Right about now, many of you are probably saying “Not again,” or “not another,” in reaction to the title of this post. I suspect that, for many of you, this is the umpteenth article you’ve encountered on the “S vs C” saga[i] that was reinvigorated following the enactment of the Tax Cuts and Jobs Act on December 22, 2017.[ii]
I, for one, continue to field questions regarding the conversion of S corporations into C corporations, which indicates that many business owners and their advisers are still struggling with this choice.
However, December 21 – the last day of the two-year period beginning with the enactment date of the TCJA – may represent a “deadline” for reaching this decision in the case of many S corporations and their shareholders.
Thus, a brief review and some reminders are in order.
Whither the “Small” Corps?
A few years back, as LLC statutes were being enacted throughout the country,[iii] you may recall having heard many people wonder why any business owner would ever use an S corporation. The LLC provided the pass-through treatment of a partnership for tax purposes[iv] and the limited liability protection of a corporation under state law, but without all of the limitations of an S corporation.
Then, more recently, came the reduction in the C corporation federal income tax rate,[v] from a top marginal rate of 35-percent to a flat rate of 21-percent, plus the repeal of the corporate alternative minimum tax.[vi] Again, you must have heard some folks saying that the S corporation would become obsolete.
The Resiliency of the S Corp
Although the S corporation has its shortcomings, and has certainly been challenged by the developments described above, it remains a viable choice for the owners of many closely held businesses.
For example, it offers an alternative for reducing the employment taxes that would otherwise be incurred by a member of an LLC with respect to their share of the LLC’s net income.
Assume two similarly situated owners, one a member of an LLC, the other a shareholder of an S corporation; each entity has a single class of equity; neither business is capital intensive; neither is very reliant on debt financing; all of the owners are individuals and participate to some degree in the business.[vii] The member receives a “guaranteed payment” from the LLC in respect of their services rendered to the LLC;[viii] the shareholder of the S corporation is paid “reasonable” compensation for their services rendered to the corporation.[ix]
The sum of the member’s guaranteed payment, plus their distributive share of the LLC’s net income, is subject to self-employment taxes.[x] Now substitute the shareholder-employee of the S corporation. Only the compensation paid to the shareholder is subject to employment taxes;[xi] the shareholder’s pro rata share of the S corporation’s net income is not subject to such taxes.
Using an LLC? The Irony
In order to qualify as a small business corporation for which its shareholder may elect treatment as an S corporation, the corporation must satisfy various conditions.[xii] For example, generally speaking, the shareholders must all be taxable as U.S. individuals;[xiii] there can be only one class of stock issued and outstanding;[xiv] there cannot be more than one hundred shareholders.[xv]
What’s more, S corporations and their shareholders have found ways of dealing with many of the conditions that a corporation must satisfy in order to achieve “S” status.
For example, the fact that S corporation stock may not be held by another corporation, a partnership, or a nonresident alien may seem to greatly limit the corporation’s ability to raise capital from these sources. True, but not entirely. S corporations have found they may still joint venture with such persons.
In fact, the IRS has blessed the use of partnerships as vehicles through which a non-qualifying shareholder may participate in the business of an S corporation; that is to say, the IRS has decided such use was not inconsistent with the purpose of the partnership tax rules.[xvi]
Assume taxpayers A and B form partnership PRS to conduct a bona fide business. A is a corporation that has elected to be treated as an S corporation. B is a nonresident alien. PRS is properly classified as a partnership for tax purposes. Because B is prohibited from being a shareholder in A, they choose to form a partnership as a means of retaining the benefits of subchapter S treatment for A and its shareholders while also enabling A to conduct joint business activity with B.
According to the IRS, the partnership tax rules are intended to permit taxpayers to conduct joint business activity through a flexible economic arrangement without incurring an entity-level tax. The decision to organize and conduct business through PRS is consistent with this intent. Although it may be argued that the form of this partnership transaction should not be respected because it does not reflect its substance (inasmuch as application of the “substance over form” doctrine arguably could result in B being treated as a shareholder of A, thereby invalidating A’s “S” election), the facts indicate otherwise. The shareholders of A are subject to tax on their share of A’s income, and B is subject to tax on B’s distributive share of partnership income.[xvii] Thus, the form in which this arrangement is cast accurately reflects its substance as a separate partnership and an S corporation.
One Level of Tax on a Sale
There are plenty of “mature” S corporations out there, the shareholders of which may be contemplating the sale of the business in the not-too-distant future. In many cases, if not most, it would be folly for the owners of these S corporations to revoke their “S” election and thereby become taxable as C corporations.
Imagine a C corporation at this stage of its existence. Assume its shareholders are individuals. The potential buyer of the corporation’s business has expressed an interest in acquiring the assets of the business, as opposed to the stock held by the shareholders. In this way, the buyer will be able to recover the purchase price for the assets much faster – by expensing, depreciating and amortizing most of the purchase price – and thereby reduce the economic cost of the transaction.[xviii]
The shareholders of the target C corporation don’t care for the tax consequences of an asset sale by the C corporation:
- a 21-percent federal corporate income tax[xix] on the gain from the asset sale at the corporate level, followed by
- a 20-percent federal tax on the capital gain realized by the shareholders on receipt of the distribution of the after-corporate-tax proceeds from the sale in liquidation of the corporation,[xx] plus
- a 3.8-percent federal surtax on such shareholder gain.[xxi]
In other words, an effective federal tax rate of 39.8-percent before considering state and local taxes.[xxii]
The shareholders had hoped to sell the stock of the corporation. Assuming most of the shareholders did not satisfy the conditions for the exclusion-of-gain provision for “qualified small business stock,”[xxiii] they would still enjoy long-term capital gain treatment on the sale of their stock, taxable at a 20-percent federal tax rate. Unfortunately, their gain would also be subject to the 3.8-percent federal surtax on net investment income, regardless of the shareholders’ level of participation in the business. This yields a federal tax rate of 23.8-percent.
How can the shareholders of the selling C corporation reduce the corporate-level gain from an asset sale? How can they reduce the combined federal tax liability of 39.8-percent to bring it closer to the 23.8 percent of a stock sale?
Bypassing the C corporation, somehow, is one way of addressing this issue. Before the TCJA, the buyer could, for example, pay the target corporation’s shareholders for a non-compete agreement;[xxiv] the buyer would receive an amortizable asset, while the shareholders would pay federal income tax at a rate of 39.6-percent. Yes, this was high, but better than the pre-TCJA result of a corporate asset sale and liquidating distribution, which resulted in a combined federal rate of almost 50-percent.
After the TCJA, this approach yields a federal tax rate of 37-percent for the “bypass payment” versus a combined federal rate of 39.8-percent for the asset sale and distribution – not as much of a difference.
If the shareholders were able to demonstrate that they owned personal, non-corporate, goodwill related to the business, they may be able to dispose of this personal asset directly to the buyer, thus avoiding gain at the corporate level. However, it may be very difficult to support a claim of personal goodwill.[xxv]
Thanks, But Good-Bye “S”
Notwithstanding the “resiliency” of the S corporation,[xxvi] there will be shareholders of such corporations who are seriously considering, based on their facts and circumstances – including the fact they are not planning to sell the corporate-owned business at any time in the foreseeable future[xxvii] – and those of their business, whether C corporation status may be right for them.
In the case of those shareholders who are thinking about taking the plunge into subchapter C,[xxviii] there are a number of factors to consider, including some tax benefits they may be leaving behind, unused, as a result of a conversion. Then there are those relatively new statutory provisions that are intended to mitigate some of the economic consequences of such a conversion. Unfortunately, the time for securing some of these benefits has almost expired.
There are also a couple of traps of which these shareholders should be aware.
With the foregoing cautions in mind, how would the shareholders go about ending the “S” election?
What immediate tax-related consequences should the S corporation’s shareholders expect?
What did the TCJA provide to ease the transition from “S” to “C” status?
Revoking the “S” Election
The revocation of a corporation’s “S” election requires the consent of more than one-half of the outstanding shares of the corporation’s stock, including non-voting shares,[xxix] on the day on which the revocation is made.[xxx]
The shareholders can select a date that occurs after the date the revocation is filed on which the S election will terminate.
If they fail to do so, and the revocation is filed on or before March 15 of the current tax year, the revocation will be effective as of January 1 of the year;[xxxi] if it is filed after that date, the revocation is effective on Jan. 1 of the succeeding tax year.[xxxii]
Short Tax Years
Assuming a revocation is effective during a tax year, the year is divided into two short tax years: a short S year, and a short C year.[xxxiii]
The corporation’s income has to be allocated between the two short years. Under the default rule, the corporation’s income is allocated based on the number of days in each of the two periods.[xxxiv] Alternatively, and provided all of the shareholders consent, the S corporation may elect to close its books as of its last day as an S corporation and apply its normal accounting rules to determine its income for the short period.[xxxv]
This decision should not be taken lightly, especially in the case of a seasonal business.[xxxvi]
Re-electing “S” Status
Once the corporation’s election has been revoked, the corporation may not be able to re-elect “S” status for a period of five years.[xxxvii]
During those five years, the corporation’s assets will, presumably, appreciate in value. If the corporation were to convert[xxxviii] to S corporation status again at that point, the gain inherent in its assets at that time, including its goodwill and going concern value, would remain subject to the corporate-level built-in gains tax for an additional five-period.[xxxix]
In other words, a revocation results in a ten-year waiting period during which a re-electing S corporation will remain subject to a corporate-level tax on the gain that was inherent in its assets at the time it revoked its S status plus all subsequent appreciation to the time it re-elected S status.[xl]
If the S corporation has a subsidiary for which it has made a QSUB election,[xli] the revocation of the “S” election will also terminate the QSUB election, thus causing the subsidiary to become a taxable C corporation.
In general, this “conversion” from a “disregarded” entity to a separate corporation should be tax-free;[xlii] however, the shareholders should consider whether the “assumption” by the “newly-formed” corporation of the QSUB’s liabilities exceeds the basis of the QSUB assets deemed contributed to the corporation, which may trigger some gain recognition.[xliii]
Although the “new” parent-subsidiary corporations may be able to file a consolidated return, the parent may also consider merging the wholly-owned subsidiary corporation into a wholly-owned subsidiary LLC in order to maintain its status as a disregarded entity for tax purposes.[xliv]
As discussed below, an S corporation that revokes its election may be required to change its accounting method from the cash[xlv] to the accrual method.[xlvi] That’s because a C corporation may not, generally speaking, use the cash method – it must determine its taxable income using the accrual method.[xlvii] Consequently, the revoking S corporation would be forced to include in income for its first C corporation year an amount derived from its previously accrued but unrecognized income and deductions.[xlviii]
Prior to the TCJA, an exception to this rule was made for a C corporation if its average annual gross receipts did not exceed $5 million for all prior years (the ‘‘gross receipts test’’) – meaning it would be allowed to continue using the cash method of its predecessor S corporation.
Gross Receipts Test
In order to further mitigate the impact of a change in accounting method resulting from the revocation of an “S” election, the TCJA expanded the universe of taxpayers that may use the cash method of accounting to include C corporations with average annual gross receipts that do not exceed $25 million[xlix] for the three prior taxable years.[l]
Accordingly, a former S corporation – now a C corporation – with average annual gross receipts that do not exceed $25 million, and that used the cash method prior to revoking its S corporation election, may be eligible to remain on the cash method as a C corporation, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor.[li]
But if an S corporation with gross receipts in excess of $25 million converts to “C” status, it will have to convert to the accrual basis.
Required Change in Accounting Method
Where the corporation is required to change from the cash method to the accrual method upon converting from an S to a C corporation, it must include in its income for its first year under the accrual method certain adjustments to compensate for the change.
The IRS has generally allowed taxpayers to account for the adjustments over a period of four years, beginning with the year of the change.[lii]
In order to provide additional relief for the adjustments resulting from the change, the TCJA provided that any such adjustment of an “eligible terminated S corporation” (an “ETSC”) attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) is taken into account ratably during the six-taxable-year period beginning with the year of change.[liii]
An ETSC is any C corporation that (1) was an S corporation on December 21, 2017 (i.e., the day before enactment of the TCJA), (2) revokes its S corporation election during the two-year period beginning December 22, 2017 (i.e., the date of enactment), and (3) has all of the same owners (and in identical proportions) on the date the S corporation election is revoked as it had on December 22, 2017.[liv]
When the after-corporate-tax profit of a C corporation is distributed as a dividend, the recipient shareholder is subject to income tax. [lv]
In contrast, an S corporation shareholder generally is not subject to tax on corporate distributions unless the distributions exceed the shareholder’s adjusted basis in the stock of the corporation.[lvi] That’s because the shareholder’s stock basis is increased by the amount of income and gain that flows through to the shareholder, which facilitates the distribution of such already-taxed income or gain – to the extent of such basis – without the imposition of any additional tax.[lvii]
If the amount distributed exceeds the shareholder’s stock basis, the excess is treated as gain from the sale of the stock.[lviii]
Where the S corporation has accumulated earnings and profits (“AEP”),[lix] the amount distributed is first treated as a tax-free return of basis to the extent of the corporation’s accumulated adjustments account (“AAA”).[lx] The remaining portion of the distribution is treated as a dividend distribution that carries out C corporation AEP to the extent thereof and which, consequently, is taxed to the shareholders. To the extent this remaining portion of the distribution exceeds the corporation’s AEP, the excess is treated as a return of stock basis and then as gain from the sale of the stock.
The shareholders of a former S corporation would lose the benefit of its AAA following its conversion to “C” status unless the AAA was distributed to the shareholders during the post-termination transition period (“PTTP”).[lxi]
Under a special rule, however, the shareholders’ receipt of a distribution of money[lxii] by their former S corporation during the PTTP is tax-free to the extent of the recipient’s basis in their stock with respect to which they received the distribution, and is taxed as gain from the sale of property to the extent the distribution exceeds the recipient’s basis in that stock. If the corporation exhausts its AAA during the PTTP, then subsequent distributions may be treated as regular dividends.[lxiii]
In other words, this rule allows shareholders of the resulting C corporation to benefit from the corporation’s former status as an S corporation. Without this rule, shareholders of the former S corporation would be precluded from receiving distributions allocable to AAA.
The PTTP is generally the one-year period after the S corporation election terminates.[lxiv] If the former S corporation fails to distribute all of its AAA within the PTTP, the corporation cannot recover that “unused” AAA if it re-elects “S” status some time later.[lxv]
The TCJA extended the period during which the shareholders of a C corporation can benefit from AAA generated during such corporation’s former status as an S corporation by allowing the C corporation’s distribution of money that would otherwise be treated as a dividend to be sourced, in whole or in part, from AAA.[lxvi]
Specifically, in the case of any distribution of money by an ETSC after the PTTP, the ETSC may elect to allocate its AAA to such distribution, and to treat the distribution as chargeable to AEP, in the same ratio as AAA bears to AEP.[lxvii]
Losses incurred by an S corporation flow through to its shareholders, up to the amount of each shareholder’s adjusted basis for their stock,[lxviii] plus their basis for any loans they’ve made to the corporation.[lxix] If a shareholder’s pro rata share of the loss realized by the corporation exceeds the shareholder’s aggregate stock and debt basis, the excess is “suspended” and carried forward indefinitely until the shareholder increases their basis sufficiently to utilize the suspended loss, or until the shareholder disposes of their shares.[lxx]
In addition, a shareholder’s suspended losses would normally be lost once the corporation’s “S” election is revoked.
However, the Code provides that any such suspended loss will be treated as having been incurred on the last day of the PTTP, and may be used to the extent of the shareholder’s basis in its shares as of that day.[lxxi]
Thus, a shareholder in that situation may want to consider making a capital contribution to, or purchasing more stock in, the former S corporation to increase their stock basis and thereby utilize the suspended loss.
It’s Not Over Yet
If an S corporation’s shareholders are serious about converting to “C” status, all things considered, and they have determined that they will likely benefit from the extended six-year period over which to include the adjustments resulting from a attendant change in accounting method, or if they believe they will need the post-PTTP period in order to distribute all of the corporation’ AAA, then they better act soon to revoke the “S” election.
For those shareholders that do not fall within this group, the “S” vs “C” saga will continue to play out, often frustrating business owners, but always piquing the interest of their tax advisers.
[i] I hope one of mine is among these. https://www.taxlawforchb.com/2019/04/post-2017-is-it-time-to-kick-your-corporations-s/
[ii] P.L. 115-97 (the “TCJA”).
[iii] By the time N.Y. adopted the LLC, in 1994, over 40 states had already done so. The first was Wyoming, in 1977.
[iv] In other words, no entity-level tax on the entity’s net income; instead, it passes through, and is taxed, to the entity’s owners.
[v] For tax years beginning after December 31, 2017.
[vii] I’ve just described a large part of the universe of business organizations.
[viii] IRC Sec. 707(c).
[ix] IRC Sec. 162(a)(1); Reg. Sec. 1.162-7.
[x] IRC Sec. 1402.
[xi] IRC Sec. 3121.
[xii] IRC Sec. 1361(b).
[xiii] Estates and most trusts are taxable in the same manner as individuals, with certain adjustments. IRC Sec. 641(b).
[xiv] Meaning that all outstanding shares must have identical rights to distributions and liquidation proceeds. See Reg. Sec. 1.1361-1(l), especially the provisions dealing with “commercial agreements.”
Most commercial agreements – for example, an employment agreement or a lease – are not treated as “binding agreements as to distribution and liquidation proceeds” unless a principal purpose of the agreement is to circumvent the one class of stock requirement. The question of intent – to circumvent the one class of stock rule – is also found in the regulatory provisions dealing with buy-sell agreements, and below-market loans by the S corp. to a shareholder. Reg. Sec. 1.1361-1(l). The same inquiry would apply to any situation that may generate a constructive distribution to a shareholder, but not to all: is a principal purpose of the arrangement to circumvent the one class of stock rule?
[xv] There are some generous counting rules that enable family-owned corporations to remain within this limit regardless of how many shareholders there actually are.
[xvi] See, for example, See Reg. Sec. 1.701-2(d), Ex. 2. These are the so-called “anti-abuse” regulations under Subchapter K. https://www.taxlawforchb.com/2015/11/partnering-with-an-s-corp/
Of course, there will be circumstances in which the ineligible investor or purchaser will insist upon taking equity in the corporation itself, or you may be faced with a situation in which the corporate assets cannot actually be transferred. In that case, the F reorganization technique described later may be helpful.
[xvii] See IRC Sec. 1446 with respect to PRS’s withholding obligations as to B’s distributive share of PRS’s net income.
[xviii] IRC Sec. 167, Sec. 168(k), and Sec. 197.
[xix] IRC Sec. 11.
[xx] IRC Sec. 1(h), Sec. 331.
[xxi] IRC Sec. 1411. The surtax on net investment income.
[xxii] In the case of N.Y., with a corporate income tax rate of 6.5-percent, the combined effective corporate tax rate would be 25.1-percent; with a N.Y. personal income tax rate of 8.82-percent (assume a non-NYC resident), the total combined effective corporate and individual tax rate (including the federal surtax on net investment income) would be 49.5-percent.
[xxiv] The question of reasonableness will always be presented in such situations.
[xxv] Martin Ice Cream, 110 T.C. 189 (1998). https://www.taxlawforchb.com/2013/10/goodwill-personal-or-corporate-asset/
[xxvi] And notwithstanding the enactment of IRC Sec. 199A and the deduction provided thereunder to the shareholders of S corporations (among others) based on 20% of their pro rata share of the corporation’s qualified business income.
[xxvii] Of course, you never know when that offer will come along that is just too good to refuse. It’s a risk the shareholders may be willing to take at this point.
[xxviii] Get it? Plunge into “C” (the sea). OK, don’t all laugh at once.
[xxix] As distinguished from more than 50% of the shareholders.
[xxx] A shareholders’ agreement may require a higher threshold (usually a super-majority). Reg. Sec. 1.1362-2.
In contrast, note that an election into “S” status requires unanimity among the shareholders.
[xxxi] Assuming a calendar year corporation, as most S corporations are.
[xxxii] Reg. Sec. 1.1362-2(a)(2).
[xxxiii] IRC Sec. 1362(e).
[xxxiv] IRC Sec. 1362(e)(2).
[xxxv] IRC Sec. 1362(e)(3).
[xxxvi] Before deciding between these two income allocation methods, it would behoove the shareholders to determine the difference in results. For example, which method will result in more of the income being taxed at 37% vs 21%?
[xxxvii] At least without first obtaining the IRS’s consent. IRC Sec. 1362(g).
[xxxviii] By the consent of its shareholders.
[xxxix] The “recognition period.” IRC Sec. 1374. If a C corporation converts to an S corporation, a corporate-level tax will apply to the S corporation if it sells any of the assets it held as a C corporation during the next five years – the so-called built-in gains tax. Generally speaking, the amount of gain that may be taxed to the S corp. is capped at the gain that was inherent in the corporation’s assets at the time of the conversion.
[xl] Stated differently, the corporation’s shareholders will have to wait a total of ten years before they may enjoy only one level of tax on the sale of the corporation’s assets. Query whether this sobering fact may dampen their ardor for revoking the “S” election? After all, while beyond what is reasonably foreseeably, 10 years is not that far down the road.
[xli] IRC Sec. 1361(b)(3). An S corporation is deemed to own all of the assets and income of its QSUB – the QSUB is generally disregarded for tax purposes.
[xlii] As a deemed contribution by the former S corporation of the QSUB assets to a corporation that is deemed to have just been formed. IRC Sec. 351.
[xliii] IRC Sec. 357(c); Reg. Sec. 1.1361-5(b).
[xliv] In a transaction that qualifies as a tax-free liquidation under IRC Sec. 332.
[xlv] Taxpayers using the cash method generally recognize items of income when actually or constructively received and items of expense when paid.
[xlvi] Taxpayers using an accrual method generally accrue items of income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.
Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all the events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.
[xlvii] IRC Sec. 448.
[xlviii] IRC Sec. 481(a).
[xlix] The $25 million amount is indexed for inflation for taxable years beginning after 2018.
[l] IRC Sec. 448(c).
[li] S corporations are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of such method clearly reflects income.
[lii] IRC Sec. 481(c).
[liii] IRC Sec. 481(d). Query whether a six-year adjustment period is sufficient? Unfortunately, it is what it is.
[liv] See Rev. Proc. 2018–44 and Rev. Proc. 2018–31 with respect to the change from cash to accrual method accounting upon a conversion from “S” to “C” status.
[lv] IRC Sec. 301, Sec. 302, Sec. 1(h). The 3.8% surtax will also apply. IRC Sec. 1411.
Where the C corporation is not expected to make dividend distributions to its shareholders (as where it is reinvesting its after-tax profits), the S corporation seems “expensive” by comparison because the S corporation’s profits are taxable to the shareholders at a maximum federal rate of 37% whether or not distributed to them.
But once you start talking about making distributions to the shareholders of the corporation, the C corporation’s advantage disappears. Specifically, the combined federal rate of 21% on corporate-level profit, plus the 20% federal rate on C corporation dividends to individual shareholders and the 3.8% federal surtax on individual shareholders, is almost 40%.
[lvi] IRC Sec. 1368.
[lvii] IRC Sec. 1367 and Sec. 1366. Beware, however, the corporation’s distribution of property in-kind, which is treated as sale of the property by the corporation that may result in the recognition of gain. IRC Sec. 311(b).
[lviii] Capital gain.
[lix] Carried over from years during which it was a C corporation, or “inherited” from a C corporation that the S corporation acquired in a transaction described in IRC Sec. 381; for example, a tax-free merger under IRC Sec. 368(a)(1)(A).
[lx] IRC Sec. 1368(c). In very general terms, the AAA is a corporate account that reflects the S corporation’s income and gain that have already been taken into account by its shareholders in determining their individual taxable income, but that have not yet been distributed by the corporation to the shareholders. “
[lxi] Query whether an F-reorganization (basically, an inversion) may help here. IRC Sec. 1371(e).
[lxii] Not property in-kind; probably not a note.
[lxiii] IRC Sec. 1371(e).
[lxiv] IRC Sec. 1377(b).
[lxv] https://www.taxlawforchb.com/2015/01/from-s-to-c-to-s-or-but-i-was-already-taxed-on-that/ which discusses CCA 201446021.
[lxvi] Section 1371(f).
[lxvii] On Nov. 4, 2019, the IRS issued proposed regulations under this provision. REG-131071-18.
[lxviii] IRC Sec. 1367.
[lxix] IRC Sec. 1366(d). The losses that pass through are subject to the at-risk and passive loss rules (IRC Sec. 465 and Sec. 469).
[lxx] IRC Sec. 1366(d)(2).
[lxxi] IRC Sec. 1366(d)(3).