International Practice Unit, “Losses Claimed in Excess of Basis”

In an International Practice Unit (IPU), IRS has provided guidance to its auditors addressing whether a shareholder has sufficient basis to claim losses and deductions passed through from the S corporation.

RIA observation: IPUs are not official IRS pronouncements of law or directives and cannot be used, cited, or relied upon as such. Nonetheless, they identify strategic areas of importance to IRS and can provide valuable insight as to how IRS examiners may audit a particular issue or transaction.

Background. An S corporation shareholder takes into account, for the shareholder’s tax year in which the corporation’s tax year ends, his or her pro rata share of the corporation’s items of income, loss, deduction, or credit, as well as the corporation’s non-separately computed income or loss. (Code Sec. 1366(a)(1)) The character of the items passed through is preserved. (Code Sec. 1366(b))

However, the aggregate amount of losses and deductions taken into account by the shareholder is limited to the sum of the adjusted basis of the shareholder’s stock in the S corporation and the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder. (Code Sec. 1366(d)(1)) Any losses or deductions disallowed for any tax year are suspended and carried forward indefinitely until the shareholder has adequate stock or debt basis. (Code Sec. 1366(d)(2))

When stock and debt basis is insufficient, and there is more than one type of loss or deduction item that reduces basis, the amounts allowed as losses or deductions are allocated on a pro rata basis. The suspended losses retain their character and are carried forward and treated as incurred in the first succeeding year. If the stock is sold or otherwise disposed of, then the suspended losses are no longer carried forward and are lost forever. (Code Sec. 1366(d), Reg. § 1.1366-2(a))

Stock basis can never be reduced below zero, and even if a loss is claimed in excess of basis, the stock basis at the beginning of the following year is zero. (Code Sec. 1367(a)(2)) IRS’s position is that if a shareholder claims losses in excess of basis in a year closed by statute, then the shareholder must suspend all future tax-free distributions and losses from the S corporation until the excess losses claimed, but not allowed, are recaptured. (PLR 200619021) If a taxpayer claims a loss in excess of basis in a closed statue year, then a suspense account is created, pursuant to Code Sec. 1366(d)(2), to track the excess losses. The balance in the suspense account must be reduced to zero before the taxpayer is allowed to take tax-free non-dividend distributions or report pass-through losses.

IPU guidance. The IPU provides a process for auditors to follow in determining whether a shareholder has sufficient basis to claim losses and deductions passed through from an S corporation.

The process applies when the shareholder:

  1. Is allocated a loss or deduction item on Schedule K-1,
  2. Deducts all or a part of the loss or deduction items on Form 1040 or Form 1041, and
  3. Does not have sufficient basis to deduct the claimed losses or deductions.

To determine if the loss or deduction items exceed basis, auditors are instructed to compare the estimated beginning stock and debt basis of the S corporation with its current year Schedule K losses and deductions. Once the auditor determines that the requisite criteria have been satisfied, the auditor should determine whether to pursue the issue, with the IPU stating that the issue should be pursued if the shareholder claimed “material losses or deductions” on their Forms 1040 or 1041 in excess of the combined estimated basis. (No definition of “material” is provided for this purpose.)

To determine each shareholder’s stock and debt basis, the IPU instructs auditors to:

  1. Verify or recompute the shareholder’s basis. In completing this step, auditors are reminded that S corporation shareholders are required to both maintain adequate books and records to substantiate their basis and adjust that basis each year for the activities of the corporation, and to attach a basis computation to their return when claiming a loss or deduction, as stated in the Instructions for Schedule E (Form 1040) and the Shareholder’s Instructions for Schedule K-1 (Form 1120S). Auditors should review the shareholders’ returns for the required basis computations and request it if not attached, including basis computation for all years since the S election or since the shareholder first acquired the stock. In reviewing the shareholder’s stock and debt basis computation, auditors should:
    1. Verify the shareholder’s initial stock basis and any subsequent contributions, and consider requesting documentation to support contributions, purchases, gifts or bequests of stock;
    2. Obtain prior years Schedules K-1 information and reconcile the increases and decreases to the shareholder’s basis computation;
    3. Inquire about changes in ownership and consider the impact to basis;
    4. Verify that the proper stock and basis ordering rules are followed;
    5. Verify that any loans from a shareholder to the corporation are bona fide; and
    6. Verify that the shareholder had the necessary funds to lend or contribute to the S corporation.

The IPU provides additional steps to estimate initial stock basis for situations where historical records are not available and says that if an estimate “appears to be unreasonable based on the facts and circumstances”, consider using zero.

  1. Ascertain whether any losses were claimed in excess of basis in a closed statute year. For this step, auditors are instructed to review the basis computation schedule and identify any years for which the losses and deductions exceed the shareholder’s basis, compare the basis computation to the shareholder’s return to determine if the losses claimed in closed statute years exceed basis, and establish (or increase) the suspense account accordingly.
  2. Determine whether losses were taken in excess of basis in an open statute year. If the shareholder has a suspense account from step (2), above, then auditors should reduce the shareholder’s basis by the lesser of
    1. The absolute value of the suspense account, or
    2. The basis after the current-year increases.

Auditors are instructed to review the basis computation schedule and identify open statute years for which the losses and deductions exceed the shareholder’s basis, then compare the basis computation to the shareholder’s return to determine if the losses claimed in open statute years exceed basis. Any losses or deductions in excess of basis should be disallowed, after verifying that each loss or deduction item was properly limited on a pro rata basis.

References: For basis limitations on shareholder’s deduction of S corporation losses, see FTC 2d/FIN ¶ D-1775; United States Tax Reporter ¶ 13,664.


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