St. Charles Investment Co., Burton C. Boothby, Tax Matters Person v. Commissioner

110 T.C. No. 6

UNITED STATES TAX COURT

ST. CHARLES INVESTMENT CO., BURTON C. BOOTHBY,
TAX MATTERS PERSON, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5793-96. Filed February 5, 1998.

Prior to Jan. 1, 1991, X was a closely held C
corporation, which incurred passive activity losses
(PAL's) giving rise to suspended PAL's pursuant to sec.
469, I.R.C. A portion of the suspended PAL's was
attributable to depreciation. X reduced the bases of
the properties used in the passive activities by the
amounts of such depreciation. X elected S corporation
status as of Jan. 1, 1991. During 1991, it disposed of
several of the passive activities and calculated the
gain (loss) from those dispositions using the bases of
the properties involved as reduced by the depreciation.
X used suspended PAL's allocable to the sold activities
which had arisen prior to 1991, in calculating its
taxable income for 1991. Held, sec. 1371(b)(1),
I.R.C., precludes X from using its suspended PAL's in
1991, an S corporation year. Held, further, X may not
recompute the bases of the sold properties to include
amounts representing the portions of the suspended
PAL's attributable to depreciation.
 - 2 -

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).

1
Unless otherwise indicated, all statutory references are
to the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
 - 3 -

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.
 - 4 -

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
 - 5 -

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.
 - 6 -

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). It is essentially a transactional provision, i.e.,

it deals with the tax treatment of particular activities. In

2
The exceptions are the taxes imposed on built-in gains
under sec. 1374 and on excess net passive income under sec. 1375.
3
See infra pp. 20-22 for a discussion of the impact of
other provisions of sec. 1371(b).
 - 7 -

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):

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
 - 8 -

eliminating, use of PAL's, and (2) including section 1371(b)(1)

to narrow the liberalizing thrust of subchapter S 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).

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
 - 9 -

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 interpretation of section 1371(b)(1). Clearly, Congress

could not have had PAL's specifically in mind when it enacted

section 1371(b)(1) in 1982, since section 469 was not enacted

until 1986. But even petitioner does not suggest that this

factor, in and of itself, is determinative. Rather, petitioner

goes on to argue that the word "carryforward" was intended to

refer only to those items which are specifically so described in

other provisions of the Code.4 We disagree.

In construing the meaning of a statute, we seek the plain

meaning of its language, assuming that Congress uses common words

in their popular meaning, and relying on the words as generally

understood. Norfolk S. Corp. v. Commissioner, 104 T.C. 13, 36-37

(1995) and cases cited thereat, modified 104 T.C. 417 (1995).

The language of section 1371(b) ("No carryforward, and no

carryback") is broad, unlike that of other sections which specify

certain types of carryforwards and carrybacks. See supra note 4.

The legislative history of section 1371(b) supports a broad

4
See, e.g., sec. 170(d)(1) and (2) (charitable
contributions); sec. 38(a) (business credit carryforwards and
carrybacks); sec. 172 (net operating loss carryovers and
carrybacks); sec. 904(c) (foreign tax credit); sec. 1212 (capital
loss carrybacks and carryovers); sec. 1374(b)(2) and (3) (net
operating loss carryforward, capital loss carryforward, and
business credit carryforwards).
 - 10 -

interpretation in that the prohibition reflected in this

provision appears in similar terms and follows a list of specific

examples of passthrough items. S. Rept. 97-640 (1982), 1982-2

C.B. 718, 725; H. Rept. 97-826 (1982), 1982-2 C.B. 730, 737.

Although section 469(b) does not use the term "carryforward", we

think the phrase "shall be treated as a deduction * * * allocable

to such activity in the next taxable year" has the same meaning.

We think this is particularly true in the case of a closely held

C corporation where passive losses are available as deductions

against active losses. Our view in this respect is reinforced by

that fact that the Senate Finance Committee report, accompanying

the enactment of section 469, states that "Suspended passive

activity losses for the year are carried forward indefinitely,

but are not carried back" (emphasis added). S. Rept. 99-313

(1986), 1986-3 C.B. (Vol. 3) 1, 722; see also H. Conf. Rept. 99-

841 (Vol. II) (1986), 1986-3 C.B. (Vol. 4) 1, 137, describing the

Senate version of section 469 (there was no House of

Representatives version) as providing that "Disallowed losses and

credits are carried forward" (emphasis added). Moreover, while

we recognize that the use of captions is limited, see section

7806(a), we think it not amiss, in the context of this case, to

note that section 469(b) is entitled "Disallowed Loss or Credit

Carried to Next Year" (emphasis added).

Petitioner points to Congress' placement of section 469

within subchapter E, part II of the Code, entitled "Methods of
 - 11 -

Accounting". Petitioner argues that the PAL rules, like other

methods of accounting, such as basis and depreciation, are to be

continued after a C corporation becomes an S corporation. As the

subject of an accounting method, petitioner argues, PAL's are not

carryovers within the meaning of section 1371(b)(1).

"The term 'method of accounting' includes not only the over-

all method of accounting of the taxpayer but also the accounting

treatment of any item." Sec. 1.446-1(a)(1), Income Tax Regs. A

material item, for purposes of a method of accounting, is any

item which involves the proper time for the inclusion of the item

in income or the taking of a deduction. Sec. 1.446-1(e)(2)(ii),

Income Tax Regs. The legislative history of section 469

expresses concern over the mismatching of deductions and income

from passive activities which leads to the sheltering of other

income. S. Rept. 99-313, supra, 1986-3 C.B. (Vol. 3) at 716-717.

An accounting method addresses the timing of the deduction

of an item, it does not provide for any deduction per se. Sec.

1.446-1(a)(1), Income Tax Regs., states: "These methods of

accounting for special items include the accounting treatment

prescribed for research and experimental expenditures, soil and

water conservation expenditures, depreciation, net operating

losses, etc." Section 1371(b)(1) clearly precludes the carryover

of net operating losses (NOL's). Rosenberg v. Commissioner,
 - 12 -

supra; cf. sec. 1374(b)(2)5 (allowing NOL carryforward

"Notwithstanding section 1371(b)(1)"). Similarly, it appears

Congress intended section 1371(b)(1) to apply to carryover of

research and other business credits. See sec. 1374(b)(3)(B)

(allowing business credit carryforwards "Notwithstanding section

1371(b)(1)"). In short, Congress evinced an intention to

recognize specific exceptions, rather than a general exception to

the application of section 1371(b)(1). It does not follow, as

petitioner suggests, from the fact that the statute specifies

certain items to be excluded from the application of section

1371(b) for one purpose, namely built-in gains under section

1374, that other items are excluded from the application of

section 1371(b) for other purposes.

Thus, even if section 469 is treated as an accounting

method, we are still left with the question whether section

1371(b)(1) applies to a particular item, in this case, PAL's.

Moreover, we note that, although Congress placed section 469 in a

part of the Code entitled "Methods of Accounting", the

legislative history indicates that such treatment is not as

significant as petitioner would have us believe. The statute

itself and the legislative history treat section 469 separately

5
Sec. 1374(b) provides limited exceptions for the purpose
of calculating the tax on built-in gains, a tax imposed on the S
corporation resulting from a subchapter S election by a C
corporation which at the time of the election has unrealized
gains on its properties. See supra note 2. The instant case
does not involve the tax on built-in gains.
 - 13 -

from the provisions dealing with accounting matters. Compare

title V entitled "Tax Shelter Limitations; Interest Limitations",

which includes the provisions of section 469, with title VIII

"Accounting Provisions" of the Tax Reform Act of 1986, Pub. L.

99-514, 100 Stat. 2085, 2233-2249, 2345-2375; H. Conf. Rept. 99-

841 (Vol. II), supra, 1986-3 C.B. (Vol. 4) at 134, 285.

We are not impressed by petitioner's attempt to reinforce

the "method of accounting" argument that PAL's should not be

treated in the same fashion as NOL's under section 1371(b)(1) by

pointing to the fact that the regulations under section 469

disallow ratably the deductions which enter into the

determination of whether the taxpayer has incurred a PAL. The

regulations upon which petitioner bases this argument provide:

(ii) Allocation within loss activities--(A) In
general. If all or any portion of a taxpayer's loss
from an activity is disallowed under paragraph
(f)(2)(i) of this section for the taxable year, a
ratable portion of each passive activity deduction
(other than an excluded deduction (within the meaning
of paragraph (f)(2)(ii)(B) of this section)) of the
taxpayer from such activity is disallowed. * * *

* * * * * * *

(iii) Separately identified deductions. In
identifying the deductions from an activity that are
disallowed under this paragraph (f)(2), the taxpayer
need not account separately for a deduction unless such
deduction may, if separately taken into account, result
in an income tax liability for any taxable year
different from that which would result were such
deduction not taken into account separately. * * *
[Sec. 1.469-1T(f)(2), Temporary Income Tax Regs., 53
Fed. Reg. 5706 (Feb. 25, 1988); emphasis added.]
 - 14 -

According to petitioner, these regulations make it clear

that deductions do not lose their character in determining a PAL

but are the items that are carried over under section 469(b)

whereas such deductions lose their character in the case of an

NOL. We think petitioner reads too much into the regulations and

in effect ignores the word "loss" in section 469(b). In this

connection, we note that, with respect to section 469, the

conference report on the Tax Reform Act of 1986 speaks of

"Deductions in excess of income (i.e. losses)" and states:

"Disallowed losses and credits are carried forward and treated as

deductions and credits from passive activities in the next

taxable year." (Emphasis added.) H. Conf. Rept. 99-841 (Vol.

II), 1986-3 C.B. (Vol. 4) at 137. In sum, we view section 469 as

denying the PAL deduction with the regulations merely supplying

the mechanics for allocating expenses among the taxpayer's

various activities in order to calculate the amount of expenses

to be deducted in computing the PAL from a particular activity.

Going beyond the "method of accounting" argument, petitioner

points to specific provisions of section 469 to support the

position that PAL's are not carryovers for purposes of section

1371(b)(1). Petitioner argues that, since PAL's are not personal

to the taxpayer but may follow the property as basis adjustments

in certain types of transfers, PAL's more closely resemble basis

(which does "carry over" from C corporation to S corporation)

than NOL's (which do not).
 - 15 -

In the cases of a disposition of an interest in a passive

activity by gift or distribution of such an interest by an estate

or trust, the basis of the interest is increased by the suspended

PAL's allocated to that activity. Sec. 469(j)(6), (12).

However, while the increase in basis affords the recipient the

benefit of using the equivalent of the suspended PAL's upon the

recipient's disposition of the activity, the original taxpayer is

denied any deduction of the suspended PAL's in any taxable year.

Sec. 469(j)(6), (12). Where the taxpayer transfers the interest

in the passive activity by reason of death, the suspended PAL's

allocated to that activity are treated as if there were a sale,

but only to the extent that the PAL's allocated to that activity

exceed the step-up in basis by reason of death to the transferee.

Sec. 469(g)(2). The taxpayer is denied the deduction in any

taxable year of the amount of the PAL's allocated to the disposed

of activity which equal the amount of the basis step-up. Id.

We are not convinced by petitioner's arguments that

suspended PAL's of St. Charles should be treated as basis

adjustments and therefore should not be considered carryforwards

within the meaning of section 1371(b)(1).

Finally, petitioner argues that, even if PAL's are

carryforwards, section 469 is a specific provision which should

prevail over the general provisions reflected by section

1371(b)(1). It is a basic principle of statutory construction

that a specific statute controls over a general provision.
 - 16 -

Bulova Watch Co. v. United States, 365 U.S. 753, 758 (1961).

However, when two statutes are capable of coexistence, "it is the

duty of the courts, absent a clearly expressed congressional

intention to the contrary, to regard each as effective." Vimar

Seguros y Reaseguros, S.A. v. M/V Sky Reefer, 515 U.S. 528, 533

(1995); see DeSalvo v. IRS, 861 F.2d 1217, 1219 (10th Cir. 1988).

Petitioner points to section 469(b), (f)(2), and (g)(1) to

sustain this position. Petitioner argues that the clause "Except

as otherwise provided in this section" (emphasis added) in

section 469(b) dictates the conclusion that section 1371(b)(1),

not being in section 469, does not apply to PAL's and, therefore,

St. Charles should be allowed to use the suspended PAL's.

As previously noted, see supra pp. 4-5, 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(b) accomplishes two things: (1) It maintains

the deductibility of suspended PAL's activity by activity,

important to the overall working of section 469, and (2) it

allows the taxpayer further opportunity to take such a loss.

Even without the interplay of section 1371(b)(1), section 469(b)

does not mean the taxpayer must recognize the loss in the

immediately following year; the taxpayer may not have sufficient
 - 17 -

passive activity income6 to use all or any of the suspended PAL's

in that year. In such case, the unused suspended PAL's are again

disallowed and will be similarly treated as a deduction in the

next (third) year, and so on. See H. Conf. Rept. 99-841 (Vol.

II), supra, 1986-3 C.B. (Vol. 4) at 137; S. Rept. 99-313, supra,

1986-3 C.B. (Vol. 3) at 722 (where it is specified that suspended

PAL's are "carried forward indefinitely").

Petitioner further points out that it is only using the

suspended PAL's allocated to the properties which were sold, and

not those allocated to other activities that St. Charles

conducted. Petitioner goes on to argue that the losses at issue

stem entirely from the operation of section 469(g)(1)(A), see

supra p. 5, not from section 469(a) and (b); that is, they

consist solely of excess PAL's that "shall be treated as a loss

which is not from a passive activity." This, petitioner argues,

is another reason why the losses which respondent disallowed are

not carryovers and therefore section 1371(b) is inapplicable.

The application of section 469(g)(1)(A), however, turns on

the meaning of the parenthetical phrase "determined after the

application of subsection (b)" which appears twice therein, once

with respect to the disposed activity and then with respect to

all other passive activities. There is no way to determine the

amount of excess PAL's to be treated as nonpassive losses without

6
For the closely held C corporation, this would include
active income as well. Sec. 469(e)(2).
 - 18 -

the application of section 469(b). Indeed, a principal function

of section 469(g) is to take into account the suspended PAL's

created by section 469(a) and (b). Although the excess PAL's are

no longer treated as PAL's, they are derived from suspended

PAL's.

In our view, a precondition to the applicability of the

parenthetical language in section 469(g)(1)(A) is that the

suspended PAL's be available under section 469(b). Our previous

analysis indicates that section 1371(b) makes the PAL's

unavailable in the year at issue and therefore precludes the

application of section 469(b) and consequently section

469(g)(1)(A).

Petitioner further argues that section 469(f)(2) provides

specifically for the situation at issue herein. That section

provides:

If a taxpayer ceases for any taxable year to be a
closely held C 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 * * *.

Respondent responds that the legislative history of section

469(f)(2) indicates that this section was meant to apply to

closely held C corporations that become "regular" C corporations,

not to those that become S corporations.

While the legislative history discusses a closely held C

corporation that, due to change in stock ownership, is no longer
 - 19 -

closely held, it does so as an example of the situation that

arises "when a corporation * * * subject to the passive loss rule

ceases to be subject to the passive loss rule because it ceases

to meet the definition of an entity subject to the rule." S.

Rept. 99-313, supra, 1986-3 C.B. (Vol. 3) at 728. Under these

circumstances and given the broad statutory language, we think

that section 469(f)(2) applies to St. Charles, which ceased to be

a closely held C corporation by virtue of its subchapter S

election.

Section 469(f) ensures that once a taxpayer has suspended

PAL's, the taxpayer's use of the suspended PAL's continues to be

subject to section 469. Thus, section 469(f)(1) provides that,

where the activity is no longer passive with respect to the

taxpayer, the unused PAL's are to be used to offset income from

that activity, and any remaining PAL's shall be treated as

arising from a passive activity. Section 469(f)(2) provides that

PAL's shall continue to be treated as such where the taxpayer is

no longer a closely held C corporation (and otherwise would not

be subject to section 469). Thus, the passive nature of St.

Charles' PAL's is preserved.

Petitioner argues that section 469(f)(2) requires St.

Charles to use the suspended PAL's and that, if it is not

permitted to use them against the gains from the disposition of

the disposed passive activities, it will be denied the use of the

PAL's forever. Petitioner seeks to buttress this position by
 - 20 -

arguing that section 469(b) allows those PAL's disallowed under

section 469(a) to be used in subsequent years and that, if

section 1371(b)(1) disallows the PAL's, section 469 does not

apply because there is no other basis for allowing their

subsequent use. Respondent argues that since St. Charles is the

same taxpayer, albeit subject to a different taxing regime,

section 1371(b)(1) merely prevents it from using the PAL's during

the "new regime" but does not preclude their preservation for use

by St. Charles when that "new regime" ends and St. Charles

becomes a taxpayer subject to section 469, as a closely held C

corporation.7

We think petitioner's position as to the dire consequence of

applying section 1371(b) is unfounded in that it ignores the

pattern reflected by section 1371(b) in its entirety, which

provides:

(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.

7
Although not a fact involved in our analysis, we note
that St. Charles reverted to C corporation status in 1995.
 - 21 -

The clear import of section 1371 is that a change in the

taxing regime applicable to a taxpayer as it moves from being an

S corporation to a C corporation or vice versa should not be an

occasion for permitting prior losses of one taxpayer from inuring

to the benefit of another taxpayer. Thus, the losses of a C

corporation should not inure to the benefit of its shareholders,

thereby giving them an opportunity to utilize a deduction which

would not otherwise have been available to them. Sec.

1371(b)(1).8 Similarly, losses of an S corporation, which pass

through, i.e., inure to the benefit of, its shareholders should

not be taken away from them for tax purposes in order to offset

income of their corporation which has forgone its S status. Sec.

1371(b)(2). To round out the picture, section 1371(b)(3) makes

it clear that the losses remain available for future use although

the clock will continue to tick for the purpose of computing the

period of availability. Consequently, the application of section

1371(b)(1) to preclude St. Charles from using its PAL's during

the year before does not extend to destroying their availability.

See Amorient, Inc. v. Commissioner, 103 T.C. 161, 167 (1994). In

this connection, we think it significant that, unlike NOL's,

PAL's may be carried over indefinitely. See S. Rept. 99-313,

8
We note that St. Charles is not seeking to use its
suspended PAL's against gains from the disposition of passive
activities. Rather, it seeks to utilize the disposition of those
activities at a substantial loss as the occasion for converting
the suspended PAL's into losses "not from a passive activity"
under sec. 469(g)(1)(A), thereby creating a significant tax
benefit to pass through to its shareholders.
 - 22 -

supra, 1986-3 C.B. (Vol. 3) at 722. Under section 469(b),

contrary to petitioner's contention of permanent loss, they

remain available for potential use in subsequent years if and

when St. Charles relinquishes its S status.

In sum, we are satisfied that PAL's are losses within the

meaning of section 1371. Not only is the word "carryforward" in

that section unqualified, but PAL's are in effect NOL's albeit

computed separately for a particular activity and thus should not

be treated any differently than NOL's to which section 1371

unquestionably applies.

Taking into account the language of the statute and the

legislative history, including the objective of Congress in

enacting sections 469(b) and 1371(b)(1), we conclude that St.

Charles is precluded from carrying forward its suspended PAL's to

the taxable year before us.9 We emphasize that, as our analysis

has revealed, there is no conflict between sections 469(b) and

1371(b)(1) with the result that our preclusion of use in 1991 is

grounded on the unavailability of the PAL's during that year and

their continued availability for future use.

Adjustment of Basis for Suspended PAL's

Petitioner argues in the alternative that, if respondent is

sustained on the suspended PAL's issue, St. Charles should be

9
We reiterate that this case does not involve the tax on
built-in gain pursuant to sec. 1374, and thus our holding does
not extend to the use of suspended PAL's in calculating such
gain.
 - 23 -

allowed to recompute the bases of the disposed properties to

restore amounts for the portion of the suspended PAL's

attributable to depreciation (and then recalculate the gain or

loss realized from the dispositions). According to petitioner,

the reductions in basis for depreciation should not have been

taken because the depreciation deductions were neither "allowed"

nor "allowable". Respondent's position is that the depreciation

deductions were allowable; it was the PAL's that were disallowed.

To a substantial degree, petitioner's alternative argument

is premised upon the assumption that we would hold that the

suspended PAL's are lost as a result of the subchapter S

election, an assumption which has proved to be erroneous.

However, petitioner's arguments suggest that they should also

apply even if the suspended PAL's are held to remain available

for future use. Consequently, we shall discuss petitioner's

alternative position.

Taxpayers are required to reduce the basis of property for

depreciation by the greater of (1) the amount allowed as

deductions in computing taxable income and resulting in a

reduction for any taxable year of the taxpayer's taxes or (2) the

amount allowable as deductions in computing taxable income

whether or not the amount properly allowable would have caused a

reduction for any taxable year of the taxpayer's taxes. Sec.

1016(a)(2); sec. 1.1016-3(a)(1)(i) and (b), Income Tax Regs.

"'Allowable deduction' generally refers to a deduction which
 - 24 -

qualifies under a specific Code provision whereas 'allowed

deduction', on the other hand, refers to a deduction granted by

the Internal Revenue Service which is actually taken on a return

and will result in a reduction of the taxpayer's income tax."

Lenz v. Commissioner, 101 T.C. 260, 265 (1993).

Petitioner asserts that depreciation, which was deducted in

computing the PAL's, was neither allowed nor allowable because

they were "disallowed". In support of this position, petitioner

points to section 1.469-1T(f)(2)(ii), Temporary Income Tax Regs.,

53 Fed. Reg. 5706 (Feb. 25, 1988), see supra p. 13, where the

method for allocating deductions entering into the calculation of

a PAL, is that "a ratable portion of each passive activity

deduction * * * of the taxpayer from such activity is disallowed"

(emphasis added). Petitioner insists that the phrase "is

disallowed" means that the depreciation was neither allowed nor

allowable. Noting that the loss to which the depreciation

deduction contributed was a nondeductible PAL and therefore

produced no tax benefit, petitioner concludes that the

depreciation deduction cannot be considered "allowed" or

"allowable" within the meaning of section 1016(a)(2).

We disagree. To a large degree, our reasons for so doing

have been set forth in our analysis of the provisions of the

regulations, upon which petitioner relies, in connection with

petitioner's assertion that the deductions and not the PAL are

the subject of the carryover. See supra p. 13.
 - 25 -

We are reinforced in our reasoning by the legislative

history of section 469, which states: "The determination of

whether a loss is suspended under the passive loss rule is made

after the application of the at-risk rules and the interest

deduction limitation, as well as other provisions relating to the

measurement of taxable income." S. Rept. 99-313, supra, 1986-3

C.B. (Vol. 3) at 723. The "basis is reduced as under present

law, even in the case where deductions are suspended under the

passive loss rule." Id. at 723 n.9.

In sum, the description of the deductions as being

"disallowed" has no independent substantive significance but

relates only to the manner of their treatment in the calculation

of the PAL.

Nor are we persuaded by petitioner's argument that the

restoration of depreciation is required by the "proper

adjustment" of basis language in section 1016. Whatever the

impact of that language might be in the context of a disallowance

of a deduction for depreciation which has a permanent effect, it

has no bearing herein. Our conclusion that the PAL's cannot be

utilized in 1991 but remain available to potential future use

supplies a critical difference from the situation that existed in

Perkins v. Thomas, 86 F.2d 954 (5th Cir. 1936), affd. on another

issue 301 U.S. 655 (1937), relied upon by petitioner. The fact

that the deduction for depreciation resulted in no tax benefit to

St. Charles in 1991 is beside the point. The PAL's, which were
 - 26 -

increased by the deductions, remain available for potential

future use, albeit that the conditions for such use may never

occur. In this respect, the PAL situation is strikingly similar

to that which exists in the case of an NOL which is increased by

a depreciation deduction but which may, but not necessarily, be

used in a subsequent year.

In keeping with the foregoing, respondent's motion for

partial summary judgment is granted, and petitioner's motion is

denied.

An appropriate order will

be issued.