Essential S corporation basis rules for deducting losses
Essential S corporation basis rules for deducting losses
An S corporation shareholder reports all flow-through income or loss from the entity that is proportionate to stock ownership on his or her individual federal income tax return. This creates a corresponding adjustment to the basis of the shareholder’s corporate shares. Fundamentally, a basis increase will arise from allocated income items and a basis decrease from allocated losses. As with all flow-through entities, an existing basis in the ownership of stock of an S corporation, or ownership of a partnership interest or LLC member unit is required for the owner’s deductibility of losses. Maximizing the S corporation owner’s potential for loss write-off is essential to basic tax planning, which begins first in the complete understanding of how basis in stock is created and reduced. Then, once the stock basis is ultimately reduced to zero, a second essential understanding is how additional basis is created through the proper management of shareholder debt to the corporation.
The original determination of an S corporation’s shareholder’s stock basis will vary under different fundamental tax concepts, depending on the manner of acquisition of the stock. If the owner’s interest was acquired by cash purchase, the basic principles create a beginning basis in the stock equal to the monies exchanged for the purchase. Alternatively, shares acquired by gift generally carry the donor’s basis in the stock unless special circumstances exist in which the stock’s fair market value at the time of the gift is lower than the donor’s basis.
After the initial stock basis has been established, assuming an S corporation election is in place, there are very specific timing-ordering rules by which the stock’s basis increases or decreases absent an election to apply the alternative ordering rules. All of these ordered adjustments are generally effective at the end of the tax year with the exception that any planned sale of a shareholder’s stock triggers the adjustments to be applied immediately preceding the disposition.
The ordering scheme begins with the requirement that the stockholder’s basis be increased by his or her pro rata share of separately stated items of taxable income, gains, and tax-exempt income, then by his or her pro rata share of non-separately stated income, followed by the amount by which any applicable depletion deduction exceeds the depleted property’s basis. Next, focusing solely on stock basis rules for tax years beginning on or after 8/18/98, any distributions from the S corporation that have no accumulated earnings and profits will result in a reduction of basis or gain when distributions exceed basis. If there are accumulated earnings and profits, however, the layer of the accumulated adjustments account consisting of income allocations taxed in prior years will be first decreased, followed then by a decrease of the stock basis for the tax year. A reduction for separately stated expenses and losses follows; non-separately stated losses, non-deductible expenses that are not capitalized, and any depletion deductions that do not exceed the depleted property’s basis all then reduce stock basis. After the S corporation stock basis is reduced to zero and consideration of shareholder loans for additional basis for losses is not an option, all remaining deductible losses have an unlimited carryover period until stock basis has been increased through future pro rata “basis-increase” adjustments from future allocations of separately or non-separately stated income. Once basis does increase in such manner, the suspended losses are deductible in the tax year of the basis increase. On the other hand, additional capital contributions can increase the stock basis and trigger the application of unused loss deductions.
Alternatively, after following the ordering scheme of above through which the shareholder first reduces the basis of his or her corporate stock to zero in claiming allocated losses, each shareholder is then allowed to consider the available basis of any loans from the shareholder to the corporation. The basis of these loans, if sufficient, can then be used to secure a deduction for any remaining unapplied allocated losses that exceeded the shareholder’s stock’s basis. Certain shareholder debt basis may be used as basis to deduct excess losses and has been the source of annual tax planning for decades. As case law has reflected and is discussed herein, historically, S corporation shareholders often have managed their ability to fully deduct flow-through losses by managing their personal lending to the corporation, in lieu of making formal capital contributions.
