Deducting losses after an S corporation terminates

Generally, unused losses caused by lack of basis are not available after the S corporation election terminates. However, a special relief provision allows a shareholder to deduct those losses under certain conditions for one year (or more) during the post-termination transition period (PTTP). Also, the corporation can make nontaxable cash distributions to the extent of the accumulated adjustments account (AAA), limited to the amount of stock basis. The PTTP is:

1. The period beginning on the day after the last day of the corporation's last S corporation tax year and ending on the later of—
   1. One year after the last day, or
   2. The due date, including extensions, of that last year's tax return;
2. The 120-day period beginning on the date of a determination that the corporation's S election had terminated for a previous tax year; and
3. The 120-day period beginning on the date of any determination pursuant to an IRS audit occurring after the termination of the S election, if an S corporation item of income, loss, or deduction is adjusted (Sec. 1377(b)).

Per Sec. 1377(b)(2), "determination" means (1) a Tax Court decision or a judgment, decree, or other order by any court that has become final; (2) a closing agreement; or (3) an agreement between the corporation and the IRS that the corporation failed to qualify as an S corporation. While the date that a court decision becomes "final" has not been clarified by the IRS, it presumably is the date after which the decision can no longer be modified or appealed.

The PTTP applies when the S ­election terminates, regardless of whether the termination occurs voluntarily because the corporation revokes its S election or involuntarily (e.g., an ineligible shareholder acquires stock in the corporation).

Measurement of the PTTP is illustrated in the following examples.

Example 1. Measuring the PTTP by the due date of the tax return: A calendar-year S corporation involuntarily terminates its S election on April 10, 2019. The final S corporation tax return (Form 1120S, U.S. Income Tax Return for an S Corporation) is due on March 15, 2020, but can be extended to Sept. 15. Assuming the corporation extends the due date of the return, the PTTP will begin on April 10, 2019, and end on Sept. 15, 2020 (even if the return is filed prior to Sept. 15).

Example 2. Measuring the PTTP by the expiration of one year after the S election terminates: A calendar-year S corporation voluntarily terminates its S election on Nov. 10, 2019. The final S corporation tax return is due on March 15, 2020, but can be extended to Sept. 15. The PTTP will begin on Nov. 10, 2019, and end on Nov. 9, 2020.

Example 3. Measuring the PTTP when the corporation is audited: J is the sole shareholder in K Corp., an S corporation. K Corp. voluntarily revokes its S election on Dec. 31, 2017, when the AAA balance is $25,000 and J's stock basis is $32,000. J withdraws $25,000 in cash from the corporation on March 15, 2018. Since the withdrawal is made during the PTTP, it is a distribution of AAA and reduces the AAA to zero and J's stock basis to $7,000. On Feb. 3, 2019, the IRS begins an audit of K Corp.'s prior returns. The auditor finds the S corporation's depreciation deduction was overstated by $5,000. On March 18, 2019, J signs a closing agreement showing an assessment of additional tax on a prior Form 1040, U.S. Individual Income Tax Return, because of the error on K Corp.'s return. J's stock basis and the AAA will increase by the additional income, $5,000, and J can withdraw the AAA in cash tax-free if the withdrawal is made by July 15, 2019 (i.e., the end of the 120-day PTTP that begins on March 18, 2019).

Losses that have not been used when the S election terminates are treated as incurred on the last day of the PTTP. Thus, the shareholder can increase stock basis by making contributions to capital during the PTTP, and losses can be deducted against this additional basis. However, losses suspended on the date the S election ends can be deducted only to the extent of the shareholders' stock basis, as determined at the close of the last day of the PTTP (Sec. 1366(d)(3); Regs. Sec. 1.1366-2(b)). Increasing debt basis during that period does not allow the deduction of losses. Unused losses cannot be deducted after the end of the PTTP.

Caution: Losses that are unused at the date the S election terminates are considered to be incurred on the last day of the PTTP, and shareholder basis is determined at the close of that day. Thus, the use of suspended losses after the S corporation has terminated its S status is available only to those shareholders remaining at the close of the PTTP.

Example 4. Deducting losses during the PTTP: J is the sole shareholder of a calendar-year S corporation. On Feb. 5, 2019, he sells 75% of his stock to a partnership, causing the immediate termination of the S election. On Dec. 31, 2018, J had a $5,000 suspended passthrough loss attributable to his stock basis. The corporation incurred an additional $3,000 loss from Jan. 1 through Feb. 4, resulting in a suspended passthrough loss of $8,000 due to lack of basis on the date the S status terminated. J has until March 15, 2020, (the due date of the final S corporation return) to inject $8,000 of capital to deduct the $8,000 suspended passthrough loss (Sec. 1377(b)(1)(A)). If the due date of the corporate tax return is extended, J will have until the extended due date to contribute the additional capital.

Example 5. Timing loss deductions by using the PTTP: On Dec. 1, the tax practitioner projects that V Co., a calendar-year S corporation, will have a loss of approximately $25,000 for the current year. W, the sole shareholder, materially participates in the operations of the corporation. Before considering the expected loss, he has $2,000 in stock basis. On Jan. 1 of the next year, W will sell a portion of his stock to a nonqualified shareholder. Consequently, the S corporation election will terminate as of Dec. 31, the day before the disqualifying event takes place. W believes the corporation at some point will become profitable again, and he wants to make a loan to the corporation to provide working capital. He feels that his personal income will be greater in the following year and that the loss may be more valuable then.

W can take the loss in either year, depending on when his basis increases. He can increase his stock or debt basis before Dec. 31 and deduct the loss in the current year. If he waits until the termination is effective, he can increase his stock basis during the subsequent year and deduct the loss in the following year (i.e., at the end of the PTTP).

A shareholder may increase stock basis during the PTTP by making capital contributions to the corporation or ­purchasing stock in the corporation (see Field Service Advice 200207015). Also, stock basis is increased if the shareholder is allocated additional passthrough income from the S corporation due to an IRS audit.

Losses of an S corporation suspended under the at-risk rules of Sec. 465 are carried forward to the S corporation's PTTP. The losses can be deducted at the end of the PTTP to the extent stock basis and at-risk limits increase by capital contributions during the PTTP (Sec. 1366(d)(3)).   

This case study has been adapted from PPC's Tax Planning Guide: S Corporations, 33d edition (March 2019), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).