Deducting S Corporation Losses in Excess of Basis

In February of 2017, the IRS announced a major shift in enforcement methods for its Large Business and International (LB&I) division, with the revamped approach centering on issue-specific “campaigns.” The initial 13 campaigns are already underway.

In past years, the enforcement activities of the LB&I have predominantly consisted of audits of the largest corporations, with the examinations spanning a variety of issues. This new, issue-centered enforcement approach will be more likely to reach S corporations that have previously enjoyed a degree of “invisibility” to the IRS.

Deducting S Corporation Losses in Excess of Basis

What Is an S Corporation?

An S corporation is a corporate entity with a “pass through” structure, meaning that the corporation’s income, losses, and deductions are assigned to its shareholders. The shareholders report these items on their personal tax returns and assume any resulting tax liability or benefit.

Each year, the S corporation provides every shareholder with a Schedule K-1, which details the shareholder’s share of all income, losses, deductions, and any other tax-influencing elements. Many shareholders mistakenly assume that if their K-1 assigns them a loss, they can report the entire loss amount on their personal tax returns. That is not true, and this issue is at the center of one of the LB&I’s 13 initial campaigns.

The Campaign Against S Corp Losses and Deductions Claimed in Excess of Basis

As the IRS explains in its own announcement of the 13 initial campaigns, “The law limits (shareholders’) losses and deductions to their basis in the corporation.” Basis, for purposes of this discussion, is essentially a measure of a shareholder’s capacity to absorb the losses assigned to them.

For example, if a shareholder is assigned $25,000 in losses and $2,000 in deductions (for a total of $27,000) on a K-1 but has a basis of only $18,500, then the largest figure that individual can report on a tax return for S corporation losses and deductions is $18,500, not $27,000.

Basis has two primary components: stock basis and debt basis. Both are complicated to compute, usually requiring the assistance of a qualified tax professional. Most importantly, a shareholder’s basis changes year by year, and so must be recalculated for each year’s tax return.

Stock Basis

Many S corporation shareholders do not have an adequate understanding of their stock basis. A calculation of stock basis begins with the shareholder’s initial buy-in amount (either the price of the stock purchased or the amount of capital contributed). Every dollar of gain or loss that subsequently flows from the S corporation to the shareholder changes the shareholder’s stock basis

There is a very important distinction to be made here between assigned income and a distribution. Income assigned to a shareholder on a K-1 passes to the shareholder for tax purposes, but the shareholder does not actually receive the money—it is held by the corporation. Hence, assigned income increases a shareholder’s stock basis. A distribution is an actual payment of cash from the S corporation to a shareholder, which reduces the shareholder’s stock basis (since the value of assets held by the company decreases).

Debt Basis

An S corporation shareholder’s debt basis is a measure of the amount of debt owed by the corporation to the shareholder. In other words, a debt basis exists when the corporation has borrowed money from the shareholder. The issuance of corporate bonds is a commonly known example of a corporation engaging in borrowing from the general public, but S corporations usually borrow more directly from individual shareholders.

IRS rules strictly define what constitutes a bona fide debt owed to the shareholder, and only debts meeting those conditions may be included in a shareholder’s debt basis. First and foremost, the debt cannot take the form of a third-party transaction, such as the shareholder acting as guarantor of a loan from a bank or other individual. The shareholder must personally provide the loan funds to the S corporation—in other words, there must be the equivalent of a direct transfer of cash form the shareholder to the corporation.

The IRS requires a written document detailing the amount of the debt, a schedule for maturity/repayment, and a specified interest rate, along with substantial additional documentation. Debt basis will be acutely examined under the LB&I’s campaign. Understanding the difference between bona fide debts and those that do not factor into debt basis will be vitally important for all S corporation shareholders.

Conclusion: If There Is a Campaign, There Is a Reason

The LB&I did not develop the 13 initial campaigns by randomly drawing enforcement issues out of a hat. The IRS clearly believes that many S corporation shareholders currently claim losses and deductions beyond their basis in the corporation, in violation of the law. The law has not changed, but the LB&I’s deployment of resources to enforce the law has. Know and understand your basis. The IRS is watching!