Incorrectly Deducted S Losses Affect Basis Computation

In Field Service Advice 200230030, the IRS concluded that a taxpayer's basis in S corporation stock for an open year must be adjusted for improper deductions in excess of basis in closed years.

S deductions and losses pass through to shareholders. Under Sec. 1366(a), the shareholders report their pro-rata share of the deductions and losses on their individual returns. The deduction is limited to their basis in their S stock and amounts loaned by them to the S corporation. A deduction or loss that cannot be claimed due to basis limits may be carried over and used in future tax years, to the extent the shareholder has basis.

Basis Improperly Claimed in Closed Year

Example: M was the sole shareholder of S corporation C, and had a $20,000 adjusted stock basis. In year 1, C had a $50,000 loss, which M deducted in full and reduced his basis to zero. M should have deducted only $20,000 (his adjusted stock basis), then reduced his basis to zero. In year 2, C had a $30,000 ordinary loss, which M deducted in full, despite having zero basis; he claimed that his adjusted basis remained at zero. In year 3, C had $90,000 of ordinary income, which M reported as income, claiming his adjusted basis was $90,000.

Excess Losses Taken into Account

The IRS audited M in year 4. Years 1, 2 and 3 were closed under the statute of limitations. The Service concluded that even though years 1 and 2 were closed for determining a tax deficiency based on the excess losses, it had to use the correct determination of gains and losses from the closed years to calculate the correct basis in the first open year. Thus, $60,000 of excess losses ($30,000 each in years 1 and 2), which should have been suspended due to basis limits, had to be taken into account in formulating M's basis, even though years 1 and 2 were closed for audit purposes. As a result, M had a $30,000 basis at the beginning of year 4 ($90,000 – $60,000 of excess losses).

From Marietta Courtney, MST, CPA, Gray, Gray & Gray, LLP, Boston, MA