Passive Loss Carryovers—A Reversal.

The complexity of the tax law has resulted in numerous instances of apparent contradictions between Internal Revenue Code sections. In an effort to eliminate the conflict, the courts usually try to apply some general rules of code construction. In a case of first impression (an issue it had never decided before), the Tenth Circuit Court of Appeals resolved an existing conflict, reversing a Tax Court decision that passive losses may not carry over from a C to an S corporation.

The case involved the St. Charles Investment Co., which was a C corporation for tax years 1988 to 1990. During that time it engaged in passive real estate operations generating passive loss carryovers. On January 1, 1991, the company’s shareholders elected S corporation treatment for St. Charles. After the election, the corporation sold the passive investments. On its 1991 tax return it claimed the passive loss carryovers based on IRC section 469(g)(1)(A). The IRS denied the deductions on the grounds that section 1371(b)(1) prevented any carryover to an S year from a C year. The Tax Court ruled for the IRS and the taxpayer appealed.

Result. For the taxpayer. Section 469(b) provides that any disallowed passive losses are treated as losses in the following year except as provided in other parts of that section. Section 1371(b) says no carryover arising in a C year may be carried over to an S year. The Tenth Circuit acknowledged the conflict inherent in these two provisions (section 469 grants a carryover and section 1371 denies it) and evaluated them to determine which code section controlled the disputed deductions.

The plain meaning of the words must be followed in analyzing code sections unless the law is ambiguous or generates irrational results. Looking first at section 469, the court noted that it contained a general rule and a statement that the rule was to be applied except as noted in the section itself. The court pointed out that in other code sections with a similar hierarchy only the exceptions listed in that section are honored. Exceptions in other sections do not apply. Using the standard rules of statutory construction, section 469 overrides the limitation found in section 1371(b).

The court went on to say that even if we assume ambiguity in the statute, congressional intent appears to side with section 469. Subsection (f)(3) of section 469 says that in any year it ceases to be a closely held C corporation the taxpayer should continue to apply this section as if it were still a C corporation. Thus congressional intent appears to allow the carryover even after a change in the taxpayer’s status.

This decision allows a taxpayer to claim a loss on the disposition of a passive activity even though its tax status has changed. This can prevent actual losses from evaporating unused.

By ruling in the taxpayer’s favor on the conflict issue, the Tenth Circuit never considered St. Charles’ second argument which said that if it could not carry over the loss, then the depreciation deductions should be added back to the property’s basis before the gain or loss on the disposition of the assets is calculated. It is interesting to speculate whether the court would have accepted this argument. A pro-taxpayer decision might have had unexpected implications for taxpayers affected by the alternative minimum tax and other limitation provisions.

St. Charles Investment Co. v. Commissioner, 232 F3d 773; 2000-2 USTC 50, 840.