Deducting S Corporation Losses to Extent of Shareholder Basis

Editor: Albert B. Ellentuck, Esq.

An S corporation shareholder reports corporate income or loss on the personal income tax return for the year in which the corporate year ends (Sec. 1366(a)). Losses or deductions passed through to the shareholder first reduce stock basis. After stock basis has been reduced to zero, remaining loss amounts are applied against debt basis (Sec. 1367(b)(2)(A)). Debt basis is not reduced by passthrough losses or deductions if the debt has been satisfied, disposed of, or forgiven during the corporation’s tax year (Regs. Sec. 1.1367-2(b)). A “net increase” first restores debt basis to the extent debt basis has been reduced by losses or deductions in tax years beginning after 1982 (Sec. 1367(b)(2)(B); Regs. Sec. 1.1367-2(c)(1)). A “net increase” is, generally, the amount by which the sum of passthrough income and gains exceeds the sum of passthrough loss, deductions, and distributions.

Example 1: B Inc., a calendar-year corporation, was formed on Jan. 1, 2010. At formation, P contributed $50,000 in exchange for 100% of B’s stock and loaned $45,000 to the corporation. The corporation’s nonseparately stated (taxable) income or loss for each year is shown in Exhibit 1.

The corporation had no other income or expense items. No loan payments were made to P, and P did not contribute additional capital to the corporation. B distributed $100,000 to P in 2012. Is P’s basis adequate to permit full deduction of corporate losses? P’s basis is shown in Exhibit 2.

P has stock basis of $48,000 (after taking into account distributions to P of $100,000 during the year) and debt basis of $45,000 at the end of 2012. Each loss was fully deductible in the year it occurred because P had sufficient basis in stock and debt to cover the loss.

Planning to Obtain Additional Basis

In a year losses decrease stock and debt basis to zero, the losses can be deducted in that year only if the shareholder increases basis. (Basis must be increased before the end of the corporation’s tax year.)

Example 2: Continuing with the same facts as in Example 1, in 2013, B Inc. shows a net loss of $125,000. P’s stock basis and debt basis are zero at the end of the year as shown in Exhibit 3. Unless his basis is increased, P will have a nondeductible loss of $32,000, computed as shown in Exhibit 4.

P would have to obtain additional basis of $32,000 before the end of the corporation’s tax year to deduct the entire loss in 2013. He could establish additional stock basis by:

1. Contributing cash to the corporation. If necessary, P could personally borrow the money from an unrelated lender and contribute the proceeds to the corporation. P, rather than the corporation, should make the loan payments.
2. Contributing property to the corporation in exchange for stock. P’s stock basis is increased by his adjusted basis in the property. If P recognizes gain on the transaction, the gain also increases stock basis.
3. Purchasing additional shares. P could purchase the shares from the corporation or, if there were other shareholders, from one or more of the other shareholders.

P could increase his debt basis by:

1. Lending money to the corporation. If necessary, P could personally borrow the money from an unrelated lender and use the proceeds to make the payments. P, rather than the corporation, should make the loan payments to the lender.
2. Paying all or part of corporate debt that P has guaranteed. Banks and other lenders may require that the shareholders guarantee loans that are made to the corporation. If P makes payments on such guaranteed loans, those payments increase his debt basis. If necessary, P could personally borrow the money from an unrelated lender and use the proceeds to make the payments. Note that merely guaranteeing a loan does not give the shareholder debt basis.
3. Having the lender substitute P’s note for a note from the corporation to a third-party lender. If the lender substitutes P’s note for that of the corporation and releases the corporation from liability to repay the debt, P obtains debt basis because the corporation then becomes indebted to the shareholder under the doctrine of subrogation.
4. Advancing the corporation funds as open account debt. Open account debt owed to the shareholder provides debt basis. Within limits, open account advances and repayments can be netted and treated as one indebtedness. However, under the regulations, open account debt is treated as if it were evidenced by a written note when the balance of open account debt equals or exceeds $25,000 at the end of the corporation’s tax year.

If P’s basis is not increased by the end of 2013, the $32,000 loss will carry forward and become deductible in a year in which all or part of the basis is restored. Basis restoration occurs when the shareholder acquires additional stock or debt basis, or when corporate income increases basis.

Increasing Basis Not Always Best Course of Action

Basis increases occurring before the end of the S corporation’s tax year can be used to deduct current and prior losses. Practitioners should be aware, however, that making capital contributions or loans to increase basis so that losses can be deducted is not always the optimal course of action. This is especially true if there is a risk that the corporation may become insolvent. For example, if the taxpayer makes a contribution to capital of $10,000 and cannot recover that amount because of the corporation’s insolvency, the taxpayer has actually lost the $10,000, net of the tax savings from claiming the tax deduction. Before the taxpayer parts with cash, or makes a binding obligation to repay a loan, both the tax and nontax factors should be assessed carefully.

Planning tip: Shareholders who increase basis by making contributions to capital should, if possible, purchase stock from the S corporation. If the transaction is structured to fit the requirements of Sec. 1244, and the stock later becomes worthless, the resulting loss will be treated as an ordinary loss. If the shareholder makes contributions to capital and does not acquire Sec. 1244 stock, any resulting loss will be short-term or long-term capital loss, depending on when the contribution was made.

Claiming Business or Nonbusiness Bad Debt Loss at Shareholder Level

Shareholders who increase basis by making loans to the S corporation can take a bad debt loss if the loan becomes uncollectible. Shareholders can deduct two types of bad debt losses: business and nonbusiness (Sec. 166). Business bad debts result in ordinary losses; nonbusiness bad debts result in short-term capital losses. The shareholder can claim a business bad debt loss when the loss from a worthless debt is incurred in the shareholder’s trade or business (Sec. 166(d)(2); Regs. Sec. 1.166-5(b)). A shareholder may establish that a loan to another business (such as the shareholder’s S corporation) is a business loan if it was made to protect the taxpayer’s status as an employee, source of income, business relationship, or business reputation.

In Litwin, 983 F.2d 997 (10th Cir. 1993), the Tenth Circuit allowed a shareholder/employee’s business bad debt deduction for amounts loaned to the corporation. The deduction was allowed because the taxpayer’s predominant motives for making the loans were that he (1) wanted to remain employed, earn a salary, and remain useful to society; (2) spent a large portion of his time working for the corporation; (3) intended to draw a salary in the future; and (4) took a sizable risk when he guaranteed loans in excess of his investment (indicating a motive besides investment). Although the taxpayer’s loans were much larger than the salary anticipated in the near future, the court ruled his business motives outweighed his investment motives.

In contrast, the Seventh Circuit ruled that a taxpayer’s advances to a controlled corporation did not result in business bad debts (Hough, 882 F.2d 1271 (7th Cir. 1989)). The taxpayer received no compensation from the corporation and was not considered to be in the business of loaning money, nor was he in the business of selling corporations he owned. Thus, when a taxpayer’s predominant motivation for making loans is to protect his investment as a shareholder, nonbusiness bad debt status generally applies.

The Ninth Circuit held that a shareholder/employee’s business bad debt deduction for loans he made to his corporation was a miscellaneous itemized deduction subject to the 2% floor and not an adjustment to gross income as the employee had contended (Graves, 220 Fed. Appx. 601 (9th Cir. 2007), aff’g T.C. Memo. 2004-140). The court relied on Sec. 62(a)(1), which provides that trade or business expenses do not include those connected with services as an employee. The performance of personal services as an employee does not constitute carrying on a trade or business (Temp. Regs. Sec. 1.62-1T(d)).

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 26th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller, and Kimberly Drechsel, published by Practitioners Publishing Co., Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com).