St. Charles Inv. Co. v. Comm'r of Internal Revenue, 5793–96.

• Decision Date: 05 February 1998
• Docket Number: No. 5793–96.,5793–96.
• Citation: 110 T.C. 46,110 T.C. No. 6
• Parties: ST. CHARLES INVESTMENT CO., Burton C. Boothby, Tax Matters Person, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

110 T.C. 46

110 T.C. No. 6

ST. CHARLES INVESTMENT CO., Burton C. Boothby, Tax Matters Person, Petitioner,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 5793–96.

United States Tax Court.

Feb. 5, 1998.

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 WL 393062 (1993).

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.

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 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.

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 WL 542395 (1995). It is essentially a transactional provision, i.e., it deals with the tax treatment of particular activities. In 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 WL 270985 (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 eliminating, use of PAL's, and (2) including section 1371(b)(1) to narrow the liberalizing thrust of subchapter 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 WL 29011 (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 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 ...