Computing Stock and Debt Basis when Stock Is Sold during the Year

Editor:

Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from "PPC Tax Planning Guide—S Corporations," 14th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2000 ((800) 323-8241; www.ppcnet.com).

Facts: William, who has been the sole shareholder of Esscorp for several years, materially participates in its operations. His stock basis at the beginning of the corporation's calendar tax year was zero. There were no loans payable to William at that time, and he has a suspended passthrough loss (due to lack of basis) of $15,000 from prior years.

During the current year, the following transactions occurred:

• January 2: William made a capital contribution of $10,000.

• January 15: William loaned the corporation $45,000.

• March 15: The corporation made a $12,500 payment on the January 15 note, reducing the unpaid note balance to $32,500.

• July 1: William sold all of his stock in Esscorp for $39,000.

• July 15: Esscorp paid William the remaining balance ($32,500) of the January 15 note.

The corporation reported a loss for the year, and William's share of the loss was $17,000. Issue: Can William use his basis in stock and loans to deduct ordinary losses in the year of complete termination of his interest? What amount can William deduct as suspended and as current passthrough losses on his income tax return? What is his gain on the stock sale and on the note repayment?

Analysis

First, William's basis in stock and debt must be computed. Normally, the adjusted basis of a shareholder's stock is determined as of the close of the corporate tax year; the adjusted basis of stock sold or otherwise disposed of during the year is determined immediately before the sale or other disposition (Regs. Sec. 1.1367-1(d)(1)). The same premise applies to the basis of debt owed to the shareholder. Debt basis usually is determined as of the close of the corporate tax year; however, if the shareholder is not a shareholder as of the close of the tax year, debt basis is determined as of the last day that stock was owned (Regs. Sec. 1.1367-2(d)(1)).

Exhibit 1 shows how to calculate William's stock and debt basis as of the sale date.

William has sufficient basis to deduct all $32,000 of the losses ($17,000 loss from the current year 1 $15,000 carryover loss). He will report a long-term capital gain of $39,000 from the stock sale and gain of $22,000 ($32,500 note balance – $10,500 basis) from the note repayment. The gain is long-term capital gain, because the debt is evidenced by a written note and William held the stock for more than 12 months. It would be ordinary income if there were no debt instrument.

Conclusion

William can deduct his entire $32,000 of losses. His gain on the stock sale is $39,000, and his gain on the note repayment is $22,000.

When shares are sold during the year, stock and debt basis are determined immediately before the sale takes place. Consequently, the basis can be used to deduct ordinary losses on the taxpayer's income tax return, rather than being used as a factor in the calculation of gain from the disposition of stock or notes.

Variation

Gain on sale of S stock does not affect basis.

• Suspended losses due to lack of basis—Assume that William has no stock basis and no outstanding loans to Esscorp on January 1 (the beginning of the corporation's tax year). On that date, William has $25,000 in suspended losses that he has been unable to deduct due to lack of basis. On July 1, William sells his shares for $39,000. At the end of the year, Esscorp passes through to William a loss of $15,000, bringing his aggregate suspended losses to $40,000.Gain on the sale of S stock does not affect basis for regular tax purposes. Therefore, William must recognize the $39,000 gain on the sale of his shares but, because he has no stock or debt basis, he cannot deduct any portion of the $40,000 of suspended losses. In fact, the loss expires on the sale of his stock and is never deductible.
• At-risk and passive-activity loss limits—As discussed, stock and debt basis are not affected by the sales of S stock. However, gain on stock disposition does increase the amount that can be deducted for at-risk purposes. Also, suspended passive losses can generally be deducted when a passive activity is disposed of.