This posting is a little technical, but we think it is worth the effort to try to explain. In our Practice we see basis issues all the time when taking on new clients and during tax planning where S Corporation losses are involved.
An S corporation’s income is taxed directly to its shareholders by allocating the corporation’s items of income, loss, deduction and credit for each day in its tax year pro rata among the persons who were shareholders on that day.
Thus, deductions and losses of an S corporation are passed through to shareholders and claimed on their own returns. However, a shareholder can deduct his pro rata share of S corporation losses only to the extent of the total of his basis in (a) the S corporation stock, and (b) debt owed directly to the shareholder by the S corporation. A deduction or loss that can’t be claimed for lack of basis may be carried over and used in the future to the extent the shareholder then has basis.
A shareholder’s basis in the stock of an S corporation is increased by his pro rata share of the following corporate income items that are passed through to him: (1) separately computed items of income (including tax-exempt income) required to be taken into account by the shareholder in computing his federal income tax liability; (2) non-separately computed income; and (3) the excess of deductions for depletion over the basis of property subject to depletion. Basis in stock is decreased (but not below zero) by: the shareholder’s share of the corporation’s items of deduction, loss and nondeductible expenses (except those chargeable to the capital account); the shareholder’s depletion deduction for oil and gas property; and distributions to the shareholder that aren’t taxable as dividends.
To help demonstrate the critical nature of basis and basis timing; in a recent court case, the Court of Appeals for the District of Columbia, affirming the Tax Court, held that S corporation shareholders weren’t entitled to fully deduct passthrough losses because they didn’t have sufficient basis in their stock. The taxpayers’ past failure to take into account suspended losses that became available didn’t operate to restore the unused basis for use in the year at issue. This was so even though the taxpayers never claimed a deduction for those suspended losses, and they were now barred by the statute of limitations from doing so.
Facts of the Case.
Marc and Anne Barnes, husband and wife, were shareholders in an S corporation, Whitney Restaurants, Inc. (Whitney).
The Barneses’ 2003 tax return claimed a deduction for their $279,289 pro rata share of Whitney’s 2003 losses. However, IRS determined that their remaining basis in Whitney at that time was just $153,283. Accordingly, the IRS limited their deduction to that amount and disallowed the deduction claimed for the remainder ($123,006) of the Barneses’ share of Whitney’s 2003 losses.
The Barneses claimed that IRS and the Tax Court erroneously calculated their basis in Whitney. The D.C. Circuit said that the issue boiled down to the following question: “Is a taxpayer’s basis in an S corporation reduced by the amount of any suspended losses in the first year the basis is adequate to absorb those losses, regardless of whether the taxpayer claims a tax deduction for those losses in that year?”
The Barneses, who in ’97 failed to claim a deduction for a suspended loss even though they had adequate basis to absorb it, said “no: no deduction claimed, no basis reduction.”
The D.C. Circuit held that IRS and the Tax Court were correct in finding that the law requires an S corporation shareholder to reduce basis by any losses that he is required to take into account under the Code. Basis is reduced even if the shareholder doesn’t actually claim the pass-through losses on his return. The plain language of the Code supported the Tax Court’s and IRS’s interpretation. Accordingly, the Barneses’ 2003 pass-through losses were limited as IRS contended.
The moral of the story, is that basis is a critical factor to consider and account for in maintaining your S Corporation. The failure to do so may result in significant limitations in your ability to deduct losses.
If you have any questions regarding S Corporation basis or your individual situation, please do not hesitate to contact us.