An S corporation’s losses and deductions are allocated among its shareholders according to their proportionate ownership of the S corporation’s stock. These losses and deductions reduce the shareholder’s basis in his or her stock or, if there is none, in the shareholder’s loans to the S corporation. However, these losses and deductions are currently deductible by each shareholder only to the extent that the shareholder has basis in his or her stock and loans to the corporation. Any excess amounts of such otherwise deductible losses and deductions over basis for stock and loans are not currently deductible and are treated as arising for that shareholder in his or her next tax year (the carryover provision).
However, there is confusion as to whether the carryover provision also applies to nondeductible, noncapital losses and expenses (e.g., nondeductible meal expenses and fines). When an S corporation has losses and deductions in excess of basis, some of which are nondeductible, noncapital expenses, will there be a carryover of the nondeductible items for purposes of reducing basis in a future year?
Increases and Decreases in Basis
Sec. 1366(d)(1) limits the amount of allowable losses and deductions flowing through to a shareholder under Sec. 1366(a) to the sum of the adjusted basis of the shareholder’s stock in the S corporation (determined after giving effect to increases in basis for items of income and the excess of depletion deductions over the basis of the property being depleted) plus the shareholder’s adjusted basis of any S corporation indebtedness to the shareholder.
Sec. 1366(d)(2) provides for a shareholder’s indefinite carryover of otherwise deductible S corporation losses and deductions that are disallowed by reason of the basis limitation. Any loss or deduction disallowed for any tax year by reason of the basis limitation is treated as incurred by the S corporation in the succeeding tax year for that shareholder. The literal language of the section does not contain any carryover provision for nondeductible, noncapital expenses or for the oil and gas depletion deduction.
Sec. 1367 provides rules for adjustments to S corporation shareholders’ basis in their stock. Generally, basis is increased for items of income (including tax-exempt income) and the excess of deductions for non–oil and gas depletion over basis of the property subject to depletion. It also allows for decreases in basis (but not below zero) by each of the following:
- Items of loss and deduction that flow through to and are deductible by the shareholder;
- Nonseparately computed loss;
- Nondeductible expenses that are not properly chargeable to capital accounts; and
- Depletion deductions for oil and gas property that do not exceed the adjusted basis of such property allocated to the shareholder.
Regs. Sec. 1.1367-1(f) sets forth the ordering rules for tax years beginning on or after August 18, 1998. Under these rules, unless an election is made as provided in Regs. Sec. 1.1367-1(g) (discussed below), the Regs. Sec. 1.1367-1(f) adjustments are made in the following order:
- Any increase in basis attributable to income items and the excess of non– oil and gas depletion deductions over the basis of the property subject to depletion;
- Any decrease in basis attributable to S corporation distributions that are not taxable to the shareholder under the distribution rules of Sec. 1368;
- Any decrease in basis attributable to nondeductible, noncapital expenses and the oil and gas depletion deduction to the extent the depletion deduction does not exceed the proportionate share of the adjusted basis of that property allocated to the shareholder; and
- Any decrease in basis attributable to separately stated and nonseparately stated items of loss or deduction that are taken into account by the shareholder.
Regs. Sec. 1.1367-1(g) provides an elective ordering rule under which a shareholder may elect to decrease basis under Regs. Sec. 1.1367-1(f)(4) prior to decreasing basis under Regs. Sec. 1.1367-1(f)(3). Thus, the shareholder may elect to allow his or her separately and nonseparately stated items of loss or deduction to reduce basis prior to the nondeductible expenses. The regulation continues by saying that if a shareholder does make this election, any amount of deduction described in Regs. Sec. 1.1367-1(f)(3) (i.e., the nondeductible, noncapital expenses) that exceeds the shareholder’s basis in stock and indebtedness is treated, solely for purposes of this section, as such an amount in the succeeding tax year. Thus, if the Regs. Sec. 1.1367-1(g) election is made, the nondeductible, noncapital expenses will carry forward until used to reduce stock or loan basis in a future year. Furthermore, once a shareholder makes an election under Regs. Sec. 1.1367-1(g), he or she must continue to use those rules for that S corporation in future tax years unless the shareholder receives permission from the IRS.
Example 1: On January 1, 2009, X,a calendar-year shareholder of Z, an S corporation, had a basis in his stock of $5,000. X holds no Z debt. During 2009, X’s share of Z’s losses and deductions is $15,000, consisting of $9,000 of ordinary loss and $6,000 attributable to nondeductible, noncapital expenses. In 2010, X’s share of Z’s taxable income is $11,000.
Under the general rule of Regs. Sec. 1.1367-1(f), the basis adjustments would be calculated in the following manner. X’s $5,000 basis as of January 1, 2009, would be reduced by the $6,000 of nondeductible, noncapital losses, but not below zero. Thus, on December 31 the stock’s basis would be zero. Under Sec. 1366(d)(2), X could not deduct the $9,000 operating loss in 2009, but it would be treated as occurring in the year 2010 for X. Then in 2010 X would report $11,000 of income, increasing his stock basis to $11,000, and would deduct the $9,000 loss from 2009, reducing his stock’s basis to $2,000 on December 31, 2010. The $1,000 of nondeductible losses that did not reduce basis in 2009 would disappear and would not be carried over to a future tax year because the provision for carrying over losses relates only to those losses that are allowable as a deduction.
Example 2: Assume the same facts as Example 1, except that X uses the elective ordering rule under Regs. Sec. 1.1367-1(g).
The $9,000 operating loss would reduce the basis of X’s stock to zero, allowing X a deduction of $5,000 of the operating loss in 2009. The other $4,000 of deductible operating loss would be carried over and treated as incurred for X for 2010, the next tax year. In addition, the $6,000 of nondeductible losses would also be treated as incurred in 2010. In 2010, X would report the $11,000 as income, increasing his stock basis to $11,000. He would deduct the $4,000 carryover loss from 2009, reducing basis to $7,000, and then would further reduce it by the $6,000 nondeductible 2009 loss. X’s stock basis would therefore be $1,000 on December 31, 2010.
S corporation nondeductible, noncapital expenses allocated to a shareholder that exceed the shareholder’s basis in the S corporation’s stock and loans from the shareholder to the corporation do not carry over to a succeeding shareholder tax year and do not reduce basis in any succeeding shareholder tax year unless an election under Regs. Sec. 1.1367-1(g) is made. Thus, in Example 1, when the election is not made, the $1,000 of nondeductible, noncapital losses in excess of basis in 2009 will not reduce basis in any future year. In Example 2, where the Regs. Sec. 1.1367-1(g) election is made, the $6,000 of nondeductible losses in excess of basis from 2009 will be carried over to the next year (2010) for that taxpayer.
Sydney S. Traum, through his professional corporation, Sydney S. Traum, P.A., is of counsel to Levey, Filler, Rodriguez, Kelso & DeBianchi, LLP, in Miami Beach, FL. He is author of The S Corporation: Planning and Operation (Aspen) and The S Corporation Answer Book (Aspen). For more information on this article, please contact Mr. Traum at firstname.lastname@example.org.