The Transfer of Loss Property Between an S Corporation and Its Shareholders

The S corporation tax rules were designed for small corporations, and even though there can now be 100 shareholders (even more if the shareholders are related), the majority of S corporations are still closely held. As a result, there are often transactions between S corporations and their shareholders. One type of transaction that occurs frequently is when the shareholder or the corporation holds property with a basis greater than its fair market value (FMV) and there are good business and tax reasons to transfer the property between the shareholder and the corporation.

When these transactions are done, various rules, including loss disallowance rules, can affect both the shareholder making the transfer and the corporation. Moreover, the nontransferring S corporation shareholders’ taxable income and bases can also be affected. The discussion below surveys the various possible results of the loss property transfers.

Sec. 351 Transfers

When a shareholder transfers property that has depreciated in value to a controlled corporation, the transaction may be a nontaxable Sec. 351 transfer.1 The shareholder’s basis in the stock received is usually his or her basis in the transferred property, but, under Sec. 362(e)(2), the corporation’s basis will become the property’s FMV, not its carryover basis. The shareholder will have a built-in loss on the stock received that will not be recognized until the stock is sold. This treatment will yield the correct result if the S corporation has other shareholders that did not transfer depreciated property, because the basis rules will prevent these other shareholders from benefiting from the built-in loss.

The shareholder can elect to limit the stock basis to the contributed property’s FMV, and the corporation will have the higher carryover basis in the asset.2 When this election is made and the corporation later sells the property to an unrelated party, a loss may be realized, recognized, and allocated to the shareholders in proportion to their ownership when the property is sold. While the shareholder’s ownership when the transfer occurred must be at least 80% to qualify under Sec. 351, it may be more or less than 80% when the asset is sold. It seems that the goal of these rules is to prevent a double deduction for the built-in loss, and Congress is not too concerned about who gets the loss—the corporation or the shareholders.

S Corporation Distributions of Loss Property

The IRS Office of Chief Counsel recently reviewed the taxation of an S corporation’s distribution of depreciated property to its shareholder in Chief Counsel Advice (CCA) 201421015. ­According to the CCA, since the S corporation Code sections do not include any special provisions addressing this type of transaction, the general corporate tax rules apply.3 Specifically, Sec. 311(a) dictates the taxation of gain at the corporate level, but a loss (the amount of basis in excess of the value of the distributed property) is nondeductible.

The first item the CCA addresses is the effect of this distribution transaction on the shareholder’s stock basis. It is no surprise that the CCA states that the shareholder must reduce the stock basis by the value of the property received. The basis of the property in the hands of the shareholder will also be FMV.

Sec. 1367(a)(2) requires the shareholder to reduce stock basis by distributions, losses, and “any expense of the corporation not deductible in computing its taxable income and not properly chargeable to capital account.”4 The regulations state that fines, penalties, and expenses related to tax-exempt income qualify as nondeductible, noncapital expenditures.5 The regulation does not mention the Sec. 311 denied loss. Since the S corporation regulations are silent about this nonrecognized loss, the IRS turned to the consolidated return regulations. Regs. Sec. 1.1502-32 specifically states that the Sec. 311 denied loss is a nondeductible, noncapital item. Therefore the CCA states the Sec. 311 denied loss is a nondeductible, noncapital item for the S corporation and that the taxpayer must reduce her stock basis by the amount of the denied loss.

As additional support for the IRS’s conclusion, the CCA also points out that this treatment maintains the equality of inside and outside basis. The corporation’s asset basis is reduced by the basis of the distributed property. The shareholder must reduce the basis of the stock by the value of the property and the denied loss. The value of the property plus the denied loss equals the corporation’s basis in the property. Therefore, the inside and outside bases are reduced by the same amount, maintaining consistency. The CCA clarifies the effect of the nonrecognized loss on the stock basis.

The CCA next turned to the effect, if any, that the Sec. 311 denied loss has on the accumulated adjustments account (AAA) of former C corporations. Sec. 1368(e)(1)(A) states that the AAA is an account of the S corporation that is adjusted for the S period in a manner similar to the stock basis adjustments under Sec. 1367 except that tax-exempt income is not taken into account. Regs. Sec. 1.1368-2(a)(3) expands this statement by providing that AAA is reduced by any nondeductible, noncapital expenditures, other than federal taxes attributable to any tax year in which the corporation was a C corporation, and expenses related to income that is exempt from tax. Given that the CCA ruled that the denied Sec. 311 loss is a nondeductible, noncapital expenditure, the CCA’s conclusion that AAA was required to be reduced by the denied loss was expected.

A potential question is whether the regulation is correct. Since AAA is not increased by tax-exempt income, why is it reduced by nondeductible items? To be consistent, AAA should either be increased by tax-exempt items and decreased by nondeductible, noncapital items, or both should have no effect on AAA. However, the chance that the regulation would be ruled invalid is very small. Given that AAA only applies to S corporations that have earnings and profits, it is doubtful that the regulation will be challenged. Therefore, a shareholder must reduce the stock basis, and the corporation must reduce the AAA by the loss denied under Sec. 311.

Instead of distributing the property as a dividend, the corporation may use the property to redeem some stock. Under Sec. 302, the shareholder will treat the redemption as either a sale or a dividend. Whether the transaction is a sale or dividend, the corporation must apply Sec. 311 to the distributed property.6 If the property is appreciated, gain is recognized. If the property is depreciated, no loss is recognized, and the denied loss will follow the dividend rules discussed above.

Property Sales

If the S corporation sells property to a shareholder and realizes a gain, the gain is recognized. The character of the gain may be reclassified as ordinary under Sec. 1239 if the property is depreciable in the shareholder’s hands.

A loss from the corporation’s sale of property to its shareholder may be nondeductible under the related-party rules of Sec. 267(a)(1). Under Sec. 267(b)(2), a corporation and a shareholder are related if the shareholder owns directly or indirectly more than 50% of the value of the outstanding stock. Indirectly owned stock is stock the shareholder owns as a result of the constructive ownership rules of Sec. 267(c).

Although the loss is not recognized, Sec. 267(d) allows the loss to potentially be used in the future. When the purchaser sells the acquired property, the purchaser can reduce the gain realized from the property’s resale by the previously disallowed loss. If that gain is less than the previously disallowed loss, the amount of gain is zero, and the remaining amount of disallowed loss expires without being recognized. If the resale of the property produces a realized loss, that second realized loss is recognized by the property’s purchaser, and the original disallowed loss expires. If the initial sale is at FMV, it is unlikely that the resale will generate gain equal to the disallowed loss, especially if the resale occurs shortly after the initial sale. Therefore, it is usually recommended that an S corporation not sell property to a shareholder at a loss.

When a shareholder disposes of the purchased loss property in a nontaxable transaction, the application of Sec. 267(d) may vary. If the shareholder gifts the property to another person, Sec. 267(d) will not apply, and the loss will expire. Therefore, if the donee sells the property at a gain, the full amount of the realized gain will be recognized.7 If, instead of making a gift, the shareholder exchanges the purchased property for like-kind property in a nontaxable Sec. 1031 transaction, then Sec. 267(d) will apply when the shareholder sells the property acquired in the like-kind exchange. In other words, the replacement property will be treated the same as the purchased property.

Secs. 351, 721, and 267

The seller may have a disallowed loss, but the purchaser transfers it to a new entity, either a new corporation or partnership, in a nontaxable Sec. 351 or 721 transaction in exchange for an ownership interest. If this occurs, the entity will take the property with a carryover basis. The loss will continue to come under Sec. 267(d) with the ownership interest the shareholder received treated as the purchased property. Therefore, when the new entity sells the property, the entity will recognize any realized gain or loss. On the other hand, the ability to use a loss against a subsequent gain is retained by the shareholder: The shareholder will be able to apply the disallowed loss to reduce any gain realized on a sale of the new corporation’s stock or the partnership interest received in the Sec. 351 or 721 transaction.

The S Corporation’s Disallowed Loss

When the S corporation is denied a loss from a sale to the shareholder, the shareholder will be affected beyond the Sec. 267 loss denial rule. Regs. Sec. 1.1367-1(c)(2) states that losses denied by Sec. 267(a)(1) are nondeductible, noncapital items. Therefore, the loss will reduce the shareholders’ basis in their stock, and the corporation will reduce the AAA. At first glance, it might appear that the loss is deferred and not nondeductible since it may offset a future gain and therefore should not affect basis and AAA. However, a realized gain that is reduced by the loss is a gain realized by the shareholder, not the corporation. A nondeductible, noncapital item is an expenditure that will not affect the computation of the corporation’s income. The Sec. 267(a)(1) denied loss will never affect the corporation’s income. Therefore, it is correctly labeled as a nondeductible, noncapital item with the stated results.

The classification of the loss as nondeductible and noncapital can also be supported by a basis analysis. As stated under the Sec. 311 discussion, adjustments to inside and outside basis should be equal. Since the sale of the property at a loss will reduce the inside basis of the corporation’s assets by an amount equal to the loss, an equal reduction in the outside stock basis is reasonable and correct because it maintains the equality of the inside and outside basis.

A potential question is how to allocate the denied loss among the shareholders.8 All items of income, gain, and loss are allocated among the shareholders based on the percentage of stock owned and whether the items are separately stated or not. Although these nondeductible items are not discussed, it would be reasonable to conclude that they are also allocated among all shareholders based on stock ownership percentage. A shareholder who did not buy the property could question the fairness of allowing the buyer to reduce future gain by the full amount of the denied loss, given the fact that the purchaser did not reduce his or her stock basis by the full amount of the loss. This potential question does not affect the actual application of the existing allocation rules. It does reinforce the recommendation that depreciated corporate property should not be sold to a related shareholder.

The procedures for adjusting stock basis are discussed in the regulations. Regs. Sec. 1.1367-1(f) contains the order of these adjustments. Basis is increased by income items, then decreased by distributions; noncapital, nondeductible items; and deductible losses and expenses. Sec. 1366(d) states that deductible losses and expenses are limited to the basis of the stock and shareholder debt. Given this order, a loss denied under Sec. 267(a)(1) will reduce the shareholder’s stock basis and then debt basis before the deductible items reduce the shareholder’s basis. The result is that these denied losses may prevent the deductible losses and expenses from reducing the shareholder’s income in the year incurred. In these cases, the deferred deductions are carried forward and are deducted in a future year in which the shareholder’s stock or debt has a positive basis.

Assume the basis of the S corporation stock that a shareholder owns is $100 and the shareholder has no basis in the corporation’s debt. Assume also that the corporation has a Sec. 267(a)(1) denied loss and the amount of that loss allocated to the shareholder is $160. Since Sec. 1366 clearly provides that the stock basis cannot be reduced below zero, this example should result in the basis of the stock being zero. What, if anything, happens to the additional $60 allocated denied loss?

Sec. 1366(d) states that losses and deductions denied because of zero basis are carried forward indefinitely for the shareholder. Since the Sec. 267(a)(1) denied loss is classified as a nondeductible, noncapital item, it is possible to argue that the excess Sec. 267(a)(1) loss does not qualify as a deduction or loss and is therefore not carried forward. This treatment will result in a reduction of inside basis that exceeds the reduction in outside basis. Of course, the IRS might argue that the Sec. 267(a)(1) item falls within the meaning of loss as used in Sec. 1366(d) and therefore is carried forward and reduces future positive stock basis. There does not appear to be any case or ruling that addresses this particular question.

Sec. 267(f): Related Parties in Controlled Groups Rule Applies to S Corporations

Sec. 267(a)(1) is a long-established rule denying a loss deduction that most tax advisers know. The loss rule in Sec. 267(f) may not be as familiar.

Sec. 267(f) applies to sales between corporations in a controlled group as defined in Sec. 1563(a). The relevant group for owners of S corporations is a Sec. 1563(a)(2) brother-sister controlled group. A brother-sister controlled group consists of two or more corporations in which five or fewer persons (individuals, estates, or trusts) own stock possessing more than 50% of the total voting power or value of the outstanding stock, taking into account the stock ownership of each person only to the extent the stock ownership is identical with respect to each corporation. S corporations can be members of a brother-sister controlled group.9

Sec. 267(f) applies a variation of the consolidated return intercompany transaction rules to sales between controlled group members. Instead of denying the loss, Sec. 267(f) defers it. The deferred loss will be recognized when the matching or acceleration rules of the consolidated return regulations would cause an intercompany transaction to be recognized. Unlike under the consolidated return rules, the character of the loss will not be reclassified under the reattribution rules.

The effect of Sec. 267(f) on an S corporation loss from a sale to a brother-sister corporation is best illustrated by modifying Example (1) from Regs. Sec. 1.267(f)-1(j).

Example 1: T owns 100% of the stock of X Corp., an S corporation. T also owns 100% of the stock of Y Corp., which is also an S corporation. X Corp. sold property held for investment with a basis of $130 to Y Corp. for $100 in year 1. Y Corp. holds the property for sale to its customers in the ordinary course of business. Y sells the property to an unrelated person for $110 in year 3.

X Corp. realizes a $30 loss on the sale of the property to Y Corp., which is deferred. When Y Corp. resells the property, it realizes a gain of $10. In the year of sale (year 3), Y Corp. will recognize $10 ordinary income, and X Corp. will recognize a $30 capital loss.

Notice that the loss is deferred, not denied. X Corp. recognizes a capital loss, and Y Corp. does not reduce its recognized ordinary income. Therefore, shareholder T should not reduce his or her basis in the X Corp. stock in the year of sale. In addition, X Corp. should not reduce its AAA in the year of sale. In year 3, the loss is recognized. It will pass through to T, who will deduct the loss and reduce his or her basis. X Corp. will reduce its AAA in year 3.

Y Corp. recognizes ordinary income. This income will pass through to T, who will recognize it and increase his or her basis, while Y Corp. increases its AAA. The outcome is significantly different than an S corporation’s sale of depreciated property to a related person under Sec. 267(a)(1).

The example discussed above involved a resale of the property to an unrelated party. If the loss property is transferred to a related party (as defined in Sec. 267(b) or 707(b)), the outcome is different. Regs. Sec. 1.267(f)-1(c)(1)(iii) states that for transfers to a related party, the loss is recognized, but only to the extent of any income or gain recognized as a result of the transfer. The remainder of the deferred loss is reclassified as a Sec. 267(d) loss, if it is from a sale or exchange, rather than from a distribution. This variation in the rule is best illustrated by discussing a modified example.10

Example 2: T owns 100% of X and Y corporations, both S corporations. X sells land with a basis of $130 to Y for $100 in year 1. In year 3, Y contributes the land to a partnership in exchange for a 60% profit and capital interest.

In year 1, X has a $30 realized loss from the sale of the land that is deferred. In year 3, Y, which contributed the purchased property to a partnership, does not recognize gain or loss under Sec. 721. This transfer triggers the Sec. 267(f) variation rule. Since Y did not recognize any gain, X does not recognize any loss. The loss became a Sec. 267(d) loss and will reduce any gain the partnership recognizes when it disposes of the land Y contributed.

Applying the S corporation rules to the above example will have these additional results. In year 3, the deferred loss will become a denied loss. As discussed above, this will convert the loss into a nondeductible, noncapital item. T will reduce his or her basis in the X stock by the denied loss, and X will reduce the AAA by the amount of the denied loss.

The best way to understand the conclusion in the above example is by applying the consolidated return intercompany rules, including the attribute redetermination rule, to the transactions. The initial sale between X and Y is a deemed intercompany transaction with a deferral of the loss. When Y contributes the property to the partnership, the matching rule applies. To determine the actual outcome, the attribute redetermination rule must be applied first. Since X and Y are treated as a single corporation under the consolidated rules, Y’s contribution of the property would reclassify the character of the loss from the initial sale as a loss arising from a Sec. 267(a)(1) transaction. In other words, the original sale is treated as a sale by X to a related party. This view, using the consolidated return intercompany rules, explains why the loss is now a Sec. 267(d) denied loss, not a deferred loss, causing the basis and AAA adjustments.

What would be the outcome if Y had distributed the acquired property to T as a dividend, rather than making the partnership contribution? The Sec. 267(f) regulations specifically state that in the case of a distribution, the balance of the loss not taken into account is not treated as a Sec. 267(d) loss,11 and it would seem this part of the loss remains deferred until the shareholder disposes of the property. However, the regulations provide the IRS with the right to revise the outcome if the transactions are designed for tax avoidance.12 Therefore, it is likely that the IRS will treat this as a tax-avoidance step transaction and impose the Sec. 267(a)(1) rules on the initial transferor S corporation, generating the same outcomes as discussed in the previous paragraph.

Recently, the IRS applied Sec. 267(f) in an unexpected situation involving an S corporation. In CCA 201433014, an S corporation owned a qualified subchapter S subsidiary (QSub). The shareholder elected to revoke the S election. As a consequence, the S corporation became a C corporation, and the QSub became a new C corporation. This “new” corporation is treated as formed by a deemed transfer of its assets and liabilities from the parent corporation to the newly formed corporation. Normally, Sec. 351 applies to eliminate the recognition of any gains and losses from the deemed asset transfer to the new corporation in exchange for its stock.

In this CCA, the QSub was insolvent (i.e., its liabilities exceeded the value of the assets). Consequently, the IRS ruled that Sec. 351 did not apply. To apply Sec. 351 to the deemed transaction, the IRS stated that the value of the contribution must exceed the liabilities assumed.13 Therefore, the parent corporation was treated as selling the assets to the new subsidiary. For those assets with a value that exceeded their basis, the deemed sale caused a gain to be realized and recognized. An asset with a basis greater than its FMV generated a realized loss as a result of the deemed sale. According to the CCA, the loss fell under Sec. 267(f) and was not currently recognized. Instead, it was deferred and would be recognized when the subsidiary sells or exchanges the property with an unrelated third party.

The CCA does not mention, but appears to assume, that the parent corporation does not elect to file a consolidated return.14 If a consolidated return election is made, then the transaction would qualify as an intercompany transaction with the gains and losses deferred until recognizable under the consolidated return intercompany regulations. Without the election, the gains, but not the losses, will be recognized under Sec. 267(f). This will have a negative effect on the parent corporation that owns the insolvent subsidiary.

At least two relevant issues were not addressed by the CCA: the amount of the deemed asset sale price and its allocation. At a minimum, the sale price should equal the assumed liabilities. As a general rule, assumed liabilities are treated as cash the transferor received. That the corporation is insolvent and the assumed liabilities exceed the value of the tangible assets is immaterial.

The transferee corporation was deemed to be a new entity. Therefore, the parent corporation (transferor) did not own any stock of the transferee before this deemed sale. So, the stock owned by the parent corporation as a result of the deemed sale should be treated as part of the sale price, and the value of the stock should increase the deemed sale price. Given that the subsidiary is insolvent, the stock may have a zero FMV. However, under Sec. 165, for stock to be worthless, it must have no current or future value.15 Since the parent corporation did not terminate the business, it is possible to assume that it anticipates the subsidiary will improve and survive its insolvency, which suggests the business has a future value. Therefore the stock has value, which will increase the deemed asset sale price. The bottom line is the sale price equals the amount of liabilities assumed and the value of the subsidiary stock the parent corporation owns.

The transferee corporation has a business, which is deemed transferred from its parent corporation to the subsidiary. Under this analysis, the transaction would fall under Sec. 1060, which requires allocating a business’s acquisition price using the residual method. The residual method allocates the purchase price first to cash and cash equivalents and to tangible and intangible assets up to their FMV. Any remaining amount of the sale price (the residual amount) is allocated to goodwill and going-concern value. This allocation method will result in the parent corporation’s recognizing a capital gain equal to the amount of the sale price allocated to the goodwill and going-concern value. The subsidiary will be entitled to amortize the amount of goodwill and going-concern value over 15 years under Sec. 197. Applying these answers to the questions raised will result in an increase in the gains that the parent corporation must recognize as a result of the deemed asset sale. This will also result in unequal inside and outside bases.

Conclusion

If an S corporation distributes or sells loss property to a shareholder, the loss will not be recognized, and the stock basis and AAA still must be reduced. Consequently, depreciated property should not be sold or distributed to a related shareholder.

If an S corporation sells loss property to a related controlled corporation, Sec. 267(f), and not Sec. 267(a)(1), will apply. The loss will be deferred, rather than denied. Depending on what the acquirer does with the loss property, the recognition of the deferred loss will be affected. These rules may also apply to the revocation of the S corporation election if the S corporation owns a QSub.

Footnotes

¹ A similar rule would apply to a contribution by a shareholder that is not treated as income under Sec. 118.

² Sec. 362(e)(2)(C).

³ Sec. 1371(a).

⁴ Sec. 1367(a)(2)(D).

⁵ Regs. Sec. 1.1367-1(c)(2).

⁶ For a discussion of a possible exception to the application of Sec. 311 to property used in a redemption, see Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, ¶9.23[1].

⁷ Regs. Secs. 1.267(d)-1(a)(3) and (4), Example (3).

⁸ Since Sec. 267 uses constructive ownership, it is likely the shareholder who purchased the property does not own 100% of the stock.

⁹ Regs. Sec. 1.1563-1(b)(4), Example (4).

¹⁰ Regs. Sec. 1.267(f)-1(g), Example (6).

¹¹ Regs. Sec. 1.267(f)-1(c)(1)(iii).

¹² Regs. Sec. 1.267(f)-1(h).

¹³ The CCA cites Meyer, 129 Ct. Cl. 214 (1954), H.G. Hills Stores Inc., 44 B.T.A. 1182 (1941), Rev. Rul. 59-296, and Prop. Regs. Sec. 1.351-1(a)(1)(iii). This proposed regulation is known as the no-net-value regulation and has been outstanding since 2005.

¹⁴ The CCA also discussed income allocation. In this discussion, the CCA mentions that ownership of the subsidiary is taken over by a regulator and therefore a consolidated return is not available.

¹⁵ Morton, 38 B.T.A. 1270 (1938); Geddis, T.C. Memo. 2005-191.