Under Section 1366, “[i]n determining the tax of a shareholder for the shareholder’s taxable year in which the taxable year of the S corporation ends (or for the final taxable year of a shareholder who dies, or of a trust or estate which terminates, before the end of the corporation’s taxable year), there shall be taken into account the shareholder’s pro rata share of the corporation’s
(A) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and
(B) nonseparately computed income or loss.”
I.R.C. § 1366(a)(1).
A shareholder cannot take corporate losses and deductions into account on his personal tax return to the extent that such items exceed his basis in the stock and debt of the S Corporation. Gitlitz v. Commissioner, 531 U.S. 206, 209 (2001) (citing to I.R.C. § 1366(d)). If those items exceed the basis, the excess is “suspended” until the shareholder’s basis becomes large enough to permit the deduction. Id. at 210.
Under Section 1367, the basis of each shareholder’s stock in an S corporation is increased for any period by the sum of the items of income described in subparagraph (A) of section 1366(a)(1). I.R.C. § 1367(a)(1)(A). In Gitlitz, the United States Supreme Court held that cancellation of indebtedness income of an insolvent S corporation, although exempt from taxation to the shareholders, is an item of income under Section 1366(a) that flows through to the shareholders of the S Corporation and increases the tax basis in their stock. Gitlitz, 531 U.S. at 206. The Court concluded that discharge of indebtedness income may therefore be used to increase a shareholder’s basis in the stock of an insolvent S Corporation to allow the shareholder to take advantage of suspended corporate losses. Id.
However, there is a limitation on the ability to take advantage of suspended losses. Taxpayers who have invested in a business in which they do not “materially participate” are subject to the passive activity loss rules in Section 469, which disallows the passive activity loss for any individual, estate or trust. I.R.C. § 469(a)(1)-(2). Under Section 469, the term “passive activity” is defined as any activity which involves the conduct of any trade or business in which the taxpayer does not materially participate and specifically includes any rental activity. I.R.C. § 469(c)(1)-(c)(2).
Section 469 further provides, however, that if during the taxable year a taxpayer disposes of his entire interest in any passive activity, if all gain or loss realized on such disposition is recognized, the excess of (i) any loss from such activity for such taxable year over (ii) any net income or gain for such taxable year from all other passive activities shall be treated as a loss which is not from a passive activity. I.R.C. § 469(g). See also St. Charles Inv. Co. v. Commissioner, 232 F.3d 773, 775 (10th Cir. 2000) (holding that “only upon the disposition of the passive activity does the entire [passive activity loss], including the suspended [passive activity losses] from previous years, become available as a deduction against both passive activity gains and other, ordinary income.”)
In the case at hand, the discharge of indebtedness may be used to increase the decedent’s basis in the S Corporation stock and allow him to take a deduction against any passive activity gains or other ordinary income.