Chapter 3
Basis in S Corporation Stock
Learning Objectives
Upon completion of this chapter, you will

Understand the rules relating to the adjustment of basis in stock by S corporation
shareholders.

Understand how losses are limited by basis.
Introduction
In this chapter, we will discuss the following:

Basis Adjustments

Order of Application to Basis

Indebtedness to Shareholders

Losses Limitations
Under Section 1367 a shareholder’s basis in his or her stock is generally computed at the end of
the S corporation’s tax year.
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Computation of Basis
Stockholder’s basis is computed in the following manner:
Original cost or basis
+ Additional capital contributions, stock purchases, gifts of stock, or inheritance of stock
+ Share of separately stated income items [Section 1367(a)(1)(A)]
+ Share of nonseparately stated income and gains [Section 1367(a)(1)(B)]
+ Share of tax-exempt income
+ Excess of deduction for depletion over the basis of the property subject to depletion
+ Excess of the shareholder’s deductions for depletion (other than oil and gas) over the
shareholder’s proportionate share of basis in the property subject to depletion
+ Certain business tax credit recapture [Section 50(c)(5)]
– Distributions [Section 1367(a)(2)(A)]
– Share of nondeductible, non-capital expenses [Section 1367(a)(2)(D)]
– Share of nonseparately stated ordinary loss [Section 1367(a)(2)(C)]
– Share of separately stated deductions/losses [Section 1367(a)(2)(B)]
– Shareholder’s deduction for depletion [Section 1367(a)(2)(E)]
– Certain business tax credit recapture & certain income in respect of a decedent
= Shareholder’s stock basis not below zero
Revenue Ruling 2008-16 clarified the adjustments made to basis in S corporation stock for
charitable contributions of appreciated property made by S corporations. Essentially, an S
corporation’s shareholders will increase the basis in their stock by the appreciation in the
property contributed and then reduce the basis by the fair market value of the property gifted (but
not below zero). This rule is similar to the rule used by partnerships. Originally these rules
applied only to 2006 and 2007 but the 2008 Tax Extenders and AMT Relief Act extended the
provisions to 2008 and 2009.
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Stock basis is adjusted in the following order:

All positive items including taxable and nontaxable income and the excess of the
deductions for depletion

Distributions

Nondeductible, noncapital expenses

–
Examples include illegal bribes, kickbacks, fines, penalties, expenses related to taxexempt income, related-party losses, disallowed meals, and entertainment. Payment
of life insurance premiums is not clear.
–
Note that these items absorb basis before deductible loss items are taken into account,
therefore reducing the amount of deductible loss.
Separately and nonseparately stated deductions and loss items but not below zero.
Remaining loss reduces basis of any indebtedness to shareholder.
–
Losses, which are not deductible due to the passive loss, rules, the investment interest
limitations, etc., still reduce basis of both stock and debt.
Under Reg. Section 1.1367-1(e) a taxpayer reduces his basis by nondeductible, noncapitalizable
expenses before other expenses or losses. This order could create a problem if the shareholder
does not have sufficient basis to absorb all the deductions. In this case, Reg. Section 1367-1(f)
allows the taxpayer to elect to reduce basis by separately and nonseparately stated deductions
and loss items before reducing basis by nondeductible, noncapitalizable expenses. If the election
is made, the taxpayer will carry over to the next tax year the nondeductible, noncapitalizable
expenses that were not allowed in the current year the loss carryover retains its character. The
election is made by attaching a statement to the taxpayer’s tax return for that year. Once made,
the election cannot be changed without permission of the Commissioner.
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Example 3-1
D owns all the stock in an S corporation. D’s basis at the beginning of the year is
$2,500. For the year, S has a bottom line income amount of $3,500 and items of income
that must be separately stated of $1,800. The S corporation also has a $1,300 capital
loss. The corporation made a distribution to D of $2,000.
What is the effect of these transactions on D’s basis?
D’s basis in his stock is calculated as follows:
Original Basis
Add income items:
Nonseparately stated income
Separately stated items
Basis before distributions and losses items
Distribution
Basis before loss items
Less loss items:
Capital Loss
Basis, end of the year
Basis
$2,500
3,500
1,800
7,800
(2,000)
5,800
(1,300)
$4,500
In this case, D had sufficient basis to deduct the entire capital loss of $1,300.
The ordering rule under Reg. Sec. 1.1367-1(e) changed for tax years beginning after August 18,
1998. Prior to that time basis was adjusted for all income and expense items first and
distributions were deducted last. This change could have a dramatic difference in the amount of
tax an S corporation shareholder may have to pay.
Let us look at an example to show the difference.
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Example 3-2
Assume an S corporation shareholder that owns 100% of the company had a basis of $10,000
at the beginning of the year. During the year, the S corporation had a capital gain of $8,000
and an operating loss of $15,000. The corporation made a distribution of $7,000.
Under the pre-1998 rules D’s basis in his stock would be calculated as follows:
Original Basis
Add income items:
Capital Gain
Basis before distributions and losses items
Less loss items:
Operating loss
Basis before loss items
Distribution
Capital gain on distribution
Basis
$10,000
8,000
18,000
(15,000)
3,000
(7,000)
$(4,000)
In this case D had sufficient basis to deduct the entire operating loss of $15,000. Assuming he
was in a 35% tax bracket he would get a tax benefit of $5,250. The distribution exceeds the
shareholder’s basis so he would report a capital gain of $4,000 which would be taxed at 15%
or $600. The shareholder would have a reduction in his taxes of $4,650 ($5,250 tax benefit –
$600 capital gains tax).
Instead, under the current rules D’s basis in his stock would be calculated as follows:
Original Basis
Add income items:
Capital Gain
Basis before distributions and losses items
Distribution
Basis before lost items
Less loss items:
Operating loss
Suspended loss (can never have negative tax basis)
Basis
$10,000
8,000
18,000
(7,000)
11,000
(15,000)
$(4,000)
In this situation the distribution was less than D’s basis, thus, the distribution was tax-free
however, under Section 1367(a)(2) he would only be allowed to deduct $11,000 of the
operating loss. The other $4,000 would be suspended until increased his basis. Again,
assuming he is in a 35% tax bracket his total tax benefit would be $3,850.
The difference between the two scenarios is $800 ($4,650 – $3,850).
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Business Credit and Recapture Can Affect Basis
If the basis of a corporate asset is reduced because the corporation is taking the business credit,
each shareholder's basis in the S corporation is reduced by the stockholder's share of the
reduction. Also, when recapture of the business credit that was taken by the S corporation causes
an increase in an asset's basis, each shareholder's basis in the corporation is likewise increased
[Section 50(c)(5)].
When Is Basis Adjusted?
Basis is generally computed at the close of the tax year using year-end data. [Reg. Section 13671(d)(1)]
There is an exception if either a shareholder’s entire interest in the S corporation is disposed of
[Section 1377(a)(2)] or if certain stock is disposed of, issued, or redeemed [Reg. Sec. 1.13681(g)(2)]. In this case the taxpayer can elect to close the books at the date of the disposition of the
stock. If this election is made, basis is adjusted as if the tax year consists of two separate years,
one runs from the first day of the tax year to the date of disposition and the second that starts the
day after the disposition and runs to the end of the tax year. Adjustments to shares that are
disposed of during the year are effective immediately prior to the stock disposition [Reg. Sec.
1.1367-1(d)(1)]. The next example shows the difference between a shareholder’s basis if the S
corporation adjusts the basis using the entire tax year versus adjusting the basis using a closing of
the books.
Example 3-3
Ben owns 30% of ABC Inc., an S corporation. His basis in the stock at the beginning of
the year is $10,000. This year the corporation had net income of $24,000. The income
was not earned evenly through out the year. As of March 31st the company had an
operating loss of $15,000. Ben sold his stock on March 31st for $20,000.
If the S corporation chooses to allocate income at year-end, Ben would be allocated
$1,800 ($24,000 × .30 × 3/12) of income which he would report on his personal income
tax return. The $1,800 would also increase his basis in his stock. Thus, he would
report an $8,200 capital gain on the sale of his stock ($20,000 – $11,800 basis).
If the S corporation chose to allocate income using a closing of the books method, Ben
would be allocated a $4,500 loss which he would deduct on his personal income tax
return. The $4,500 would reduce his basis in his stock and would report a $14,500
capital gain on the sale of his stock ($20,000 – $5,500 basis).
In this case Ben would be better off if the S corporation had chosen to allocate income
based on a closing of the books, but that is not always the case.
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Basis Adjusted by Share
Basis is adjusted share by share. Increases are allocated ratably among the shares (e.g., if the
shareholder has 10 shares with a basis of $1 each, and the shareholder’s share of income is $100,
the basis of each share is increased by $10 to $11 per share). Decreases are also allocated ratably
per share. However, if a reduction to basis attributable to a particular share exceeds the basis of
the share, the excess is applied to reduce the remaining basis of all other shares of stock of the
shareholder, proportionate to the shareholder’s basis in each of the remaining shares.
Example 3-4
ABC Inc., an S corporation, has two shares of stock outstanding, both owned by D. D
purchased the first share for $80 and the second share for $20. This year, the
corporation suffered a loss of $60. One-half of the loss, $30, is allocated to each of D’s
shares. The $30 loss allocated to the stock with the $80 basis is completely absorbed,
reducing its basis to $50. The $30 loss allocated to the stock with the $20 basis reduces
the basis to zero. The additional $10 loss is applied against the basis of the other
share. Thus, D has a $40 basis in his first share and a zero basis in the second share.
If the shareholder has different lots of shares, the calculation of each share’s basis gets more
complicated if the number of shares changes during the year. If any share's pro rata passthrough of losses and deductions exceeds the basis of that share, the excess reduces the basis of
all other shares held by the same shareholder in proportion to the basis of the remaining shares,
after reducing the shares' basis for their portion of the loss and deductions.
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Example 3-5
Ellen owns four shares of S Inc. stock. Her share of the corporate loss for the year is
$1,300. Ellen's basis in the shares is shown below. Share #3 was sold June 1st of this
year, and share #4 was purchased on September 1st of this year. Each share's basis is
determined as follows:
Share
#1
#2
#3
#4
Basis
$300
$650
$800
$400
Days Held
365
365
151
153
$459
$459
$190
$192
(365/1034 × $1,300)
(365/1034 × $1,300)
(151/1034 × $1,300)
(153/1034 × $1,300)
$0
$161
$514
$175
$191 – ($191/$1,009 × $159)
$610 – ($610/$1,009 × $159)
$208 – ($208/$1,009 × $159)
Loss allocation:
#1
#2
#3
#4
Basis after allocation:
#1
#2
#3
#4
Ellen can deduct the loss attributable to share #3, even though it was sold during the
year. Her basis for determining gain from the sale of that share is $514. See Reg. Sec.
1.1367-1(c)(3) and Reg. Sec. 1.1367-1(d)(1).
Inherited Basis
Basis in S corporation stock that is inherited is increased to reflect undistributed income, while
basis is reduced by any amount of income that constitutes income in respect of a decedent.
Income in respect of a decedent (IRD) is made up of income amounts a decedent was entitled to
that were not includable in taxable income under the method of accounting used by the decedent
for the year of death [Reg. Sec. 1.691(a)-1(b)]. The IRD is included in assets on the decedent's
estate tax return and is also included in the income of the beneficiary when it is received. In the S
corporation context, IRD includes the decedent's share of interest, dividends, and accounts
receivable due to a cash basis S corporation.
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The income that represents IRD is passed through by the S corporation to the beneficiary that
acquires the shares. The beneficiary is allowed to deduct the federal estate tax attributable to the
IRD [Section 691(c)]. The deduction is taken on the beneficiary's Schedule A as a miscellaneous
itemized deduction, not subject to the 2% of AGI limitation [Section 67(b)(7)].
The IRD passed through by the S corporation to the shareholder increases the shareholder's basis
and AAA. To avoid stock basis being increased twice (once by the pass through of IRD and once
by the estate asset step-up), the shareholder must reduce the step-up in the stock's basis to the
extent the stock's value is attributable to IRD [Section 1367(b)(4)].
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Basis of Indebtedness to Shareholder
If a shareholder is not allowed to deduct the entire loss because of his or her stock basis is zero,
any remaining loss can be used to reduce (but not below zero) the shareholder’s basis in
indebtedness. However, the indebtedness must be a direct shareholder loan to the S corporation
[Section 1367(b)(2)(A); Reg. Sec. 1.1367-2(b)(1)] Personal guarantees of corporation’s debt do
not increase basis [See Rev. Rul, 70-50 clarified by Rev.Rul.71-288].
The initial basis of the debt is reduced for losses in excess of stock basis. The taxpayer can
reduce only those loans outstanding on the last day of the taxable year [Reg. Sec. 1.1367-2(b)].
Losses do not reduce loans during the year. Thus, any loans satisfied during the corporation’s
year are not subject to basis reduction.
If multiple debts are outstanding at year-end, the shareholder must allocate the reductions pro
rata based on the basis of the debt outstanding [Reg. Sec. 1.1367-2(b)]. Shareholder loans such
as advances and open accounts not evidenced by a note are treated as a single indebtedness.
Example 3-6
T owns all of the stock of Humdrum Inc., a calendar-year S corporation. The
corporation’s records for 2003 through 2006 reveal the following information.
Year
2003
2004
2005
2006
Net Ordinary Income (loss)
($12,000)
($19,000)
$9,000
$30,000
T’s basis in his stock on January 1, 2003 was $18,000. On that same date, he had a
note receivable from the corporation for $12,000. The note was issued in 1995. The
corporation paid off the note on December 13, 2006.
T would have to report the following income and losses for each year
Year
2003
2004
2005
2006
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Income (loss)
Allowed
($12,000)
($18,000)
$8,000
$30,000
Stock Basis
$6,000
$0
$0
$26,000
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Debt Basis
$12,000
$0
$8,000
$12,000
Restoration of Basis in Debt
Basis of debt to shareholder is restored to the extent of reductions made to debt basis in tax years
beginning after 1982 before the basis of the shareholder’s stock [Section 1367(b)(2)(B); Reg.
Sec. 1.1367-2(c)]. However, only the basis of debts outstanding on the first day of the year are
restored. In addition, the debt basis is restored only to the extent of the outstanding balance on
that day [Reg. Sec. 1.1367-2(c)(1)]. The restoration is made prior to accounting for any
repayment.
Practice Tip. As discussed earlier, debt basis is increased by pass-through items when the debt
basis has previously been reduced by pass-through losses. Further, debt basis is reduced by passthrough losses and deductions when stock basis has been reduced to zero. It is important to note
that such debt basis increases are based on debt basis held by the shareholder at the beginning of
the taxable year, while such debt basis decreases are based on debt basis held at the end of the
taxable year.
Example 3-7
Using the facts in Example 3-6, assume in 2005 that the corporation planned to pay out
its income of $9,000. Which would have been the better approach: (1) pay a dividend of
$9,000 or (2) repay $9,000 of the note?
If the corporation paid a distribution with respect to stock of $9,000, T would not have
any gain as a result of the distribution due to $9,000 of stock basis being restored under
Section 1367(b)(2)(B) and Reg. Sec. 1.1367-2(c)(1). See Example 4 at Reg. Sec.
1.1367-2(e). If the corporation decides to repay $9,000 of the note, T would have
$3,000 of gain, the amount by which the $9,000 payment (75% of the debt) exceeds the
basis of debt by ($9,000 – $6,000). In this situation it would be better to pay a
distribution with respect to stock.
Debt repayment in excess of basis results in ordinary income if the debt is an open account and
capital gain if the debt is evidenced by a note [Paul G. Cornelius, Dr., 74-1 USTC P9446 (CA-5,
1974)]. In determining the amount of gain resulting from the repayment, a special formula must
be applied (Rev. Rul. 64-162). For example, if 10% of principal is repaid, only 10% of the basis
is deemed to be recovered. Thus, if the basis of a $100 debt had been reduced to $60 and $10 of
the debt was repaid, 10% of the current basis can be offset against the payment, resulting in a $4
gain.
If there are multiple debts outstanding at the beginning of the year, first restore the basis of any
debts paid off during the year. Remaining restorations are made ratably based on the relative
reductions in the basis of each debt.
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Example 3-8
RC Corporation has one shareholder, Ray. In 2006 RC lost $150,000. Ray’s stock basis
at the beginning of 2006 was $60,000. He loaned the corporation $90,000 in order to
establish sufficient basis to deduct the 2006 loss in full. That loss reduced both his stock
basis and debt basis to zero.
In 2007, the corporation earned $100,000 net income and repaid Ray’s $90,000 loan in
full.
In 2007, Ray would increase his basis in his debt to $90,000 and his basis in his stock
to $10,000. Thus, he would not have any income on the repayment of his loan.
Example 3-9
Jennifer owns all of the stock of Jenco, an S corporation. At the beginning of 2006,
Jennifer had a basis of $60,000 in her Jenco stock, and had made no loans to Jenco.
In 2006, Jenco reported a loss of $75,000.
In 2007, the corporation has income of $15,000.
Maggie owns all of the stock in Magco, an S corporation. At the beginning of 2006, she
had stock basis of $10,000. She loaned Magco $50,000 in 2006. The loan was a direct
loan, so the IRS would not challenge the validity of her basis. In 2006, the corporation
loses $75,000.
In 2007, the corporation has income of $15,000
Below is the effect of these transactions:
Jennifer Stock
Basis before 2006 loss
2006 Loss
Deductible
Suspended
Basis, beginning of 2007
Income, 2007 (net of suspended loss)
Basis at end of 2007
Maggie Stock
Debt
60,000
10,000
50,000
60,000
15,000
0
0
0
10,000
15,000
0
0
0
50,000
In this example the two shareholders have the same tax effect with two different
ownership structures.
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0
0
0
Open Accounts
The Fleming G. Brooks v. Commissioner1case involved the issue of open account debt.
Specifically, two brothers owned 50% and 49% of the S corporation. They lent money on open
account to the S corporation.2 In 1997 the brothers advanced $1 million to the S corporation. In
January 1999 the S corporation repaid the advance. On December 31, 1999, the brothers
advanced $1.6 million and the S corporation repaid the $1.6 million on January 3, 2000. On
December 29, 2000, the brothers advanced $2.2 million. Thus, at the end of any given year the
shareholders had basis in the loans so that they could deduct the losses from the S corporation.
The IRS maintained that the debt repayments should be treated separately, like notes, so that the
repayment resulted in income to the brothers at the time of the repayment, when the loan basis
was zero. The court held that there was no income recognition required because the loans were
open advances.
With the verdict in this case in mind, Treasury has issued final regulations in October 2008 that
would limit open account debt amounts to $25,000. Basically under this rule any open account
debt that exceeds $25,000 per shareholder will be treated as notes. The amount owed will be
measured at the corporation’s tax year-end or when stock is sold. The regulations are effective
for debt created after October 20, 2008.
Guaranteed Loans
An S corporation's shareholder has basis only in any indebtedness of the S corporation to the
shareholder [Section 1367(b)(2)(A)].
There are innumerable court decisions in which S corporation shareholders lost part or all of the
allocated net operating loss because of a lack of basis. These decisions show that the borrowings
of an S corporation generally provide no basis for the S corporation's shareholder even if the
shareholder has guaranteed the loans. For example, in Estate of Daniel Leavitt,3 the Tax Court
held that a loan to the corporation was a loan and not a capital contribution, even though the
bank would not have made the loan without the shareholder's guarantee. The court left no room
for argument by stating that a shareholder's guarantee of a loan to an S corporation is not treated
as a capital contribution to the corporation unless the shareholder suffers some economic outlay.
One taxpayer who did prevail, however, was Selfe.4 In that case, a shareholder was found to have
basis in a loan guaranteed by her. The Court said that an S corporation shareholder would be
considered to have basis in a guaranteed loan if the facts showed that, in substance, the
shareholder had borrowed the funds and advanced them to the corporation. The facts in Selfe fit a
1
T.C. Memo 2005-204, August 25, 2005.
Pursuant to Reg. 1.1367-2(a) shareholder advances not evidenced by separate written instruments and repayments
on the advances are referred to as open account debt and are treated as a single indebtedness.
3
90 TC 206 (1988), aff’d 89-1 USTC 9332 (1989, CA4).
4
778 F2d 769 (1985, CA110).
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very narrow set of circumstances, and that case should not be used as a planning device, but may
provide a defense in some circumstances.
The moral here is that shareholders, rather than the S corporation, must borrow from outside
sources, if borrowing is necessary. The shareholders then either contribute the borrowed funds to
the corporation or lend them to the corporation. It is essential that the transaction be properly
documented. If the funds are loaned to the corporation, the note should show a maturity date, and
a reasonable rate of interest should be paid.
Debt Basis Arises Only if Shareholder Experiences Economic Outlay
The shareholder acquires debt basis only if the shareholder experiences an actual economic
outlay.5 As we discussed above, substituting the shareholder’s note for an unrelated creditor’s
note will generally provide the shareholder with debt basis because the shareholder has
experienced economic outlay (i.e., is responsible for payment of the debt to the bank or other
unrelated creditor).
However, in the case of William T. Ellis and Wilma O. Ellis,6 the Tax Court ruled that the
shareholders did not have basis when the shareholders substituted their note for the corporation's
note. Basis was denied because the shareholders experienced no economic outlay; however, it
should be noted that the substitution occurred when the corporation was insolvent. This decision
makes note substitution a more worrisome course of action. It may be better for the shareholder
to obtain a new loan.
Loans from Related Entity
Rather than making direct loans to their S corporations, many shareholders have relied on loans
to provide debt basis when the loans were from another entity that is owned or controlled by the
shareholder. Such related entities might include a brother-sister corporation, an estate, a trust, or
a partnership. In the litigated cases, the shareholder seldom wins on this issue, because of the
rule that debt basis arises only if the debt is owed by the corporation directly to the shareholder
[Section 1366(d)(1)(B)]. For example in the case of Bergman,7 the Eighth Circuit ruled that
shareholders who remitted a check directly to their wholly owned S corporation did not have
debt basis in the loan. The shareholders exchanged a series of checks between themselves and
three S corporations they controlled. The court ruled that the exchanges resulted in the
shareholders lending the S corporation funds they had borrowed from the other S corporations.
5
Rev. Rul. 81-187; 1981-2 CB 167; Rafe Silverstein v. U.S., AFTR 2d 73-902, 349 F. Supp. 527, 73-1 USTC 9217
(DC La. 1972).
6
57 TCM 677, P-H Memo 89,280 (1989), aff’d. 937 F.2d 602 (1991, CA4).
7
Larry and Patricia Bergman v. U.S., 83 AFTR 2d 99-1882, 174 F.3d 1324, 99-2 USTC 50,475 (1999, CA8). See
also F. Howard Hitchins, 103 TC 711 (1994); Bill L. Spencer v. Comm., 110 TC 62 (1998), aff’d 84 AFTR 2d 996040, 194 F.3d 1324, 99-2 USTC 50,830 (1999, CA11); Jerry L. Thomas, TC Memo 2002-108 (2002), aff’d 92
AFTR 2d 2003-5292 (2003, CA11); Donald G. Oren v. Comm., 93 AFTR 2d 2004-858, 357 F.3d 854, 2004-1
USTC 50,165 (2004, CA8), aff’g. TC Memo 2002-172 (2002).
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The court collapsed the entire transaction and determined that the shareholders did not suffer any
economic outlay that left the shareholders poorer in a material sense. Thus, the shareholders did
not have basis in the debt.
The Third Circuit, however, allowed debt basis to a shareholder when loans were made from one
controlled corporation to his S corporation. The court treated the loans as if they were personal
loans to the shareholder from the controlled corporation, followed by personal loans to the S
corporation. The corporation’s records reflected the fact that the advances by the controlled
corporation to the S corporation were made on the shareholder’s behalf, with the intention that
the shareholder would be the creditor.8 The Tax Court reached a similar result in Charles E.
Yates.9
Practice Tip. Under the Code, an S shareholder has debt basis only if the debt is owed by the
corporation directly to the shareholder. The decisions in Culnen and Yates are outliers. The tax
practitioner should not rely on these decisions. Shareholders should always write loan checks
directly to the S corporation. The shareholder will unarguably have debt basis if the check is
written to the corporation by the shareholder, and the shareholder has an economic outlay by
being the entity that will suffer the loss if the corporation does not repay the loan. It would also
be better if the amount the shareholder receives from one entity and the amount he or she loans
to the S corporation was a different amount.
Kerzner10 is the most recent case addressing the back-to-back loan strategy among related
parties. This case involved a round-tripper scenario in which a partnership lent money to an
individual who lent money to the loss S corporation that paid the partnership rent. No principal
or interest on the notes was paid. The court held that this was not an economic outlay and
therefore no Section 1366(d) basis was created.
The AICPA’s S Corporation Technical Resource Panel has submitted comments to Treasury
encouraging a safe harbor for back-to-back loans with unrelated and related parties. This type of
safe harbor would help a lot of S corporations and their shareholders from entering into
disallowed transactions.
Daniel J. Culnen, TC Memo 2000-139 (2000), rev’d and rem’d 89 AFTR 2d 2002-383, 2001 USTC 50,200 (3rd
Cir. 2002).
9
TC Memo 2001-280 (2001).
10
Kerzner, TC Memo, 2009-76.
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S Corporation Limitations of Deductions of Losses
Losses Limited to Basis – Section 1366
The amount of losses that can be deducted is limited to the sum of the shareholder’s basis and
direct loans made by the shareholder to the corporation [Sec. 1366(d)(1)]. Any loss or deduction
not allowable due to lack of basis is treated as incurred in the succeeding taxable year and carried
over indefinitely by the shareholder as long as the S corporation election is in effect and the
shareholder holds stock in the corporation [Section 1366(d)(2); Reg. Sec. 1.1366-2(a)]. If the S
election is terminated, any suspended loss is allowed as a deduction to the extent of the
shareholder’s basis in his stock (but not debt) during the post-termination transition period
[Section 1366(d)(3)]. Losses are carried over, however, only “with respect to that shareholder”
[Section 1366(d)(2)]. Therefore, losses that could not be deducted because of basis limitations
can carry over only as long as the shareholder owns stock in the S corporation. The carryover
loss cannot be used by any other shareholder (except for a spouse or former spouse), so the loss
will disappear when all of the stockholder’s shares are transferred.
The loss continues to carry over as long as the shareholder holds some of the corporation’s stock.
In other words, a partial disposition of the shareholder’s stock will not cause a portion of the loss
carryover to lapse.
If stock is transferred after December 31, 2004, to a spouse or former spouse incident to a
divorce, carryover losses related to that stock transfer to the spouse or former spouse
[Section1366(d)(2)(B)].
Treatment of Carryover Losses on Form 1040
If a shareholder has insufficient basis in its stock and there is more than one item of loss (e.g.,
ordinary loss and capital loss), the shareholder must deduct a pro rata portion of each.
Adjustments to stock basis for distributions made in a tax year are taken into account before
applying the loss limitation for the year.
S shareholders claiming pass-through losses in excess of pass-through income should attach a
schedule to the Form 1040 calculating the shareholder’s adjusted basis in stock and debt. (See
the instructions to Form 1040, Schedule E.) A carryover loss from an S corporation that becomes
deductible because the shareholder has acquired basis is shown on a separate line of Schedule E.
According to the Schedule E instructions, PYA is entered on the separate line in column (a),
Name, of Schedule E. (PYA stands for prior year amount.)
Normally suspended losses under Section 1366 are shareholder-specific. However, the 2004
American Jobs Opportunity Act allowed the suspended loss to be passed to the spouse if the
spouse received the stock in a divorce settlement. In August 2008, final regulations were issued
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that explained the appropriate treatment of these suspended losses. Basically, in the year of the
divorce and the dividing of the S corporation shares per Section 1041, each party picks up his or
her share of current year activity (presumably off of the K-1), and the transferor gets all the
suspended losses, if sufficient basis exists in the year of transfer. In the year after the transfer,
any remaining suspended losses are split between the transferor and transferee by their respective
ownership at the beginning of that year.
Example 3-10
A owns 100% of X Corporation, an S corporation. In 2008, X has a current loss of
$100,000. A has no basis in stock or debt. Thus A has a suspended loss carryover of
$100,000. In 2009, X has a loss of $80,000. In July of 2008 A and B divorce and A
transfers one-half of the X stock to B. B is entitled to $20,000 of the current year loss
(1/2 year x ½ stock x $80,000) and A is entitled to $60,000 of the current year loss. He
is also entitled to all of the $100,000 suspended loss subject to having sufficient basis
for loss purposes. In 2010, X has a $70,000 loss. B would be entitled to $35,000 of the
2010 loss plus $50,000 of the 2008 suspended loss assuming A was not able to deduct
the loss in 2009. A would be entitled to $35,000 of the 2010 loss plus $50,000 of the
2008 suspended loss plus his $60,000 2009 loss.
Example 3-11
Assume the same facts as in 3-10, but A contributes $10,000 in 2009. Then he would
be able to use current and suspended losses against his basis. Thus, $6,250
($100,000 / $160,000 x $10,000 basis) would be losses allocated to A from the
suspended loss from 2008 and $3,750 ($60,000 / $160,000 x $10,000) would be
allocated to A from the 2009 loss and be deductible to A at the individual level.
Therefore, B would be allocated in 2010 half of the remaining 2008 suspended loss of
$93,750.
Losses Limited to Amount At-Risk – Section 465
Another loss limitation applies to the amount a shareholder is at-risk for the activity. The at-risk
rules can be found in IRC Section 465.
The at-risk rules do not apply at the corporate level but apply at the shareholder level and are
treated separately for each activity (i.e., S corporation, partnership interest, or LLC membership).
Losses from an activity are deductible only to the extent the shareholder is at risk. The at-risk
rules apply only to amounts that are already potentially deductible under Subchapter S (i.e., the
shareholder has sufficient basis to absorb the losses).
The amount a shareholder is at-risk for is the sum of (1) personal funds contributed to the
corporation plus (2) the basis of other property contributed to the corporation.
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The amount at-risk includes debt owed to shareholder but not any portion of debt to other parties.
Amounts borrowed and reloaned to the corporation are added only if the shareholder is fully
liable on the debt or has pledged property not used in the S corporation as security for the
borrowed amount. No borrowed amount is considered at-risk to the extent the shareholder is
protected against loss through nonrecourse financing or the amount is borrowed from a person
having an interest in the activity (see Larry W. Van Wyk v. Commissioner, 113 TC 440 (1999)).
If property that is contributed to the S corporation is subject to debt for which the shareholder is
fully liable, the entire basis of the property contributed increases the at-risk amount. However, if
the property is subject to debt and the shareholder is not liable, the at-risk amount is increased by
the basis of the property, less the debt.
The amount at risk is increased for income and decreased for losses and distributions in the same
manner as the basis rules. The deduction of losses suspended due to at-risk rules is allowed as a
carryover. They are deductible when the taxpayer increases its amount at risk. Losses of an S
corporation that are suspended under the at-risk rules are also carried forward to the S
corporation’s post-termination period.
Losses Limited to Passive Activity Rules – Section 469
The last limitation of S corporation losses is found in IRC Section 469 relating to passive activity
losses (PAL).
Passive loss rules are applied after the at-risk rules. PAL limitations are measured on a total
return basis, not on an activity by activity basis. PALs are allowed to the extent the taxpayer has
passive income. Income or loss will be passive if the taxpayer is not a material participant in the
activity or the activity is a rental property. Passive losses that are disallowed are carried over
indefinitely until the taxpayer has passive income or the taxpayer disposes completely of the
passive activity.
The determination if S corporation income or loss is a passive activity or not depends, in most
instances, upon whether or not the shareholder materially participates in the operations of the
business. To materially participate, the shareholder (or the shareholder's spouse) must be
involved in the S corporation's operations on a regular, continuous, and substantial basis [Sec.
469(h)]. The temporary regulations expand on this definition, and set out seven situations in
which a shareholder (or other taxpayer) is deemed to materially participate in an activity [Temp.
Reg. Sec. 1.469-5T]. Those situations are as follows:

The taxpayer participates in the activity for more than 500 hours during the year.

The taxpayer's participation is substantially all of the participation in the activity.

The taxpayer participates for more than 100 hours during the year, and no other
individual participates more than the taxpayer.
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
The activity is one in which the taxpayer participates for more than 100 hours during the
year (a significant participation activity) and the taxpayer's participation in all significant
participation activities is more than 500 hours.

The taxpayer materially participated in the activity any five of the ten immediately
preceding taxable years.

The activity is a personal service activity and the taxpayer materially participated in the
activity for any previous three taxable years.

The taxpayer materially participates based on all of the facts and circumstances.
Rental Activities
Rental activities are generally passive, regardless of whether the rental property is real estate or
personal property, and regardless of whether or not the taxpayer materially participates in the
activity [Sec. 469 (c)(2)]. However, in the case of rental real estate, a taxpayer may be able to
deduct up to $25,000 of losses, if the shareholder actively participates in the real estate activity
and owns at least 10% of the value of all interests in the activity at all times during the tax year
[Sec. 469(i)]. The $25,000 deduction for rental real estate passive activity losses phases out at the
rate of 50% of the amount by which taxpayer's modified adjusted gross income (AGI) exceeds
$100,000 [Sec. 469(i)(3)(A)]. The $25,000 rental real estate loss limitation is applied at the
shareholder level, not at the S corporation level.
Active participation is a less stringent test than the one for material participation. It does not
require regular, continuous, and substantial involvement, but it does require significant
involvement in such activities as making management decisions or arranging for others to
provide service.
Rental income received by certain real estate professionals may be nonpassive.
Summary of Loss Limitations

Losses are first limited to basis in stock.

Losses in excess of stock basis are then limited to basis in debt.

Losses that are allowed under Section 1366 are also limited to amounts at risk under
Section 465.

If the loss is from a passive activity of the corporation, or if the shareholder does not
actively participate in the management of the corporation, the losses allowed by the atrisk rules are limited to the shareholder’s passive activity income from other sources.
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Recent Cases Regarding Loss Limits
A major motivation for choosing S status in a business’s early years is the ability to flow-through
entity-level losses to shareholders. There are several hurdles that a shareholder must overcome
before losses are deductible, including Section 1366 adjusted basis, Section 465 at-risk and
Section 469 passive activity loss rules. Below are some recent cases dealing with loss limits.
Basis Limitation Cases (Section 1366)
William H. Maloof aff’d 200611 dealt with a sole shareholder guaranteeing a $4 million bank
loan, assigning a life insurance policy as collateral and taking the position that this gave him
adjusted basis for loss under Sec. 1366. The court held that there was no economic outlay and,
thus, no basis increase. Why the taxpayer did not use the back-to-back loan technique is unclear.
Below are several cases where the issue of back-to-back loans was addressed.
In Timothy Miller v. Commissioner12 the Tax Court held that a taxpayer had sufficient basis in
his loans to his S corp., so he was allowed to deduct his share of S corporation losses. The court
also found that the taxpayer was at risk with respect to the loans, as defined in Section 465.
The taxpayer was the founder and one of the shareholders of MMS, an S corporation. The
company built mobile medical diagnostic facilities, and lost money from its inception. The
taxpayer obtained the agreement of a group of investors to contribute capital to the company
conditioned upon the company obtaining a $1 million line of credit. The line of credit (and
subsequent loans), were made directly to the company with shareholder guarantees. On advice
of taxpayer’s tax adviser, the loan was restructured as back-to-back loans. All of these loans
were properly documented with written loan agreements and market rates of interest. The loan to
the taxpayer was a full recourse loan collateralized by all of the assets of MMS and a second
mortgage on the principal residence of the taxpayer.
Over the years, the taxpayer had deducted the S corporation losses. Ultimately the S corporation
became insolvent and the loans were paid off by the investor group, not by the taxpayer. The
IRS disallowed the losses because they maintained the taxpayer did not have basis in the
corporation and also was not “at risk” for the amounts borrowed from the bank.
The Tax Court held in favor of the taxpayer finding that he had basis in the loans to the company
and was also at risk in the event of a default. The Court’s conclusion was based on the fact that
the taxpayer’s fully recourse note to the bank was a valid note substitution as opined in Gilday,13
which gives the taxpayer basis for loss under Section 1366. Interestingly, this court held as dicta
that borrowing from a related-party would have been fatal to the basis claim. This is to be
William H. Maloof, TC Memo 2005-75 aff’d 2006.
T.C. Memo 2006-125, June 15, 2006.
13
T.C. Memo 1982-242.
11
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contrasted with the Ruckriegel case discussed below, where the related-party nature was not a
deal breaker.
In Sid Paul Ruckriegel v. Commissioner,14 the Tax Court held that indirect payments from a
partnership to an S corporation that were routed through two brothers/owners of the entities were
back-to-back loans and that those transfers provided the brothers sufficient basis in the S
corporation to deduct part of its flow-through loss. It should be noted that although the taxpayers
won this specific aspect of the case, they lost on most of the issues.
In this case, the S corporation (Sidal) operated fast food franchise restaurants at a loss. The
taxpayer (and his brother) each owned a 50% interest in Sidal which they actively managed. In
addition, each of the brothers owned a 50% interest in a partnership (Paulan) which owned real
estate which it leased to Sidal and other restaurants. Paulan operated at a profit.
The issue was whether certain indirect payments from Paulan to Sidal were in fact loans from the
shareholders to Sidal which would create basis for the taxpayers against which losses might be
deducted. The wire transfer payments were made from Paulan to the taxpayer and from the
taxpayer to Sidal. Sidal’s principal and interest payment were made directly to Paulan. One of
the fundamental requirements for the establishment of shareholder basis is that it must involve an
economic outlay by the shareholder taxpayer. In the IRS’s view, this test is only met if the
taxpayer invests in or lends to the S corporation his own funds, or funds borrowed from an
unrelated-party to whom he is personally liable. In this case, the Court clearly rejected that view
and stated that funds lent to an S corporation that originate with another entity owned or
controlled by the shareholder of the S corporation does not preclude a finding that the loan to the
S corporation constitutes an actual economic outlay by the shareholder.
The Court explained that in their view there was nothing unusual for an individual to conduct
multiple businesses through multiple entities, some or all of which are pass-through entities. Nor
is it unusual for one or more of those entities to be unprofitable. Where the loss entity is an S
corporation, the Court found nothing in §1366(d)(1)(B) or the related regulations to require a
shareholder to fund the S corporation’s losses with funds from his mattress or with funds
borrowed from a bank or other unrelated-party. The Court’s analysis and decision discards one
of the IRS fundamental criteria for establishing shareholder basis, borrowing from an unrelatedparty.
Not surprisingly given the IRS stated related-party position, the couple in TAM 20061902115 did
not fare so well. They were 50% partners in a partnership (PRS) and 50% owners in the S
Corporation. The partnership borrowed money, lent funds to taxpayers who in turn would lend
the funds to the loss S corporation. The S corporation would then pay rent back to the
partnership. Note agreements documented the transactions, although repayments of principal or
interest were generally not made. The circular route of the funds among related parties led the
IRS to conclude that the taxpayer had not been financially impacted by these transactions. With
no economic outlay, the IRS determined that the shareholders did not create any basis in their S
14
15
T.C. Memo 2006-78, April 18, 2006.
February 7, 2006.
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corporation stock from the above transaction. The TAM went on to state that the excess losses
that arose in a closed tax year must first offset any increase in basis (from profits or capital or
debt contributions), before open year losses may be utilized.
Other cases relating to basis limitations include Veronica Chu,16 where the shareholder could not
prove she had sufficient adjusted basis in stock and debt to absorb the loss, and thus, it was
disallowed for the current year. While in Blodgett,17 an S corporation paid the legal fees, Federal
Trade Commission fines, etc., for deceptive advertising and fraud committed in a Ponzi scheme
dealing with rare coins. The liability was held to be the shareholder’s and was personal in nature.
Thus, the IRS denied the corporation the deduction for legal fees it paid. In Brady,18 an IRS
agent had a 10% ownership in an S corporation, which flowed through a loss that she deducted
on Form 1040, Schedule E. The S corporation was audited by her employer and much of the loss
was disallowed, which obviously reduced the taxpayer’s individual-level loss. The case dealt
with whether she had to increase her individual tax for the flow-through adjustment (she did).
Bilthouse19 involved the issue of when a company’s stock becomes worthless and therefore
triggers Sec. 165(g) and disposition of a passive activity for Sec. 469 purposes. The Bilthouses
were in the heavy construction industry, building large projects for municipalities in Florida.
They contributed $500,000 to an S corporation and in 1995 had huge losses that caused the
company to become insolvent. In 1997, they claimed that the company was now worthless and
wanted to take their suspended losses. Under the Gitlitz20 doctrine, they increased their basis for
debt forgiveness and took large losses. The government successfully argued that the company
was worthless in 1995 and that therefore the losses were not allowed in 1997. When in doubt
about worthlessness, a practitioner must decide whether losses should be taken in the earliest
possible year to avoid tolling the statute of limitation.
At-Risk Cases (Section 465)
Hubert Enterprises21 is a partnership case that would apply equally badly to an S corporation
situation with the same results. The taxpayer placed in service similar assets in different years
and wanted to aggregate their bases for Section 465 at risk purposes. The Tax Court held that the
language of Section 465(c)(2)(B)(ii), “aggregation of properties placed in service in any tax
year” means each tax year is treated separately. This means that if a taxpayer has invested in
multiple equipment leasing deals, only the basis in those investments made in a given year may
be combined for at-risk purposes.
16
Veronica Chu, TC Memo 2005-110.
Blodgett, F3d 1030 (8th Cir. 2005).
18
Theresa E. Brady, TC Summ. Op. 2004-131.
19
Bilthouse, DC, IL. 100 AFRTed 2007-5317.
20
Gitlitz, 531 U.S. 206 (2001). Under Gitlitz, an insolvent S corporation’s Sec. 108 cancellation of indebtedness
income increases a shareholder’s stock basis because it is tax-exempt income. The Gitlitz doctrine is not applicable
to discharges of indebtedness after October 11, 2001, due to the enactment of Sec. 108(d)(7)(a).
21
125 TC 72.
17
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Passive Activity Loss Cases (Section 469)
In Tony R. Carlos,22 a taxpayer owned two commercial properties and two S corporations (a steel
company and a restaurant) that were the tenants in the commercial property. For Sec. 469
purposes, the taxpayer elected to group the two real estate activities as one passive activity. The
restaurant property had a loss, while the steel property showed a profit. The taxpayer netted the
nonpassive rental income and the restaurant’s passive loss for a net nonpassive income. The
issue was whether the single-activity netting occurred before or after nonpassive activities were
segregated. The court ruled that if passive/nonpassive segregation occurs first, then netting
among the activities is grouped together. The result was that the taxpayer had the worst of all
worlds – suspended passive losses from the restaurant property and nonpassive income from the
steel property.
Another interesting manifestation of the PAL rules occurred in Misko,23 which involved a C
corporation (the results would have been the same using an S corporation). A successful trial
lawyer did business as a corporation and rented computer and video equipment from himself. He
usually broke even, but in 1998 and 1999, he lost money; the IRS raised hobby loss and passive
activity issues. The Tax Court held that the Sec. 183 rules did not apply, because the activity was
entered into for a profit. The taxpayer successfully maintained that the incidental activity
exception factors under Temp. Regs. Sec. 1.469-1T(e)(3)(vi)(C) applied, because there was no
rental or salary income in the two years under examination; thus, the PAL rules did not apply.
The taxpayer was also deemed to be materially participating, because no one spent as much time
on the activity as he did.
22
23
Tony R. Carlos, 123 TC 16 (2004).
Fred Misko, Jr., TC Memo 2005-166.
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Carryover after Termination of Election –
The Post-termination Transition Period
If a shareholder has unused S corporation losses or deductions, and the S corporation election is
terminated, such losses or deductions will be treated as if they were incurred by the shareholder
on the last day of the corporation's post-termination transition period, but the losses and
deductions are allowed only to the extent they reduce the basis in stock (not debt) to zero. (Also,
the losses may be subject to other limitations, such as the passive loss or at-risk rules.) Any
losses or deductions not so used are lost forever [Section 1366(d)(3); Reg. Sec. 1.1366-2(b)].
The PTTP provisions give the shareholder a chance to increase stock and at-risk basis after the S
election terminates so that unused losses can be deducted. The shareholder must determine,
however, whether it makes economic sense to contribute funds to the corporation in exchange for
the loss deduction. In effect this clause allows a shareholder to “buy losses.”
Stock basis may be increased during the PTTP by making capital contributions or by purchasing
additional shares in the S corporation.24
Definition of Post-termination Transition Period
The post-termination transition period is the period that begins on the day after the last day of the
corporation's last taxable year as an S corporation, and ends on the later of

The day which is one year after such last day, or the due date for filing the return for such
last year as an S corporation, including extensions, whichever is later;

The end of the 120-day period beginning on the day of the determination that the S
corporation's election had terminated for a previous taxable year; or

The end of the 120-day period beginning on the date of a determination under an IRS
audit occurring after the termination of the S election, if an S corporation item of income,
loss, or deduction is adjusted [Section 1377(b); Reg. Sec. 1.1377-2].
A determination as described about means either
24

A court decision which became final,

A closing agreement, or

An agreement between the corporation and the IRS that the corporation failed to qualify
as an S corporation.
FSA 200207015.
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For self study participants only, the CPE Standards require the inclusion of review
questions that provide periodic learning feedback. Please go to the review section at
the end of the course to access the review questions for this chapter.
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