Rosenberg v. Comm'r of Internal Revenue
| Decision Date | 07 March 1991 |
| Docket Number | Docket No. 12777-88. |
| Parties | ALEX ROSENBERG AND BERTHA ROSENBERG, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
A corporation constructed a 15-unit condominium building in 1979, sold one unit in 1981, and rented other units until 1984. The corporation reported its income and expenses, including carrying charges of interest and taxes, under subchapter C of the Code through its fiscal year ended Nov. 30, 1982, when a subchapter S election was made. This election was in effect in 1984 when 13 of the remaining condominium units were sold.
HELD, the carrying charges included in the net operating losses incurred while the corporation was in subchapter C status may not offset 1984 income of the S corporation passed through to petitioners, sec. 1371(b), I.R.C. 1954; the tax benefit rule does not permit petitioners to recharacterize the net operating loss carryforwards as income exclusions within the meaning of that rule. Jay H. Grant, for the petitioners.
Marilyn Devin and Marlene A. Kristovich, for the respondent.
Respondent determined a deficiency in petitioners' Federal income tax for 1984 in the amount of $151,238. The issue for decision is whether a net operating loss carryover generated by a subchapter C corporation 1 in earlier years may offset income in a later year, at which time a subchapter S election is in effect for the same corporation.
All the facts are stipulated.
Petitioners, husband and wife, were legal residents of the State of California when their petition was filed. They filed a joint income tax return and an amended joint income tax return for 1984, both with the Internal Revenue Service Center at Fresno, California.
Prince David Inc. (hereinafter, the corporation) was incorporated in April 1979 and engaged in real estate development. The only business that the corporation conducted before the end of 1984 was the construction of a 15-unit condominium building, the sale of one of the units in 1981, the rental of some of the units, and the sale of all except one of the remaining units in 1984.
The corporation reported its income as a subchapter C corporation, with a fiscal year ending November 30, until an election of subchapter S status became effective on December 1, 1982. Thereafter, at least through 1984, the corporation reported its income on a calendar year basis as an S corporation. At the time of the election, petitioners owned a total of 50 percent of the stock. During 1984, petitioners were the sole shareholders of the corporation.
As of November 30, 1982, the corporation had a net operating loss carryover of $353,773, accumulated over four taxable years:
+-----------------------+
¦FYE ¦Amount ¦
+--------------+--------¦
¦Nov. 30, 1979 ¦$6,738 ¦
+--------------+--------¦
¦Nov. 30, 1980 ¦66,938 ¦
+--------------+--------¦
¦Nov. 30, 1981 ¦110,696 ¦
+--------------+--------¦
¦Nov. 30, 1982 ¦169,401 ¦
+-----------------------+
The parties stipulated that “construction carrying charges” amounted to $303,513 of the total $353,773 carryover. Under subchapter S, the corporation had a loss of $5,645 for the remainder of 1982, a loss of $46,974 in 1983, and reported income of $46,268 in 1984.
In May 1981 the corporation sold one condominium unit. It rented other units until 1984, when it sold 13 units and distributed $340,619 2 to petitioners.
On its 1984 U.S. Income Tax Return for an S Corporation (Form 1120S), the corporation excluded $303,513 from gross sales, as follows:
+----------------------------------------------+
¦Gross sales: ¦ ¦
+------------------------------------+---------¦
¦Rental ¦$22,782 ¦
+------------------------------------+---------¦
¦Sale of condominiums ¦1,268,923¦
+------------------------------------+---------¦
¦Subtotal ¦1,291,705¦
+------------------------------------+---------¦
¦Excluded from income per Statement 2¦303,513 ¦
+------------------------------------+---------¦
¦ ¦988,192 ¦
+----------------------------------------------+
Statement 2 attached to the return explains:
Costs of $303,513 for interest, taxes and certain other costs for construction and carrying the condominium units sold in 1984 that were incurred and deducted in periods ending prior to December 1, 1982, but provided no tax benefit to the Corporation, have been excluded from the sales revenues under the tax benefit rule of Internal Revenue Code [section] 111.
Petitioners have stated their position in their brief succinctly as follows:
The corporation incurred the $303,513 of expenses in excess of income as construction carry costs to carry a 15 unit condominium project it constructed until the condominium units could be sold for the amounts owed by the Corporation. These expenses were incurred when the Corporation reported under Subchapter C from its formation in 1979 to November 30, 1982. The Corporation made an S election effective December 1, 1982. The condominium units were sold in 1984, when the S election was in effect.
Petitioners contend that $303,513 of the sale proceeds should be excluded from the corporation's income under the Tax Benefit Rule.
Respondent contends that the statutory scheme for the taxation of the income of subchapter S corporations forbids the exclusion petitioners seek and that the tax benefit rule does not apply to the facts here presented.
We hold for respondent. Although petitioners cast their argument in terms of an exclusion from income, they are in fact seeking to carry forward to the S corporation's 1984 year a deduction of the net operating losses, to the extent of $303,513, incurred while the corporation was in subchapter C status. Section 1371, which includes section 1371(b)(1) specifically forbidding such deduction, states:
(a) APPLICATION OF SUBCHAPTER C RULES.--
(1) IN GENERAL. -- Except as otherwise provided in this title, and except to the extent inconsistent with this subchapter [S], subchapter C shall apply to an S corporation and its shareholders.
* * *
(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.
The language of section 1371(b)(1) could hardly be more clear. It expressly forbids the carryforward of a net operating loss incurred by a subchapter C corporation to a later year for which the corporation is in subchapter S status. The language makes no exception supporting petitioners' attempt to recharacterize the C corporation net operating loss carryforwards as an exclusion from income. As implied by section 1371(b)(3), the carryover is not necessarily lost as a result of the subchapter S election; rather, it is suspended and may be used by the corporation if it reverts to subchapter C status within the 15-year statutory period prescribed by section 172(b)(2)(B). Leaving no doubt as to the meaning of section 1371(b)(1), the House and Senate committee reports corresponding to the enactment of the provision flatly declare that “Carryovers from years in which the corporation was not a subchapter S corporation will not be allowed to the corporation while in subchapter S status.” H.Rept. No. 97-826 (1982), 1982-2 C.B. 730, 737; S.Rept. No. 97-640 (1982), 1982-2 C.B. 718, 725.
Petitioners, however, invoke the longstanding equitable doctrine known as the tax benefit rule. Under that rule, partially codified in section 111, a taxpayer may exclude from income a “recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter,” i.e., under the income tax provisions. This is known as the exclusionary aspect of the tax benefit rule. The corollary, emphasizing the inclusionary aspect, is that when an item previously deducted by the taxpayer is restored, it must be included in income to the extent that the earlier loss (deduction) generated a tax benefit. See generally Rojas v. Commissioner, 90 T.C. 1090, 1097 (1988), affd. 901 F.2d 810 (9th Cir.1990). Notwithstanding section 1371(b)(1), petitioners claim the right to invoke the tax benefit rule under the exception set forth in section 1371(a)(1), quoted above. Petitioners appear to argue that, because section 1371(a)(1) incorporates subchapter C principles and the tax benefit rule is available to subchapter C corporations, the exclusionary component of the tax benefit rule is available to the S corporation here.
The tax benefit rule is not available to petitioners. They are in fact seeking to deduct losses incurred by the corporation when it was a C corporation. As we have discussed, section 1371(b)(1) expressly forbids the deduction. Subchapter S, in general terms, relieves electing corporations of income tax at the corporate level and requires the shareholders of electing corporations to report their pro rata shares of income, deductions, losses, and credits. The opportunities for the abuse of such an election are apparent.
Section 1371(b)(1) forbidding the carryforward to an S corporation of the net operating loss of a C corporation is only one of several provisions designed to prevent abuses of the S corporation election. Others include termination of the S...
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