Who’s up for a little S Corporation 101?
Well, I’m doing it anyway. S corporations generally don’t pay tax. Instead, the corporation’s taxable income or loss is divvied up and allocated to its shareholders, who report the income on their Form 1040.[i]
S corporation shareholders are required to maintain their “basis” in their S corporation stock. This is done primarily for three reasons: to determine gain or loss on the sale of the stock, to determine the taxability of S corporation distributions[ii], and lastly, to determine the maximum amount of S corporation loss allowable on the shareholder’s individual income tax return. It is this final reason we concern ourselves with today.
Unlike a C corporation, a shareholder’s stock basis in an S corporation is not static. Because of the “flow through” nature of S corporations, a shareholder’s basis must constantly be adjusted to prevent the corporation’s income from being taxed twice.[iii]
In general, a shareholder’s basis in his S corporation stock is increased for:
- Capital contributions
- Items of income (including tax exempt income)
And decreased for:
- Items of loss and deduction (including non-deductible expenses like M&E)[iv]
For any tax year, a shareholder’s allocable share of the S corporation’s loss can only be deducted to the extent of the shareholder’s basis in his stock, after accounting for the increases listed above.[v] To the extent a loss is limited under this rule, it is “suspended” and carried forward, where it is treated as a new loss in the succeeding year and is again subject to the basis limitation rule.
Today, the Tax Court tackled a seemingly simple, yet interesting issue. What if a shareholder neglects to deduct a loss they are entitled to. Must they reduce their stock basis for the loss, even though they received no tax benefit from the loss?
Let’s apply some round numbers to make it easier to follow. In 1995, A set up S Co. with a $50,000 capital contribution. During 1995 and 1996, A was allocated $200,000 of loss from S Co. which reduced his basis to $0 as of the end of 1996. Because the loss exceeded A’s positive basis of $50,000, A only received the benefit of $50,000 of loss during those two years, with the remaining $150,000 of loss suspended as of December 31, 1996.
In 1997, A contributed $250,000 to S Co. S Co. allocated a $50,000 loss to A in 1997, which he deducted on his Form 1040. A, however, failed to deduct the prior year suspended loss of $150,000, despite the fact that his capital contribution gave him ample basis to do so. As a result, A did not decrease his basis for the suspended loss, leaving him with $200,000 of stock basis as of December 31, 1997.
Fast forward five years. From 1998-2003, A continued to reflect this “extra” $150,000 in his basis, which stood at $300,000 on January 1, 2003. In 2003, S Co. allocated a $275,000 loss to A, which he deducted in full on his return.
The IRS disallowed $125,000 of the loss, arguing that A’s stock basis was required to be reduced by $150,000 of additional losses in 1998 — even though A did not deduct the loss on his return, as he was entitled to. Because under this calculation, A would have only $150,000 of stock basis on January 1, 2003 ($300,000 according to A less $150,000 downward adjustment from 1998), S Co.’s 2003 loss of $275,000 was limited to A’s stock basis of $150,000.
In defense of his stock basis calculation, A argued that I.R.C. § 1367 requires basis reduction only for losses that the S corporation shareholder reports on his or her tax return and claims as a deduction when calculating tax liability.
The Tax Court disagreed and sided with the IRS, holding that a shareholder is required to reduce his basis in S corporation stock for his allocable share of the S corporation’s loss, even if the shareholder did not deduct the loss on his Form 1040. From the court:
The class of losses described in section 1366(a)(1)(A)[S corporation losses] is not limited to losses that were actually claimed as a deduction by the shareholder on the shareholder’s tax return. Therefore, the basis reduction rule in section 1367(a)(2)(B) is not limited, as the Barneses contend, to losses that were actually claimed as a deduction on a return.
As a result, A was denied $150,000 of loss on his 2003 tax return. Of course, A would have been entitled to amend his 1996 return to take the $150,000 loss he was entitled to during that year, if it weren’t closed by statute. Ouch.
[i] S corporation shareholders are generally required to be individuals, but see I.R.C. § 1361 for the rules regarding certain qualifying trusts.
[iii] To illustrate, assume Mr. A contributed $100 to S Co. in exchange for all of its stock. S Co then earns $20 in year 1, which is not taxed at the S corporation level, but rather flows through to Mr. A and is taxed on his Form 1040. Presumably, the value of S Co. is now $120. If Mr. A sells the stock for $120, were he not required to adjust his basis in the S Co. stock, he would recognize $20 on the sale ($120 sales price – $100 basis). By increasing Mr. A’s stock basis by the $20 of income recognized by S Co., Mr. A recognizes no gain on the sale of the S Co. stock ($120 sales price – $120 basis). Thus, the $20 earned by S Co. is only taxed once.
[iv] I.R.C. § 1367
[v] The regulations at Treas. Reg. §1.1367-1(f) also require distributions to reduce stock basis before losses.