf. Rept. 99-
841 (Vol. II), supra, 1986-3 C.B. (Vol. 4) at 134, 285.
We are not impressed by petitioner's attempt to reinforce
the "method of accounting" argument that PAL's should not be
treated in the same fashion as NOL's under section 1371(b)(1) by
pointing to the fact that the regulations under section 469
disallow ratably the deductions which enter into the
determination of whether the taxpayer has incurred a PAL. The
regulations upon which petitioner bases this argument provide:
(ii) Allocation within loss activities--(A) In general. If all or any portion of a taxpayer's loss from an activity is disallowed under paragraph (f)(2)(i) of this section for the taxable year, a ratable portion of each passive activity deduction (other than an excluded deduction (within the meaning of paragraph (f)(2)(ii)(B) of this section)) of the taxpayer from such activity is disallowed. * * *
* * * * * * *
(iii) Separately identified deductions. In identifying the deductions from an activity that are disallowed under this paragraph (f)(2), the taxpayer need not account separately for a deduction unless such deduction may, if separately taken into account, result in an income tax liability for any taxable year different from that which would result were such deduction not taken into account separately. * * * [Sec. 1.469-1T(f)(2), Temporary Income Tax Regs., 53 Fed. Reg. 5706 (Feb. 25, 1988); emphasis added.] - 14 -
According to petitioner, these regulations make it clear
that deductions do not lose their character in determining a PAL
but are the items that are carried over under section 469(b)
whereas such deductions lose their character in the case of an
NOL. We think petitioner reads too much into the regulations and
in effect ignores the word "loss" in section 469(b). In this
connection, we note that, with respect to section 469, the
conference report on the Tax Reform Act of 1986 speaks of
"Deductions in excess of income (i.e. losses)" and states:
"Disallowed losses and credits are carried forward and treated as
deductions and credits from passive activities in the next
taxable year." (Emphasis added.) H. Conf. Rept. 99-841 (Vol.
II), 1986-3 C.B. (Vol. 4) at 137. In sum, we view section 469 as
denying the PAL deduction with the regulations merely supplying
the mechanics for allocating expenses among the taxpayer's
various activities in order to calculate the amount of expenses
to be deducted in computing the PAL from a particular activity.
Going beyond the "method of accounting" argument, petitioner
points to specific provisions of section 469 to support the
position that PAL's are not carryovers for purposes of section
1371(b)(1). Petitioner argues that, since PAL's are not personal
to the taxpayer but may follow the property as basis adjustments
in certain types of transfers, PAL's more closely resemble basis
(which does "carry over" from C corporation to S corporation)
than NOL's (which do not). - 15 -
In the cases of a disposition of an interest in a passive
activity by gift or distribution of such an interest by an estate
or trust, the basis of the interest is increased by the suspended
PAL's allocated to that activity. Sec. 469(j)(6), (12).
However, while the increase in basis affords the recipient the
benefit of using the equivalent of the suspended PAL's upon the
recipient's disposition of the activity, the original taxpayer is
denied any deduction of the suspended PAL's in any taxable year.
Sec. 469(j)(6), (12). Where the taxpayer transfers the interest
in the passive activity by reason of death, the suspended PAL's
allocated to that activity are treated as if there were a sale,
but only to the extent that the PAL's allocated to that activity
exceed the step-up in basis by reason of death to the transferee.
Sec. 469(g)(2). The taxpayer is denied the deduction in any
taxable year of the amount of the PAL's allocated to the disposed
of activity which equal the amount of the basis step-up. Id.
We are not convinced by petitioner's arguments that
suspended PAL's of St. Charles should be treated as basis
adjustments and therefore should not be considered carryforwards
within the meaning of section 1371(b)(1).
Finally, petitioner argues that, even if PAL's are
carryforwards, section 469 is a specific provision which should
prevail over the general provisions reflected by section
1371(b)(1). It is a basic principle of statutory construction
that a specific statute controls over a general provision. - 16 -
Bulova Watch Co. v. United States, 365 U.S. 753, 758 (1961).
However, when two statutes are capable of coexistence, "it is the
duty of the courts, absent a clearly expressed congressional
intention to the contrary, to regard each as effective." Vimar
Seguros y Reaseguros, S.A. v. M/V Sky Reefer, 515 U.S. 528, 533
(1995); see DeSalvo v. IRS, 861 F.2d 1217, 1219 (10th Cir. 1988).
Petitioner points to section 469(b), (f)(2), and (g)(1) to
sustain this position. Petitioner argues that the clause "Except
as otherwise provided in this section" (emphasis added) in
section 469(b) dictates the conclusion that section 1371(b)(1),
not being in section 469, does not apply to PAL's and, therefore,
St. Charles should be allowed to use the suspended PAL's.
As previously noted, see supra pp. 4-5, section 469(b)
provides: "Except 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."
Section 469(b) accomplishes two things: (1) It maintains
the deductibility of suspended PAL's activity by activity,
important to the overall working of section 469, and (2) it
allows the taxpayer further opportunity to take such a loss.
Even without the interplay of section 1371(b)(1), section 469(b)
does not mean the taxpayer must recognize the loss in the
immediately following year; the taxpayer may not have sufficient - 17 -
passive activity income6 to use all or any of the suspended PAL's
in that year. In such case, the unused suspended PAL's are again
disallowed and will be similarly treated as a deduction in the
next (third) year, and so on. See H. Conf. Rept. 99-841 (Vol.
II), supra, 1986-3 C.B. (Vol. 4) at 137; S. Rept. 99-313, supra,
1986-3 C.B. (Vol. 3) at 722 (where it is specified that suspended
PAL's are "carried forward indefinitely").
Petitioner further points out that it is only using the
suspended PAL's allocated to the properties which were sold, and
not those allocated to other activities that St. Charles
conducted. Petitioner goes on to argue that the losses at issue
stem entirely from the operation of section 469(g)(1)(A), see
supra p. 5, not from section 469(a) and (b); that is, they
consist solely of excess PAL's that "shall be treated as a loss
which is not from a passive activity." This, petitioner argues,
is another reason why the losses which respondent disallowed are
not carryovers and therefore section 1371(b) is inapplicable.
The application of section 469(g)(1)(A), however, turns on
the meaning of the parenthetical phrase "determined after the
application of subsection (b)" which appears twice therein, once
with respect to the disposed activity and then with respect to
all other passive activities. There is no way to determine the
amount of excess PAL's to be treated as nonpassive losses without
6 For the closely held C corporation, this would include active income as well. Sec. 469(e)(2). - 18 -
the application of section 469(b). Indeed, a principal function
of section 469(g) is to take into account the suspended PAL's
created by section 469(a) and (b). Although the excess PAL's are
no longer treated as PAL's, they are derived from suspended
PAL's.
In our view, a precondition to the applicability of the
parenthetical language in section 469(g)(1)(A) is that the
suspended PAL's be available under section 469(b). Our previous
analysis indicates that section 1371(b) makes the PAL's
unavailable in the year at issue and therefore precludes the
application of section 469(b) and consequently section
469(g)(1)(A).
Petitioner further argues that section 469(f)(2) provides
specifically for the situation at issue herein. That section
provides:
If a taxpayer ceases for any taxable year to be a closely held C corporation * * *, this section shall continue to apply to losses and credits to which this section applied for any preceding taxable year in the same manner as if such taxpayer continued to be a closely held C corporation * * *.
Respondent responds that the legislative history of section
469(f)(2) indicates that this section was meant to apply to
closely held C corporations that become "regular" C corporations,
not to those that become S corporations.
While the legislative history discusses a closely held C
corporation that, due to change in stock ownership, is no longer - 19 -
closely held, it does so as an example of the situation that
arises "when a corporation * * * subject to the passive loss rule
ceases to be subject to the passive loss rule because it ceases
to meet the definition of an entity subject to the rule." S.
Rept. 99-313, supra, 1986-3 C.B. (Vol. 3) at 728. Under these
circumstances and given the broad statutory language, we think
that section 469(f)(2) applies to St. Charles, which ceased to be
a closely held C corporation by virtue of its subchapter S
election.
Section 469(f) ensures that once a taxpayer has suspended
PAL's, the taxpayer's use of the suspended PAL's continues to be
subject to section 469. Thus, section 469(f)(1) provides that,
where the activity is no longer passive with respect to the
taxpayer, the unused PAL's are to be used to offset income from
that activity, and any remaining PAL's shall be treated as
arising from a passive activity. Section 469(f)(2) provides that
PAL's shall continue to be treated as such where the taxpayer is
no longer a closely held C corporation (and otherwise would not
be subject to section 469). Thus, the passive nature of St.
Charles' PAL's is preserved.
Petitioner argues that section 469(f)(2) requires St.
Charles to use the suspended PAL's and that, if it is not
permitted to use them against the gains from the disposition of
the disposed passive activities, it will be denied the use of the
PAL's forever. Petitioner seeks to buttress this position by - 20 -
arguing that section 469(b) allows those PAL's disallowed under
section 469(a) to be used in subsequent years and that, if
section 1371(b)(1) disallows the PAL's, section 469 does not
apply because there is no other basis for allowing their
subsequent use. Respondent argues that since St. Charles is the
same taxpayer, albeit subject to a different taxing regime,
section 1371(b)(1) merely prevents it from using the PAL's during
the "new regime" but does not preclude their preservation for use
by St. Charles when that "new regime" ends and St. Charles
becomes a taxpayer subject to section 469, as a closely held C
corporation.7
We think petitioner's position as to the dire consequence of
applying section 1371(b) is unfounded in that it ignores the
pattern reflected by section 1371(b) in its entirety, which
(b) No Carryover Between C Year and S Year.-- (1) From C year to S year.--No 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. (2) No carryover from S year.--No carryforward, and no carryback, shall arise at the corporate level for a taxable year for which a corporation is an S corporation. (3) Treatment of S year as elapsed year.-- Nothing in paragraphs (1) and (2) shall prevent treating a taxable year for which a corporation is an S corporation as a taxable year for purposes of determining the number of taxable years to which an item may be carried back or carried forward.
7 Although not a fact involved in our analysis, we note that St. Charles reverted to C corporation status in 1995. - 21 -
The clear import of section 1371 is that a change in the
taxing regime applicable to a taxpayer as it moves from being an
S corporation to a C corporation or vice versa should not be an
occasion for permitting prior losses of one taxpayer from inuring
to the benefit of another taxpayer. Thus, the losses of a C
corporation should not inure to the benefit of its shareholders,
thereby giving them an opportunity to utilize a deduction which
would not otherwise have been available to them. Sec.
1371(b)(1).8 Similarly, losses of an S corporation, which pass
through, i.e., inure to the benefit of, its shareholders should
not be taken away from them for tax purposes in order to offset
income of their corporation which has forgone its S status. Sec.
1371(b)(2). To round out the picture, section 1371(b)(3) makes
it clear that the losses remain available for future use although
the clock will continue to tick for the purpose of computing the
period of availability. Consequently, the application of section
1371(b)(1) to preclude St. Charles from using its PAL's during
the year before does not extend to destroying their availability.
See Amorient, Inc. v. Commissioner, 103 T.C. 161, 167 (1994). In
this connection, we think it significant that, unlike NOL's,
PAL's may be carried over indefinitely. See S. Rept. 99-313,
8 We note that St. Charles is not seeking to use its suspended PAL's against gains from the disposition of passive activities. Rather, it seeks to utilize the disposition of those activities at a substantial loss as the occasion for converting the suspended PAL's into losses "not from a passive activity" under sec. 469(g)(1)(A), thereby creating a significant tax benefit to pass through to its shareholders. - 22 -
supra, 1986-3 C.B. (Vol. 3) at 722. Under section 469(b),
contrary to petitioner's contention of permanent loss, they
remain available for potential use in subsequent years if and
when St. Charles relinquishes its S status.
In sum, we are satisfied that PAL's are losses within the
meaning of section 1371. Not only is the word "carryforward" in
that section unqualified, but PAL's are in effect NOL's albeit
computed separately for a particular activity and thus should not
be treated any differently than NOL's to which section 1371
unquestionably applies.
Taking into account the language of the statute and the
legislative history, including the objective of Congress in
enacting sections 469(b) and 1371(b)(1), we conclude that St.
Charles is precluded from carrying forward its suspended PAL's to
the taxable year before us.9 We emphasize that, as our analysis
has revealed, there is no conflict between sections 469(b) and
1371(b)(1) with the result that our preclusion of use in 1991 is
grounded on the unavailability of the PAL's during that year and
their continued availability for future use.
Adjustment of Basis for Suspended PAL's
Petitioner argues in the alternative that, if respondent is
sustained on the suspended PAL's issue, St. Charles should be
9 We reiterate that this case does not involve the tax on built-in gain pursuant to sec. 1374, and thus our holding does not extend to the use of suspended PAL's in calculating such gain. - 23 -
allowed to recompute the bases of the disposed properties to
restore amounts for the portion of the suspended PAL's
attributable to depreciation (and then recalculate the gain or
loss realized from the dispositions). According to petitioner,
the reductions in basis for depreciation should not have been
taken because the depreciation deductions were neither "allowed"
nor "allowable". Respondent's position is that the depreciation
deductions were allowable; it was the PAL's that were disallowed.
To a substantial degree, petitioner's alternative argument
is premised upon the assumption that we would hold that the
suspended PAL's are lost as a result of the subchapter S
election, an assumption which has proved to be erroneous.
However, petitioner's arguments suggest that they should also
apply even if the suspended PAL's are held to remain available
for future use. Consequently, we shall discuss petitioner's
alternative position.
Taxpayers are required to reduce the basis of property for
depreciation by the greater of (1) the amount allowed as
deductions in computing taxable income and resulting in a
reduction for any taxable year of the taxpayer's taxes or (2) the
amount allowable as deductions in computing taxable income
whether or not the amount properly allowable would have caused a
reduction for any taxable year of the taxpayer's taxes. Sec.
1016(a)(2); sec. 1.1016-3(a)(1)(i) and (b), Income Tax Regs.
"'Allowable deduction' generally refers to a deduction which - 24 -
qualifies under a specific Code provision whereas 'allowed
deduction', on the other hand, refers to a deduction granted by
the Internal Revenue Service which is actually taken on a return
and will result in a reduction of the taxpayer's income tax."
Lenz v. Commissioner, 101 T.C. 260, 265 (1993).
Petitioner asserts that depreciation, which was deducted in
computing the PAL's, was neither allowed nor allowable because
they were "disallowed". In support of this position, petitioner
points to section 1.469-1T(f)(2)(ii), Temporary Income Tax Regs.,
53 Fed. Reg. 5706 (Feb. 25, 1988), see supra p. 13, where the
method for allocating deductions entering into the calculation of
a PAL, is that "a ratable portion of each passive activity
deduction * * * of the taxpayer from such activity is disallowed"
(emphasis added). Petitioner insists that the phrase "is
disallowed" means that the depreciation was neither allowed nor
allowable. Noting that the loss to which the depreciation
deduction contributed was a nondeductible PAL and therefore
produced no tax benefit, petitioner concludes that the
depreciation deduction cannot be considered "allowed" or
"allowable" within the meaning of section 1016(a)(2).
We disagree. To a large degree, our reasons for so doing
have been set forth in our analysis of the provisions of the
regulations, upon which petitioner relies, in connection with
petitioner's assertion that the deductions and not the PAL are
the subject of the carryover. See supra p. 13. - 25 -
We are reinforced in our reasoning by the legislative
history of section 469, which states: "The determination of
whether a loss is suspended under the passive loss rule is made
after the application of the at-risk rules and the interest
deduction limitation, as well as other provisions relating to the
measurement of taxable income." S. Rept. 99-313, supra, 1986-3
C.B. (Vol. 3) at 723. The "basis is reduced as under present
law, even in the case where deductions are suspended under the
passive loss rule." Id. at 723 n.9.
In sum, the description of the deductions as being
"disallowed" has no independent substantive significance but
relates only to the manner of their treatment in the calculation
of the PAL.
Nor are we persuaded by petitioner's argument that the
restoration of depreciation is required by the "proper
adjustment" of basis language in section 1016. Whatever the
impact of that language might be in the context of a disallowance
of a deduction for depreciation which has a permanent effect, it
has no bearing herein. Our conclusion that the PAL's cannot be
utilized in 1991 but remain available to potential future use
supplies a critical difference from the situation that existed in
Perkins v. Thomas, 86 F.2d 954 (5th Cir. 1936), affd. on another
issue 301 U.S. 655 (1937), relied upon by petitioner. The fact
that the deduction for depreciation resulted in no tax benefit to
St. Charles in 1991 is beside the point. The PAL's, which were - 26 -
increased by the deductions, remain available for potential
future use, albeit that the conditions for such use may never
occur. In this respect, the PAL situation is strikingly similar
to that which exists in the case of an NOL which is increased by
a depreciation deduction but which may, but not necessarily, be
used in a subsequent year.
In keeping with the foregoing, respondent's motion for
partial summary judgment is granted, and petitioner's motion is
denied.
An appropriate order will
be issued.