Allocating S corp. losses to acquiring and terminating shareholders

Passthrough items are generally allocated to shareholders on a pro rata basis (i.e., per share, per day). However, if a shareholder's entire interest in an S corporation is disposed of, the corporation can elect to allocate passthrough items based on the actual transactions that occurred before and after the stock disposition took place. This election is referred to as the "specific accounting election," and can also be made when a qualifying disposition occurs.

Example 1: B Inc. is a cash-method hog-raising venture operating as a calendar-year S corporation. It is owned by four shareholders, each with 25% of the stock. Two of the shareholders have exhausted their stock basis via prior S corporation losses and are not willing to inject additional capital into the corporation. On Nov. 25, these two shareholders sell all of their stock to C, a new shareholder. Shortly after acquiring this stock and in recognition of earlier capital contributions by the remaining shareholders several months before, C injects $100,000 of capital. The corporation then expends these funds for supplies, feed, fuel, and other operating expenses. The overall tax loss for the full 12 months is $10,000. C expects a large tax loss to be allocated to him from B, in view of the large amount of capital he injected and the expenditures made by the corporation at year end. C estimates that from Nov. 25 to Dec. 31, the corporation had a tax loss of $90,000. How is the taxable loss of B allocated among the shareholders in view of the changes in ownership that occurred during the year?

If the general pro rata allocation method were used in this case, C would be allocated a loss of less than $500. This amount is calculated as follows: $10,000 overall loss × 36 days ÷ 365 days × 50% of stock = $493.

The corporation can elect (with the consent of affected shareholders) to use specific accounting when there is a complete termination of stock ownership by one or more shareholders. Under this method, the corporation is treated as if it had two tax years for purposes of computing the allocations to each shareholder (Sec. 1377(a)(2)). Assuming C is correct in his estimate that the corporation would have a $90,000 loss during his period of ownership, his allocation under the specific accounting election would be $45,000 computed as follows: $90,000 specific accounting period loss × 50% of stock = $45,000 allocable loss.

These facts illustrate the dramatic differences that can occur under the two methods of allocating S corporation items among the shareholders.

Passthrough losses are limited by the various loss limitation rules in the following order: the basis limitations of Sec. 1366(d); the at-risk rules of Sec. 465; and, finally, the passive activity loss rules of Sec. 469 (Temp. Regs. Sec. 1.469-2T(d)(6)). Therefore, if C borrows the $100,000 from a shareholder, the passthrough loss from the corporation would be limited by the at-risk rules, and the loss deduction could not be claimed on his personal return regardless of whether he meets the material-participation standard of the passive activity loss rules. If the $100,000 comes from personal savings, the passthrough loss would satisfy the at-risk limitation, but when deciding if the loss deduction could be claimed on his personal return, it would be necessary to ascertain whether he materially participates in the hog-farming activities for passive activity loss purposes.

If these potential limitations are overcome, the election to use specific accounting would provide the best result from C's viewpoint. This election requires the consent of all affected shareholders (Regs. Sec. 1.1377-1(b)(2)). The allocation of the $90,000 loss incurred in the final days of the S corporate year benefits C but results in the allocation of about $80,000 of positive taxable income to the original four shareholders for their ownership from Jan. 1 to Nov. 25 (Regs. Sec. 1.1377-1(b)(3)). The potential for conflict is obvious.

The following example illustrates how passthrough items are allocated when there are multiple acquisitions and terminations during the tax year.

Example 2: Assume the same facts as in Example 1, except that on Dec. 7, the remaining two 25% shareholders sell their stock to a new shareholder, J. C and J now each own 50% of the stock. How is the allocation of passthrough items made in light of the fact that there were multiple acquisitions and terminations within the S corporation year?

The general pro rata method (per share, per day) applies unless an election is made to the contrary. In this example, two elections to treat the tax year as two tax years because of a complete termination of an owner's interest could be made. The first election would cause a closing of the books as of the Nov. 25 stock disposition, and the second election would cause another closing of the books as of the Dec. 7 disposition. B would separate its transactions into three specific accounting periods for purposes of accomplishing an actual allocation to each shareholder group.

Thus, B can make the following combinations of elections to use specific accounting in connection with a complete termination of a shareholder's interest:

• Make no elections and use the general pro rata method.
• Make an election for the dispositions on Nov. 25, but not for the dispositions on Dec. 7.
• Make an election for the dispositions on Dec. 7, but not for the dispositions on Nov. 25.
• Make an election for the dispositions on Nov. 25 and the dispositions on Dec. 7.

This case study has been adapted from PPC's Tax Planning Guide: S Corporations, 31st edition (March 2017), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).