Losses Flowing to S Portion of an ESBT Can Be Carried to Other Years as NOLs

(Parker Tax Publishing September 2023)

The Office of Chief Counsel advised that the S portion of an electing small business trust (ESBT) may carry to another tax year a net operating loss (NOL) attributable to a loss passed through to the ESBT by an S corporation of which it is a shareholder. The Chief Counsel's Office noted that uncertainty in this area by commentators' speculation as to the meaning of CCA 200734019, but it concluded that the holding of that CCA does not require the disallowance of all NOL carryovers by the S portion of an ESBT. CCA 202335014.

The Office of Chief Counsel was asked to advise whether the portion of an electing small business trust (ESBT) that consists of stock in one or more S corporations (i.e., the S portion of an ESBT) may carry to another tax year a net operating loss (NOL) attributable to a loss passed through to the ESBT hy the S corporation of which it is a shareholder. Under the facts presented, an S corporation incurred in Year 1 an NOL that it passed through to its sole shareholder, an ESBT. The ESBT had sufficient basis in its stock to fully claim the loss. However, it did not have sufficient income in its S portion to cover the loss, thus creating an NOL at the trust level. The ESBT carried the NOL to Year 2 to use against the income of the S portion.

Background

S corporation shareholders generally take into account in their current tax year the items their pro rata share of the S corporation's income, loss, deduction, or credit allocated to them under Code Sec. 1366(a)(1). But the ability to use the losses flowing through in the current year may be limited for various reasons, including when the shareholder's current year income is less than the amount of the losses, the basis limitation of Code Sec. 1366(d)(1) applies, or other provisions of law such as the "at-risk" rules under Code Sec. 465 or the passive loss rules under Code Sec. 469, and such suspended losses will be deductible in other tax years only as specifically authorized by the relevant provision.

In the case of an individual S corporation shareholder who is allocated a loss from the corporation, if the amount of the loss exceeds the shareholder's gross income for the tax year, the shareholder may sustain a net operating loss (NOL), which the shareholder may carry to another tax year and claim an NOL deduction under Code Sec. 172. However, if such a loss is allocated to the S portion of an electing small business trust (ESBT) shareholder and creates a trust-level NOL, the special rules of Code Sec. 641(c)(2)(C) are implicated, complicating the question of whether such NOL may be carried over to another tax year of the trust and taken into account by the S portion in that year.

Code Sec. 641(c)(1) generally provides that for income tax purposes, (A) the portion of any ESBT which consists of stock in one or more S corporations shall be treated as a separate trust, and (B) the amount of tax imposed on such separate trust shall be determined with the modifications of Code Sec. 641(c)(2). Under Code Sec. 641(c)(2)(C), the only items of income, loss, deduction, or credit to be taken into account for purposes of Code Sec. 641(c)(1) are the following: (1) the items required to be taken into account under Code Sec. 1366, (2) any gain or loss from the disposition of stock in an S corporation, (3) state or local income taxes or administrative expenses to the extent allocable to items described in (1) and (2), and (4) any interest expense paid or accrued on debt incurred to acquire stock in an S corporation.

Reg. Sec. 1.641(c)-1(a) generally provides that an ESBT is treated as two separate trusts for income tax purposes. The portion of an ESBT that consists of stock in one or more S corporations is treated as one trust (the S portion). The portion of an ESBT that consists of all the other assets in the trust is treated as a separate trust (the non-S portion). Reg. Sec. 1.641(c)-1(d)(2)(i) generally provides that the S portion takes into account the items of income, loss, deduction, or credit that are taken into account by an S corporation shareholder pursuant to Code Sec. 1366 and the regulations thereunder. The regulation states: "Rules otherwise applicable to trusts apply in determining the extent to which any loss, deduction, or credit may be taken into account in determining the taxable income of the S portion." Reg. Sec. 1.641(c)-1(j) provides in part that upon the termination or revocation of an ESBT election, if the S portion has a NOL under Code Sec. 172, a capital loss carryover under Code Sec. 1212, or deductions in excess of gross income, then any such loss, carryover, or excess deductions shall be allowed as a deduction, in accordance with the regulations under Code Sec. 642(h), to the trust, or to the beneficiaries succeeding to the trust property of the trust if the entire trust terminates.

Code Sec. 642(d) provides that the benefit of the deduction for NOLs provided by Code Sec. 172 shall be allowed to estates and trusts under IRS regulations. Reg. Sec. 1.642(d)-1 provides the NOL deduction allowed by Code Sec. 172 is available to estates and trusts generally. Code Sec. 642(h)(1) provides that if on the termination of an estate or trust, the estate or trust has a NOL carryover under Code Sec. 172 or a capital loss carryover under Code Sec. 1212, then such carryover shall be allowed as a deduction to the beneficiaries succeeding to the property of the estate or trust.

According to the IRS, uncertainty has been created in part by commentators' speculation as to the meaning of CCA 200734019. In the CCA, a residuary testamentary trust (Trust) was created pursuant to the will of A, who died on Date 1. On Date 2, Trust was funded with assets including stock of X, an S corporation, which A had held directly during life. During the administration of A's estate (between Dates 1 and 2), A's estate did not have sufficient income to absorb losses attributable to the X stock, giving rise to an NOL. The NOL carryover remained unused at the termination of the estate and funding of Trust on Date 2, and Trust succeeded to it under Code Sec. 642(h)(1). Pursuant to Code Sec. 1361(c)(2)(A)(iii), Trust qualified as an S corporation shareholder for the 2-year period beginning on Date 2. To remain as an eligible shareholder following that period, Trust elected to be an ESBT effective Date 3.

The CCA concludes that Code Sec. 641(c)(2)(C) provides a complete list of the items of income, loss, deduction, or credit that the S portion of an ESBT may take into account, the flush language specifically denying a deduction or credit for any amount not included in the statutory list. Because the NOLs that Trust succeeded to under Code Sec. 642(h)(1) are not listed, the S portion was precluded from taking deductions attributable to them. However, the NOLs would be available as a deduction to the non-S portion. The CCA notes that the taxpayer had argued that the NOL should be allocated to the S portion of Trust because it is attributable to losses sustained by the S corporation whose stock is held in that portion. The CCA rejects this taxpayer argument based on the "plain language" of Code Sec. 641(c)(2)(C).

The Chief Counsel's Office noted that commentators, including a standard tax treatise, have argued that CCA 200734019 should not be read as disallowing any NOL carryovers to the S portion of an ESBT.

Analysis

The Chief Counsel's Office advised that the S portion of an ESBT may carry to another tax year an NOL passed through from the S corporation of which it is a shareholder.

The Chief Counsel's Office agreed with the commentators that the holding of the CCA 200734019 does not require the disallowance of all NOL carryovers by the S portion of an ESBT. The Chief Counsel's Office noted that the ESBT described in the CCA received the NOL carryovers from another taxpayer, the estate, under the special rule of Code Sec. 642(h)(1) allowing these items to be carried over to a successor rather than lost at the estate's termination. The ESBT never had a Code Sec. 1366 item related to these losses.

The Chief Counsel's Office said it believes that if a loss flowing through to the S portion of an ESBT under Code Sec. 1366 cannot be used in the current tax year because of the lack of offsetting income, it is nonetheless an item "taken into account" by reason of Code Sec. 1366 in the prior or subsequent year in which it is deductible under Code Sec. 172. To hold otherwise, in the view of the Chief Counsel's Office, is to defeat the language of both Reg. Sec. 1.641(c)-1(d)(2)(i) that the rules "otherwise applicable to trusts apply in determining the extent to which any loss, deduction, or credit may be taken into account," and of Reg. Sec. 1.642(d)-1 providing that the Code Sec. 172 NOL deduction should be "generally" available other than for listed exceptions. The Chief Counsel's Office added that it did not feel compelled to interpret Code Sec. 641(c)(2)(C) in a manner that anomalously disadvantages certain Code Sec. 1366 flow-through losses relative to others or ESBTs relative to other S corporation shareholders.

For a discussion of trusts as S corporation shareholders, see Parker Tax ¶30,115.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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