Gain or loss from the disposition of property retains the nonpassive or passive character of the activity in which the asset was used (Temp. Regs. Sec. 1.469-2T(c)(2)(i)(A)). For example, gain or loss from the sale of assets used in a trade or business is nonpassive if the taxpayer materially participates in the business. It is passive if the taxpayer does not materially participate. Gain or loss from the sale of assets (such as marketable securities or land held for investment) that generate portfolio income is portfolio (nonpassive) income or loss. Gain or loss on the disposition of rental property is passive income or loss.
Note: Dispositions of S corporation property used in a passive activity can be subject to the net investment income tax under Sec. 1411.Carrying over unused passive losses
Losses (and credits) that a taxpayer cannot use because of the passive loss limitation rules are suspended and carry over indefinitely to be offset against future passive activity income (Sec. 469(b)). A taxpayer can apply suspended losses against passive activity income from any source, not just from the activity that created the loss.Disposing of a passive activity allows suspended passive losses to be deducted
When a taxpayer disposes of the entire interest in a passive activity, that activity is no longer subject to the passive activity rules. If the activity is disposed of in a fully taxable (as opposed to tax-deferred) transaction to an unrelated party, both current and suspended passive activity losses generated by that activity (as well as any loss on the disposition) can be deducted (Sec. 469(g)(1)).
Note: Suspended passive losses allowed under Sec. 469(g)(1) are taken into account for net investment income tax purposes in the same manner in which they are taken into account for regular income tax purposes. Therefore, losses allowed under Sec. 469(g)(1) may constitute properly allocable deductions or may be included in the calculation of net gain in the year they are allowed, depending on the underlying character and origin of the losses (Regs. Sec. 1.1411-4(g)(9)).
When the S corporation disposes of an activity in a fully taxable transaction to an unrelated party, shareholders can deduct suspended losses from that activity.
Disposition of all of the stockholder's shares in an S corporation is treated as though the shareholder disposed of each of the corporation's activities.
If the disposition of a passive activity results in a capital loss, the $3,000 capital loss limitation applies. Resulting capital loss carryovers are not subject to the passive loss rules in years following the year of disposition (Sec. 1211; Regs. Sec. 1.469-2(d)(2)(ix)).
When the S corporation stock is disposed of in an installment sale, suspended losses from the activity are deductible as installment payments are collected. The losses are allowed each year based on the ratio that the gain recognized for such year bears to the total gain (Sec. 469(g)(3)).Transfer of passive activity to a family member
When a taxpayer transfers an interest in a passive activity to a family member (other than by gift), the transferor taxpayer continues to carry forward his or her suspended losses. The taxpayer can deduct the losses against income from other passive activities the taxpayer holds. If the losses remain suspended, the taxpayer can deduct them against his or her nonpassive income only when the transferee family member disposes of the property in a fully taxable transaction with an unrelated party. When a taxpayer transfers an interest in a passive activity by gift, suspended losses increase the basis of the interest. The increase is deemed to take place immediately before the gift (Sec. 469(j)(6)(A)).
Example 1. Transferring stock in a passive activity by gift: N owns stock in an S corporation in which he does not materially participate. N has $25,000 of suspended losses from the company. N gifts the stock to his adult daughter, R. His stock basis when the gift is made is $14,000. R's stock basis is $39,000, i.e., N's basis of $14,000 plus the suspended losses of $25,000.
The suspended losses are no longer deductible by either N or R but, in effect, will reduce any gain when R sells the stock (Sec. 469(j)(6)(B)). For purposes of determining the donee's loss on the disposition of the shares, the basis of property received by gift is limited to the fair market value (FMV) of the property at the time of the gift (Sec. 1015(a); Tax Reform Act of 1986, S. Rep't No. 99-313, 99th Cong., 2d Sess. 726 (1985)). This rule can cause the passive losses to disappear, with neither the donor nor the donee receiving tax deductions for the losses.
Example 2: To illustrate, assume that the FMV of the stock on the date of the gift is $15,000, and R sells it for that amount. If her basis in the shares is computed under the general rule, she would recognize a loss of $24,000 (i.e., $15,000 sales price less $39,000 basis). However, because of the FMV limitation, she recognizes no gain or loss from the sale, as shown in the calculation below.
Thus, if R sells the shares for less than $15,000, her basis for computing the loss is $15,000. If she sells for between $15,000 and $39,000, there is no gain or loss. If she sells for more than $39,000, her basis for calculating the gain is $39,000.
Under this scenario, N should consider not giving the shares to R. Instead, N might sell the shares to an outsider to trigger recognition of the losses. Conversely, the S corporation might dispose of the activity that generated the losses, so the losses could be recognized before the shares are transferred.
The planner should perform "what if" calculations to determine whether selling the stock or making a gift of the stock provides the best tax result. A sale would generally be preferable from the transferor's standpoint if he or she expects to have passive income from other sources against which to deduct the suspended losses. However, if the transferor cannot reasonably hope to deduct the suspended losses, the best answer may be to gift the stock so that the suspended losses will add to the buyer's basis.Deducting suspended passive activity losses upon death of a shareholder
Ultimately, any unused suspended losses can be claimed in a deceased individual's final return.Carrying over suspended passive activity losses in exchange
Suspended passive losses cannot be deducted when the passive activity is exchanged in a nonrecognition (i.e., tax-deferred) transaction, such as an exchange under Sec. 351 (transfers to a controlled corporation), Sec. 721 (contributions of property to a partnership), or Sec. 1031 (nontaxable exchanges), if no gain is recognized. However, the taxpayer recognizes any gain as passive activity income, against which passive losses can be deducted (Tax Reform Act of 1986, S. Rep't No. 99-313, 99th Cong., 2d Sess. 726-27 (1985)).
The taxpayer who gives up the passive activity property in the exchange continues to carry over the suspended losses. The carryover losses can be offset against the passive income from the property received that is attributable to the original activity but not against income attributable to a different activity.
Example 3. Carrying over suspended passive losses in nonrecognition of gain transfers: C owns rental property and is carrying over $20,000 of suspended passive activity losses from the rentals. (Her adjusted gross income is too high to allow the deduction of any passive rental losses under the $25,000 rental real estate exception.) She decides to incorporate and simultaneously have the corporation elect S status. She transfers the rental property into the corporation under Sec. 351 and recognizes no gain on the exchange of the property for stock. In the first year as an S corporation, the rentals show a $3,000 loss, increasing her passive loss carryover to $23,000. In the second year, the S corporation passes through to her $14,000 of income from the rentals and $1,000 of interest income. She can deduct $14,000 of the passive activity loss against the rental income but cannot offset any passive loss against the $1,000 of interest (portfolio) income. The remaining $9,000 ($23,000 - $14,000) suspended loss carries forward, and she can deduct it against passive income in subsequent years.
C can deduct her suspended losses from the rentals if she disposes of her S corporation stock in a taxable (as opposed to tax-deferred) transaction to an unrelated party. Also, her interest in an activity will be considered disposed of if her S corporation disposes of all the assets used in that activity (Sec. 469(g); Temp. Regs. Sec. 1.469-2T(e)(3); S. Rep't No. 99-313, 99th Cong., 2d Sess. 725 (1985)).Changing level of participation from not material to material
A taxpayer who has not been materially participating in a business may start materially participating. This causes the income or loss to change from passive to nonpassive. If the business had passive losses while the taxpayer did not materially participate and the taxpayer has not deducted the losses, a special rule allows the losses to be offset against nonpassive income from the same business while the taxpayer materially participates. Any loss not applied in that manner remains passive, and the taxpayer only can apply it against passive income (Sec. 469(f)).Carrying over suspended passive losses upon terminating S status
What happens to a shareholder's suspended passive activity losses generated by an S corporation when the S election terminates? Under the regulations, the losses continue to be passive and can only be offset against passive income if the C corporation continues to conduct the same passive activities (Regs. Sec. 1.469-1(f)(4)). The regulations do not say what happens if the C corporation disposes of the passive activity that gave rise to the passive income. However, it seems logical that the suspended losses would be deductible against nonpassive income at that time, as if the S corporation disposed of the activity. If all of the stockholder's shares in the C corporation were disposed of, the shareholder could presumably deduct the suspended passive losses. More guidance from the IRS is needed on this topic.Carrying over suspended passive activity credits after disposition of activity
Taxpayers cannot use suspended passive activity credits, such as the low-income housing credit or the rehabilitation credit, against the tax on nonpassive income when an activity is sold or otherwise transferred. The credits are instead applied against the tax arising from passive income or gain in the current year, with unused credits carried forward indefinitely to be applied against passive activity income in future years.Carrying over suspended passive activity losses upon electing S status
Certain passive activity loss rules are applied to some closely held corporations (Sec. 469(a)(2)(B)). What happens to these suspended losses when an S election is made?
In St. Charles Investment Co., 232 F.3d 773 (10th Cir. 2000), the Tenth Circuit reversed the Tax Court and allowed the carryover of a C corporation's passive activity losses into an S year. The court held that the plain language of Sec. 469(b) (which states that suspended passive activity losses carry over to the following year) takes precedence over Sec. 1371(b)(1) (which provides that C corporation carryover items are not carried into an S corporation year).
Example 4: ABC Corp. is a closely held, calendar-year C corporation that conducts business activities and rental real estate activities. The corporation is carrying forward $40,000 of suspended passive activity losses from the rentals when it elects S status on Jan. 1 of the current year. ABC's shareholders have sufficient basis to deduct losses, and all of their investment is at risk, so their losses are not limited by the basis or at-risk rules. Can the S corporation deduct the $40,000 of suspended losses and pass it through to the shareholders?
Under similar facts, the Tenth Circuit held that the suspended losses were deductible by the S corporation under the passive activity loss rules. Thus, the shareholders can deduct the $40,000 suspended loss to the extent they have other passive income during the year. Furthermore, shareholders who actively participate in the rental operations can deduct up to $25,000 of the losses from rental real estate if they meet the other qualifications discussed in Sec. 811.
Rental losses that the shareholders cannot use in the current year carry over at the shareholder level, and the shareholders can use them against future passive income. The shareholder can deduct the total passive losses relating to a specific rental activity when the corporation disposes of that activity. Also, the shareholder can deduct all carryover passive losses when the shareholder sells or otherwise transfers to an unrelated party his or her entire interest in the S corporation.
Note: The passive activity rules generally apply to C corporations that are "closely held" corporations or personal service corporations (Sec. 469(a)(2)(B)). St. Charles Investment Co. was a closely held corporation, subject to the rule that passive losses of these corporations can offset active income but not portfolio income (Sec. 469(e)(2)). While this case is important, the fact pattern was narrow, and practitioners may rarely encounter a closely held C corporation with suspended passive losses when it elects S status.Built-in gains tax
Although the preamble to the built-in gains (BIG) tax regulations states that suspended passive activity losses do not carry over for BIG tax purposes, the regulations do not specifically prohibit their carryover. Although it is not clear, such losses arguably may be available to offset the BIG tax. The court did not address the issue specifically in St. Charles Investment Co.
This case study has been adapted from PPC's Tax Planning Guide: S Corporations, 30th edition (March 2016), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).
|Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.