An Analysis of the St. Charles Decision
By Steven C. Colburn
Tenth Circuit Allows Carryover of PALs to S Corporation
As encountered by a taxpayer that generates suspended passive activity losses as a closely held C corporation and later seeks to deduct those losses upon disposition of the activity in a taxable transaction as an S corporation, the provisions of IRC section 469 and IRC section 1371(b)(1) seem to contradict themselves. One such taxpayer, St. Charles Investment Co., chose to deduct those losses upon disposition, pursuant to IRC section 469(g)(1)(A). The Tax Court sided with the IRS, ruling that IRC section 1371(b)'s carryforward prohibition took precedence over section 469(b)'s carryforward position. Subsequently, the Tenth Circuit reversed the Tax Court, ruling in favor of the taxpayer. The author takes a close look at the provisions of the two code sections and details the Tenth's Circuit's reasoning. Although the IRS may challenge it in another district, St. Charles offers taxpayers greater flexibility in choosing their form of business, and is considered by some to be a windfall.
IRC section 469(b) provides that a disallowed loss from a passive activity must be carried forward and allocated to the same activity in the next taxable year. IRC section 1371(b)(1), however, prohibits carrybacks and carryforwards from a year in which the taxpayer was a C corporation to a year in which the taxpayer is an S corporation. In a case of first impression, St. Charles Investment Co. [86 AFTR 2d 2000-5527 (CA 10, 11/14/2000)], the Tenth Circuit Court of Appeals reversed a Tax Court ruling and held that an S corporation could deduct suspended passive activity losses (PAL) that arose while it was a C corporation. In so doing, the Tenth Circuit ruled that IRC section 469(b) took precedence over IRC section 1371(b)(1).
Conflicting IRC Provisions
IRC section 469. Section 469(a) disallows passive activity losses or credits for taxpayers that are individuals, estates, trusts, closely held C corporations, or personal service corporations. Taxpayers may not deduct aggregate passive losses in excess of aggregate passive income. Rental activities are specifically included in section 469(c)(2) as passive activities.
An exception applies to closely held C corporations that may use net passive losses to offset net active income in a taxable year. Section 469(b) provides that "except as otherwise provided in this section," disallowed losses and credits from passive activities are carried to the next taxable year, where they are treated as deductions or credits allocable to the same passive activities.
Change in business form. Under IRC section 469(f)(2), if a closely held C corporation changes its status to another business form, section 469 will continue to apply to losses and credits generated by the entity when it was a closely held C corporation. Passive losses and credits that arose when an entity was a closely held C corporation will continue to be treated as such.
Disposition of entire interest in a passive activity. IRC section 469(g)(1)(A) provides for the deduction of suspended passive losses for an activity in the taxable year in which a taxpayer disposes of its entire interest in the passive activity. The disposal must occur in a transaction where all the gain or loss realized on the disposition is recognized. Under section 469(g)(1)(A), the deduction is:
[T]he 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. Generally, the taxpayer first offsets the suspended PAL against any passive income from the same activity. Any remaining PAL is next offset against net passive income from other passive activities and, finally, against nonpassive income. Section 1371(b)(1).
Section 1371(b)(1) prohibits carrybacks and carryforwards from a year in which the taxpayer is a C corporation to a year in which the taxpayer is an S corporation.This provision was enacted to prevent the realization of deductions that could arise as a C corporation but then provide direct benefits to shareholders after conversion to a S corporation.
The St. Charles Decision
Prior to 1991, St. Charles Investment Co. was a section 469(j)(1) closely held C corporation. It owned and operated rental real estate that generated section 469(c) PALs in tax years 1988 through 1990. St. Charles elected S corporation status as of January 1, 1991. During 1991, St. Charles sold several rental properties that had suspended PALs from 1988, 1989, and 1990. On its 1991 tax return, pursuant to IRC section 469(g)(1)(A), St. Charles deducted in full the suspended PALs associated with the properties sold in 1991. Six properties produced losses totaling over $9 million; the seventh produced a gain of about $6,000. St. Charles depreciated the properties and reduced the adjusted bases accordingly in order to determine its realized gain or loss upon disposal.
In January 1996, St. Charles received a "notice of Final S corporation administrative adjustment" from the IRS for its 1991 tax year. The adjustment disallowed the deduction of $4,879,852 in suspended PALs as well as the use of $6,038,001 in suspended PALs in calculating the alternative minimum tax (AMT).
The positions. St. Charles claimed that under section 469(b) it was allowed to carry the suspended PALs forward when it changed from a C corporation to an S corporation in 1991 and that under section 469(g)(1)(A) it was allowed to deduct the suspended PALs when the properties were sold in a taxable transaction.
The IRS disagreed with St. Charles and claimed that section 1371(b)(1) was controlling because St. Charles changed its corporate status from a C to an S corporation. It claimed that the section 1371(b) prohibition against carryforwards overrode section 469(b). The IRS also made other arguments that will be discussed later.
The Tax Court Ruling
The Tax Court concluded that section 1371(b)(1) was controlling and that St. Charles was precluded from carrying forward its suspended PALs to 1991, the year it changed from a C corporation to an S corporation.
Purposes of sections 469(b) and 1371(b)(1). The court noted that section 469(b) deals with specific transactions, whereas section 1371(b)(1) deals with taxpayer status. Section 469(a) specifically disallows current deductions for net PALs; however, section 469(b) mitigates section 469(a) by allowing deductions in the year of disposal of the passive activity in a taxable transaction. On the other hand, section 1371(b)(1) specifically permits a corporation to continue as the same corporate entity after converting from a C to an S corporation while taxing income and deductions to its shareholders instead of the corporation.
Noting these structural differences between the two code sections helped the court to take into account Congress's objectives when creating them: namely, that Section 469(b) was intended to help mitigate, but not eliminate, the restrictions imposed by section 469(a), and section 1371(b)(1) was intended to help prevent abuses under subchapter S by limiting a C corporation's ability to pass on its losses to S corporation shareholders.
Interpreting sections 469(b) and 1371(b)(1). The court addressed two arguments put forth by St. Charles:
St. Charles predicated its position on the argument that the PAL rules under section 469 constitute an accounting method that St. Charles would continue to use after converting to an S corporation. In addition, St. Charles claimed its PALs would be lost forever unless it was allowed to use them in the year it disposed of the activities that caused them. St. Charles also argued that Congress intended the term "carryforward" to apply only to specific items so described in the code.
The court, stating that "In construing the meaning of a statute, we seek the plain meaning of its language," assumed that Congress used common words and common or popular meanings [Norfolk S. Corporation, 104 T.C. 13, 36-37 (1995)]. The court noted that Congress clearly could not have contemplated PALs when it enacted section 1371(b)(1) in 1982, because section 469(b) was not enacted until 1986. The court also noted that the language of section 1371(b)(1) is broad and, unlike other code sections, does not specify items to be carried forward or back. The court also stated that a broad interpretation of section 469(b) is supported by the legislative history. Applying this reasoning, the court determined that even though "carryforward" does not appear in section 469(b), the phrase "shall be treated as a deduction allocable to such activity in the next taxable year" has the same meaning as carryforward.
The court placed little weight on St. Charles' argument that section 469 is to be treated as an accounting method that, like basis and depreciation, is to be continued after a C corporation becomes an S corporation, and, therefore, PALs are not carryovers within the meaning of section 1371(b)(1). It stated that even if section 469(b) is treated as an accounting method, the question of whether section 1371(b)(1) applies to a specific item, in this case PALs, must still be answered. Rather than providing a general exception to section 1371(b)(1), Congress provided for specific items (i.e., built-in gains under section 1374) to be excluded from the application of section 1371(b)(1). The court rejected St. Charles' argument that the exclusion of specific items from the application of section 1371(b)(1) for one purpose implies the exclusion of other items for other purposes.
St. Charles also argued that PALs should not be treated as NOLs [under section 1371(b)(1)] because the regulations under section 469 ratably disallow the deductions used to determine whether the taxpayer has incurred a PAL. It argued that deductions do not lose their character in determining a PAL; rather, they are items to be carried over under section 469(b) rather than deductions that lose their character in the case of a NOL.
The court rejected this argument, stating that the taxpayer read too much into the regulations. It viewed the primary importance of the regulations as providing a means to allocate expenses among activities in order to determine the amount to be deducted when computing the PAL from a specific activity.
St. Charles argued that even if PALs are considered carryforwards, section 469 is a specific provision and should prevail over the general provisions of section 1371(b)(1). It used the phrase "except as otherwise provided in this section" to support its argument that section 1371(b)(1), not being part of section 469, does not apply to PALs. Therefore, it concluded, the PALs should be carried forward and deducted pursuant to sections 469(f)(2) and (g)(1)(A).
Furthermore, the taxpayer claimed that the PALs arose entirely because of section 469(g)(1)(A) (i.e., the gain or loss "shall be treated as a loss which is not from a passive activity"), not from section 469(b). Therefore, it claimed that the disallowed losses were not carryovers subject to section 1371(b)(1). Finally, St. Charles claimed that section 469(f)(2) required use of the suspended losses in the year of disposition of the property; any unused losses not deducted in the year of disposition would be lost forever because of the section 1371(b)(1) prohibition on carryforwards.
The court acknowledged that a basic principle of statutory construction is that a specific statute controls over a general provision [Bulova Watch Co. v. United States, 365 U.S. 753, 758 [7 AFTR 2d 1164] (1961)]. It also noted, however, that the courts must regard each statute as effective when two statutes can co-exist and Congress has not expressed an intention to the contrary [Vimar Seguros Y. Reaseguros, S.A. v. M/V Sky Reefer, 515 [pg. 56] U.S. 528,533 (1995); DeSalvo v. IRS, 861 F.2d 1217, 1219 [63 AFTR 2d 89-312] (10th Cir. 1988)].
The court noted that section 469(g)(1)(A), as cited above, called for the prior "application of subsection (b)." By this reasoning, section 469(b) must be applied first before determining the amount of excess PALs to be deducted as nonpassive losses under section 469(g)(1)(A). The court reasoned that section 1371(b)(1) prevents the carryforward of suspended PALs under section 469(b) and therefore precludes the application of section 469(g)(1)(A).
The court rejected the taxpayer's contention that suspended losses not deducted in the year of disposition of the property would be lost forever. It also rejected the IRS's position that section 469(f)(2) was meant to apply to closely held C corporations that became regular C corporations, not to closely held C corporations that became S corporations. After reviewing the legislative history of section 469(f)(2), the court concluded that it did apply to St. Charles. The court saw section 469(f)(2) as merely preserving the suspended losses once the corporation ceased to be a closely held C corporation, not as requiring that they be deducted in any particular year.
The court thought that section 1371(b)(1) was enacted to preclude individual shareholders from directly benefiting from a change from C to S corporation status by personally deducting losses denied to the former C corporation. The court also stated, however, that section 1371(b)(3) "makes it clear that the losses remain available for future use." The court appeared to contradict itself when it further stated that PALs, unlike NOLs, could be "carried over indefinitely."
The court concluded that PALs are losses within the meaning of section 1371; that is, PALs are merely NOLs computed by activity. In addition, "carryforward" is used as an unqualified term; therefore, PALs should be treated no differently than NOLs. Section 1371(b)(1) does not prevent St. Charles from deducting its suspended C corporation losses under section 469(b) at a later date; it merely prevents St. Charles from deducting them while an S corporation. The court also asserted that no conflict existed between IRC sections 469(b) and 1371(b)(1).
The Tenth Circuit Ruling
The Tenth Circuit opened its review of St. Charles by analyzing the provisions and purposes of IRC sections 469 and 1371. It stated that its primary task in interpreting statutes was to "determine congressional intent, using traditional tools of statutory construction." Furthermore, it noted that "absent ambiguity or an irrational result, the literal language of a statute controls" [Edwards v. Valdez, 789 F.2d 1477, 1481 (10th Cir. 1986)]. If the statutory language is clear, it is not appropriate for the court to review legislative history to determine Congress's intent. Accordingly, the court clearly intended to rely on the statutory language first, rather than on the legislative history, as urged by the parties.
The conflict between sections 469 and 1371. The court focused on the following conflicting language in the two code sections: n 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 of credit allocable to such activity in the next taxable year [section 469(b)]. n No carryforward, and no carryback, arising for a taxable year for which a corporations is a C corporation may be carried to a taxable year for which such corporation is an S corporation [section 1371(b)(1)]. Reviewing its previous decisions, the Tenth Circuit noted a general rule of statutory construction that if specific exceptions to a statute are not stated in that statute, other exceptions not specifically mentioned are excluded [United States v. Goldbaum, 879 F.2d 811, 813 (10th Cir. 1989)]. For example, in O'Gilvie [O'Gilvie v. United States, 66 F.3d 1550, 1555 (10th Cir. 1995)], the Tenth Circuit ruled that the statutory language of IRC section 61(a), "except as otherwise provided in this subtitle, gross income means all income from whatever source derived," prevented other exclusions from gross income not specifically mentioned in the subtitle. Likewise, in Henry [Henry v. Office of Thrift Supervision, 43 F.3d 507, 512 (10th Cir. 1994)], the court interpreted the language of 12 USC section 1818(i)(1), "except as otherwise provided in this section … no court shall have jurisdiction [to review enforcement orders of the Office of Thrift Supervision]," as precluding a party from relying on the Administrative Procedures Act to grant the court jurisdiction to review such an order. This doctrine, the court noted, also applies when interpreting IRC section 469(b). Its plain language states that only exceptions detailed in section 469 itself would prevent losses or credits disallowed under section 469(a) from being treated as a deduction or credit allocable to the activity in the next taxable year. The court concluded that because the carryforward restrictions of section 1371(b) were not specified in section 469, the section 1371(b) provisions had no effect on section 469(b). The IRS's Position Section 1371(b) as an exception to section 469(b). The court addressed the IRS's argument that even if section 469(b) does preclude the application of exceptions outside of section 469, the section 1371(b) prohibition on carryovers from a C year to an S year does not constitute an exception to section 469(b). The IRS claimed that although section 1371(b) might not prevent the allocation of a suspended PAL from a C to an S corporation, section 1371(b) would prevent the new S corporation from actually deducting the loss. As a result, a taxpayer could repeatedly carry over unused PALs from one year to the next. The court found this argument "disingenuous" in its attempt to effect the operation of both sections. Section 1371(b), the court noted, made no reference to the deductibility of carryovers; it merely prohibited the carryover itself. Furthermore, if the IRS was correct that Congress intended for section 469(b) to allow suspended PALs to be carried over from year to year without limitation, then section 1371(b) could not prevent such carryovers. Congressional intent. Another argument advanced by the IRS was that the "except as otherwise provided" language of section 469(b) was boilerplate language used in many code sections and did not clearly express the intent of Congress. The court also rejected this argument, again referring to its long-established practice of strictly interpreting statutory construction. The court cited section 469(f)(2) as further support that its ruling was what Congress intended : 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 [IRC section 469(f)(2)]. The court interpreted section 469(f)(2) to mean that, even if a corporation changed its corporate form, it could still carry over section 469(b) suspended C corporation PALs to the new S corporation tax year. It found no support in the statute for the IRS's position that section 469(f)(2) was not intended to apply to a C corporation that later became an S corporation. PALs v. NOLs. The IRS further argued that, upon the disposition of the passive activity, section 469(g)(1)(A) transforms a PAL into a net operating loss (NOL), which is not governed by section 469. As a result, section 1371(b) would prevent the deduction of the NOL by the new S corporation. The court acknowledged that section 1371(b) does prevent the carryover of NOLs from a C year to an S year [Rosenberg v. C.I.R., 96 T.C. 451 (1991); 26 C.F.R. section 1.171-1(f)]. Nevertheless, it stated that whether or not section 469(g)(1)(A) creates an NOL was not important. The court did not believe Congress intended to create an NOL in section 469(g)(1)(A). Congress knew how to create an NOL if it wished [26 USC 108(d)(7)(B)] and could have specifically done so. According to the court, the more important issue, ignored by the IRS, was the timing of the application of sections 469(b) and 469(g)(1)(A). The key point was that section 469(g)(1)(A) does not take effect until after section 469(b) is applied. Thus, the loss is still passive at the time it is carried over. Upon disposal, Section 469(g)(1)(A) then converts the loss from passive to non-passive. Once it was determined that section 1371(b) did not block the carryforward of PALs by section 469(b), there are no provisions in subchapter S to prevent their deduction as non-passive losses. This is true regardless of whether the losses were classified as NOLs or as something else. Taxpayer windfall? The IRS's final argument was that the court's ruling would create a windfall for St. Charles shareholders. Individual shareholders could deduct losses incurred by a different taxpayer, the former C corporation. The court acknowledged that the IRC should not be interpreted to grant a windfall for a taxpayer without unequivocal support in the statute for such a result [Gitlitz, 182 F.3d at 1147-48]. In this case, the court found that the language of IRC section 469 was sufficiently clear to require this result. Implications The holding in St. Charles should encourage taxpayers that want to convert C corporations with suspended PALs to S corporations. Unless other circuit courts uphold the IRS's position in subsequent rulings on this issue, taxpayers should no longer be prevented from deducting suspended PALs upon the disposition of the passive activity just because the losses were carried over from a C year to an S year. While this ruling may at first appear to provide the taxpayer with an unintended windfall, the ruling primarily allows the taxpayer to achieve closure. This ruling will provide taxpayers more freedom to choose (or change) the form of business entity that best suits their needs without worrying that their ability to deduct suspended passive losses will be lost. Taxpayers should be advised that the IRS has not acquiesced on the Tenth Circuit's ruling in St. Charles. The Tax Court ruled in favor of the IRS, and the IRS may choose to revisit this issue through future litigation in a different appeals court. Taxpayers may not have heard the last of this issue. q Steven C. Colburn, PhD, CPA, is an associate professor of accounting at the University of Maine, Orono, Me.
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