S corporation shareholder recomputation of basis

Editor: Greg A. Fairbanks, J.D., LL.M.

The IRS recently released draft Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, to complement Form 6198, At-Risk Limitations; Form 8582, Passive Activity Loss Limitations; and Form 461, Limitation on Business Losses. The new form is required to be filed by an S corporation shareholder to report shareholder basis.

The form is based upon the 2020 instructions for Schedule K-1 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc., that includes an example format for reporting a shareholder’s basis computation for prior years. A shareholder needs to know the basis, including when the S corporation allocates a net loss to the shareholder, makes a nondividend distribution, makes a loan repayment to the shareholder, or if the shareholder disposes of stock, among other situations. Despite the requirement to report shareholder basis, shareholders do not always maintain a stock and debt basis computation and thus fail to properly limit loss and deduction items to stock and debt basis under Sec. 1366(d)(1). Failing to properly track basis may require a recomputation of the shareholder’s basis.

Computing shareholder basis

Under the normal computation rules, basis is computed by taking beginning basis and adding the items of income, reducing that by nondividend distributions; by nondeductible, noncapital expenses; and, finally, by any other loss and deduction items. Basis cannot be reduced below zero by nondividend distributions; nondeductible, noncapital expenses; and any other loss and deduction items.

Distributions in excess of stock basis are treated as a gain from the sale or exchange of property and reported as a capital gain. The capital gain is long-term or short-term depending upon the shareholder’s holding period in the stock.

Loss and deduction items in excess of basis are suspended under Sec. 1366(d)(2) until the next tax year and are carried forward to each succeeding tax year until the shareholder has basis.

If a shareholder completely disposes of the stock while loss and deduction items are suspended under Sec. 1366(d)(2), the loss and deduction items are permanently lost and may not be claimed. Any loss and deduction items suspended under Sec. 1366(d)(2) cannot be used to offset the gain on the sale of the stock.

Failure to properly limit loss and deduction items

Failure to properly limit loss and deduction items to the shareholder’s stock and debt basis causes problems for the IRS and return preparers in the computation of shareholder basis.

If the statute of limitation on assessment is still open, the shareholder should file an amended return to correct the items of loss and deduction reported. If the statute of limitation on assessment is closed, then the shareholder must determine the effect on the current-year basis computation for which the statute of limitation is still open.

The IRS provides its position in Technical Advice Memorandum (TAM) 9304004, Field Service Advice 200230030, and TAM 200619021 for how to report loss and deduction items claimed in excess of basis from closed statute years. The IRS reiterated its position in its Losses Claimed in Excess of Basis Process Unit (April 30, 2018) and is enforcing it through the S Corporation Losses Claimed in Excess of Basis Campaign.

As of publication, no court has considered the merits of the IRS’s position. (In Tomseth, No. 6:17-cv-02017-AA (D. Or. 9/27/19), the court considered a similar, but distinguishable, issue in dicta (see Jamison et al., “Current Developments in S Corporations,” 51 The Tax Adviser 322 (May 2020)).)

IRS’s position

The IRS’s position assumes for purposes of the shareholder’s basis computation that the loss or deduction item is properly limited to the shareholder’s stock and debt basis. Then in a subsequent year, when the shareholder has basis, the shareholder’s basis is reduced by any loss or deduction previously taken in excess of basis. The IRS relies on Sec. 6214(b), which allows facts from closed statute years to be considered in computing the current-year computation of tax items, and Regs. Sec. 1.1016-6(a), which provides that adjustments to basis must always be made to eliminate double deductions or their equivalent, to reduce basis in the current open year for items that were improperly claimed in a prior tax year. The shareholder is precluded from claiming the loss a second time when the basis is reduced, under the principles of estoppel (Regs. Sec. 1.1016-6(b)).

The IRS provides that the losses in excess of basis from closed statute years must reduce basis in the open statute year after considering the positive adjustments to basis but before considering nondividend distributions; nondeductible, noncapital expenses; and any other loss and deduction items.

Example 1: A is the 100% shareholder of Corp, which is an S corporation. In year 1, Corp had $50,000 in capital losses, and A had an adjusted basis of $20,000 in his Corp stock. On his individual income tax return for year 1, A deducted the entire $50,000 capital loss and reduced his basis in his Corp stock to zero. In year 2, Corp had an ordinary loss of $30,000. On his tax return for year 2, A deducted the $30,000 ordinary loss and claimed that his adjusted basis remained at zero. In year 3, Corp had $90,000 of ordinary income. In year 3, A reported his share of Corp’s income and increased the basis in his Corp stock by this income. In year 4, Corp had $10,000 of long-term capital gain income, and A received an ordinary loss of $75,000. A’s year 1, year 2, and year 3 tax years are now closed under the statute of limitation for assessment. Year 4 is open under the statute of limitation.

In this example, A’s basis at the beginning of year 4 is $30,000, computed under the normal stock basis ordering rules as if the shareholder had properly limited his loss and deduction items to stock basis. However, A may report that his basis at the beginning of year 4 is $90,000, relying upon the statute of limitation on assessment being closed for year 1, year 2, and year 3.

To account for the differences in basis computations, the IRS will begin year 4 with $90,000 of beginning stock basis and add the $10,000 of year 4 long-term capital gain, increasing A’s stock basis to $100,000. A’s stock basis is then reduced by the $60,000 of prior-year losses in excess of basis from closed statute years. This allows A to report a $40,000 ordinary loss, and he must suspend the remaining $35,000 of ordinary loss until he has basis in a future year. (Note that there is no tax difference in this example if the adjustment to stock basis takes place in year 3, a closed statute year, or year 4, the open statute year.)

The IRS’s position is not the same as negative basis. For example, if a shareholder has a loss in excess of basis from a closed statute year and the shareholder sells his or her stock, the IRS does not require the shareholder to report more gain than would otherwise be required.

Example 2: B is the 100% shareholder of Corp, which is an S corporation. B has $100,000 of losses in excess of basis from closed statute years. If B sells his stock for $300,000, he will not report a $400,000 gain as would happen if the loss in excess of basis from closed statute years were negative basis. Rather, B still reports a $300,000 capital gain, and the remaining $100,000 of losses in excess of basis from closed statute years effectively disappears due to the statute of limitation.

Unaddressed issues in the IRS position

The IRS has not provided guidance on whether the basis adjustment occurs in the year the loss should have been reported or in the first tax year with an open statute of limitation. The timing of when the adjustment to basis for losses in excess of basis from closed statute years is included in the basis computation affects the amount of beginning basis in the open statute year. There can be a computational difference in the beginning basis of the first open statute year if nondeductible, noncapital expenses or nondividend distributions exceed the shareholder’s basis in a year closed by statute after the initial year where there are losses in excess of basis in a closed statute year.

In addition, the IRS has not provided guidance on the treatment of nondividend distributions in excess of stock basis that were not reported as capital gains in a closed statute year. If nondividend distributions in excess of stock basis were not reported as capital gains, then it is unclear whether there is a basis adjustment similar to losses in excess of basis from closed statute years or if the statute of limitation on assessment precludes any current-year basis adjustment.

The IRS has also not provided guidance on the treatment if a shareholder fails to report the gain on loan repayment in a closed statute year when the loan is repaid in full in the closed statute year. Once again, the requirement to report gain in a closed statute year may preclude an adjustment to the current-year basis under the statute of limitation for assessment.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.