In Chief Counsel Advice 202335014,[1] the IRS examined whether an Electing Small Business Trust (ESBT) can carry a net operating loss—attributable to net losses passed through from the S corporation—to a later year, or whether the loss simply goes unused indefinitely.

Electing Small Business Trusts (ESBTs)

According to IRC §1361(c)(2)(A)(v), one type of trust that can hold shares of an S corporation is an Electing Small Business Trust (ESBT), as defined in IRC §1361(e)(1). The CCA outlines the tax treatment for such a trust as follows:

Section 1.641(c)-1(a) of the Income Tax Regulations generally provides that an electing small business trust within the meaning of § 1361(e) is treated as two separate trusts for purposes of chapter 1. 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). Section 1.641(c)-1(d)(2)(i) provides in general 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 § 1366 and the regulations thereunder. 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. Section 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 § 172, a capital loss carryover under § 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 § 642(h), to the trust, or to the beneficiaries succeeding to the trust property of the trust if the entire trust terminates. [Emp. added][2]

In a footnote, the IRS notes that the CCA does not address the situation where the ESBT might also have a portion treated as a grantor trust.

For purposes of this memorandum, we ignore the possibility that an ESBT might also have a “grantor portion,” consisting of that portion of the trust treated as owned by the grantor or another person under the rules of subpart E of part 1 of subchapter J.[3]

The Issue Being Considered in This Memorandum

The memorandum outlines the issue under consideration as follows:

May the S portion of an electing small business trust (ESBT) carry to another taxable 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?[4]

The facts pertinent to this case are outlined in the memorandum:

Although we understand that actual cases involving this issue have arisen in the examination process, we have not requested or received taxpayer-specific information. The facts presented are purely hypothetical, intended to clearly present the issue.

In its X taxable year, an S corporation incurred 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 its Y taxable year to use against the income of the S portion.[5]

So, Can the ESBT Make Use of the NOL or Not?

The analysis begins by highlighting the various ways in which an S corporation shareholder’s ability to utilize a loss may be restricted on their tax return.

S corporation shareholders generally take into account in their current taxable year the items their pro rata share of the S corporation’s income, loss, deduction, or credit allocated to them under § 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 § 1366(d)(1) applies, or other provisions of law such as the “at-risk” rules under § 465 or the passive loss rules under § 469, and such suspended losses will be deductible in other taxable years only as specifically authorized by the relevant provision.[6]

In some instances, losses from the S corporation may generate a net operating loss for the year on a shareholder’s tax return. IRC §172 provides a remedy for such allowed, but effectively unused, losses by permitting the shareholder to carry that loss forward to offset income in a future tax year. However, it’s worth noting that most shareholders are not subject to the specialized rules that apply to ESBTs. So, is the impact different if the shareholder does have to deal with the ESBT rules?

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 taxable year, the shareholder may sustain an NOL, which the shareholder may carry to another taxable year pursuant to § 172(b) and claim an NOL deduction under § 172(a). However, if such a loss is allocated to the S portion of an ESBT shareholder and creates a trust-level NOL, the special rules of § 641(c)(2)(C) are implicated, complicating the question of whether such NOL may be carried over to another taxable year of the trust and taken into account by the S portion in that year.[7]

The memorandum notes that some third-party authors have questioned this impact, citing a 2007 Chief Counsel Advice (CCA 200734019) as the basis for their inquiries.

Uncertainty in this area has been created in part by commentators’ speculation as to the meaning of CCA 200734019 (issued 8/24/07). In the CCA, Trust was a residuary testamentary trust 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 § 642(h)(1). Pursuant to § 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 § 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 § 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 § 641(c)(2)(C).[8]

The memorandum continues to discuss how commentators have argued that the conclusion reached in this CCA should not apply to a net operating loss (NOL) generated in years when the stock is held by the ESBT and the loss arises from deductions and losses originating from the S corporation during that year.

A standard treatise, S Corporations Federal Taxation (May 2020 updated version), Blau, Richard D., Lemons, Bruce N., and Rohman, Thomas P., (hereinafter, “Blau”) suggests at § 19:35 a possible government interpretation of the CCA that would forbid the S portion of an ESBT from using NOL carryovers in any situation:

As an additional example, consider that while losses that pass through the S corporation to the ESBT under § 1366 are specifically required to be taken into account in the S portion of the trust, the S portion of the trust may have insufficient income to absorb these losses in a particular year. In that case, the S portion of the trust would carry such loses back forward [sic], presumably, under § 172 to a prior or future year. But, when the losses are carried forward to the future year, the losses arise, not under § 1366, but, rather, under § 172. The Service might argue that since losses under § 172 are not ‘items required to be taken into account under § 1366’ as provided in § 641(c)(2)(C), these types of carry forward losses can only be taken into account with respect to the non-S portion of the trust, perhaps resulting in the inability to use the losses against future income of the S corporation passed through to the S portion of the trust. One can argue that such an approach would not be appropriate.

The footnotes to the quoted text cite to the CCA and suggest that its holding could have been reached on other grounds: “One way of dealing with this issue would have been for the Service to simply have noted that since the losses had arisen before the trust was an ESBT, the losses were necessarily part of the non-S portion of the trust.” They then suggest multiple reasons in opposition to a reading of the CCA as disallowing any NOL carryovers to the S portion of an ESBT, which we paraphrase as follows:

1. There is no policy ground for disallowing losses carried forward or back under a section other than § 1366. The statute and regulation only require that they “originate” under § 1366. Section 1.641(c)-1(d)(2)(i) states that rules otherwise applicable to trusts apply in determining the extent to which a loss or deduction may be taken into account by the S portion; under those rules, a trust would normally be able to carry over a § 1366 loss under § 172.

2. Disallowing losses that flowed through under § 1366 in a prior or subsequent year leads to an unreasonable result. If an ESBT owned stock in two S corporations, it would clearly be able to offset flow-through gain from one with a flow-through loss from the other, yet a narrow reading of the CCA would disallow the use of losses from one corporation against gain from that same corporation if they occurred in different years, which the treatise describes as “simply mak[ing] no sense.”

3. As previously noted, the CCA conclusion could have been reached on the alternative ground that the losses were part of the non-S portion because they arose before the trust was an ESBT that had an S portion.[9]

4. Losses suspended under § 1366(d) because of insufficient current year basis would be treated more favorably than other losses for no apparent reason. The statute explicitly allows these losses to carry forward, whereas losses based on insufficient current year income would be permanently lost.

5. Section 1.641(c)-1(j) does not imply any limit on the use of NOL carryovers by the S portion of an ESBT during its existence, but merely addresses the use of unused NOLs upon the termination of the S portion.[10]

Although the author of the memorandum did not concur with the third reason provided by the treatise authors, they nevertheless agreed with the overall conclusion advocated in the treatise, based on the other criteria presented.

We agree with the commentators that the holding of the CCA does not require the disallowance of all NOL carryovers by the S portion of an ESBT. The ESBT described in the CCA received the NOL carryovers from another taxpayer, the estate, under the special rule of § 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 § 1366 item related to these losses. We believe that if a loss flowing through to the S portion of an ESBT under § 1366 cannot be used in the current taxable year because of the lack of offsetting income, it is nonetheless an item “taken into account” by reason of § 1366 in the prior or subsequent year in which it is deductible under § 172. To hold otherwise is to defeat the language of both § 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 § 1.642(d)-1 providing that the § 172 NOL deduction should be “generally” available other than for listed exceptions. We do not feel compelled to interpret § 641(c)(2)(c) in a manner that anomalously disadvantages certain § 1366 flow-through losses relative to others or ESBTs relative to other S corporation shareholders.[11]

The analysis consequently supports the conclusion stated in the memorandum, which reads:

The S portion of the ESBT may carry to another taxable year the NOL passed through from the S corporation.[12]

[1] CCA 202335014, September 1, 2023, https://www.irs.gov/pub/irs-wd/202335014.pdf (retrieved September 1, 2023)

[2] CCA 202335014, September 1, 2023

[3] CCA 202335014, September 1, 2023

[4] CCA 202335014, September 1, 2023

[5] CCA 202335014, September 1, 2023

[6] CCA 202335014, September 1, 2023

[7] CCA 202335014, September 1, 2023

[8] CCA 202335014, September 1, 2023

[9] This memorandum notes the author does not find this particular point convincing, in a footnote stating “This point is not convincing. We would have reached the same answer in the CCA, as in this document, if the testamentary trust and the ESBT had existed concurrently.”

[10] CCA 202335014, September 1, 2023

[11] CCA 202335014, September 1, 2023

[12] CCA 202335014, September 1, 2023