When to reduce “basis” in S Corporation Stock for a Suspended Loss?

“Basis” is tax lingo for what the cost of a particular item is for determining gain or loss.  For example, when you sell a security, the gain or loss is determined by comparing the fair market value of that security to its basis.  Basis is generally the amount you paid for that security including, for example, the commission and other fees incurred to acquire it. 

It is not uncommon for taxpayers to operate a limited liability company (“LLC”) as an S Corporation for tax purposes (via some tax elections that allow such a fiction).  As such, the taxpayer is afforded the legal benefits of a LLC while also obtaining some of the tax benefits of an S corporation (e.g., a single level of taxation and self-employment tax benefits).  The calculation of basis is complicated when the taxpayer operates his/her business as an S Corporation.  In order to preserve the policy of a single level of taxation, the Internal Revenue Code of 1986 as amended (“IRC”) requires that the taxpayer adjust his/her basis in the shares of an S Corporation; generally annually.  Basis in an S Corporation is generally increased for contributions and taxable income and decreased by losses and distributions.  Both the IRC and the regulations thereunder provide ordering rules as to how to account for those adjustments. 

In Barnes v. Comm’r, 2013-1 USTC ¶50,267 (April 5, 2013) the U.S. Court of Appeals, District of Columbia Circuit, upheld the Tax Court’s decision that the Barnes lacked sufficient basis to absorb losses flowing through to them from their investment in an S Corporation.  The IRC is clear that in order to deduct a loss from an S Corporation the taxpayer must have positive basis in the S Corporation shares.  See IRC § 1366(d)(1).  To the extent that the losses are greater than the taxpayer’s basis in the S Corporation stock, such losses can be carried forward indefinitely.  See IRC § 1366(d)(2).  If the IRC is so clear then what was the dispute between the IRS and the Barnes?  As stated by the court:   “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?”  Accordingly, the question before the court was when to reduce basis for a suspended loss.  The taxpayer had effectively “elected” not to take the loss in 1997 but in 2003.

The Barnes incurred suspended losses in certain pre-1997 tax years; tax years closed under the statute of limitations. However, in 1997, the Barnes had adequate basis to deduct the suspended losses, but they failed to do so.  In 2003, the Barnes claimed S Corporation losses of $279,000.  On audit, the IRS determined that their remaining basis in the S Corporation was only $153,000.  Applying the basis limitation rule noted above, the IRS properly disallowed the deduction for the excess losses.  Reading IRC §§ 1367 and 1366 in conjunction the court determined:  “A shareholder's basis is decreased ‘for any period’ by the amount of that shareholder's pro rata share of the corporation's losses, and a shareholder incurs previously unabsorbed losses in the first year the shareholder has adequate basis to do so.” Emphasis added.  The court also upheld an accuracy related penalty finding that the taxpayer did not act in good faith, had no reasonable cause exception to the imposition of the penalty nor was there substantial authority for the position taken; for deducting the loss in 2003 versus 1997.  Accordingly, not only did the taxpayer permanently lose the benefit associated with the suspended losses (remember the losses should have been deducted in 1997; a closed year) they also incurred a penalty and legal costs; a costly proposition.

Basis should be computed and tracked annually.  The problem is (and this is not a self-serving comment) taxpayers don’t want to pay their tax advisor for the additional work necessary to calculate and track basis: penny wise, pound foolish.  Inevitably, what ends up happening is that the taxpayer pays the advisor more to calculate basis when it is necessary.  Finally, the more sophisticated software has the ability to calculate and track basis concurrently the preparation of the taxpayer’s tax return. 

For more information please visit my website: www.millsestateplanning.com.