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NO BASIS, NO LOSS: YEAR END PLANNING FOR S CORPORATION SHAREHOLDERS

November 22, 2002

S corporations have become very popular for a number of reasons. The biggest tax advantage is the imposition of only one level of tax on S corporation income - at the time it is earned. A schedule K-1 reports each shareholder's share of corporate income, which then is reported on the shareholder's personal return. This income can be distributed tax-free to the shareholder; if it is not distributed, it increases the shareholder's stock basis, reducing the capital gain on any future sale of the stock. C corporations, by contrast, pay their own tax on their earnings; the earnings are taxed again to the shareholders if they are distributed as dividends.

If an S corporation has a taxable loss, that is also reported on the K-1. Here we must consider a fundamental tax law principle: "Heads they win, tails you lose." In other words, while shareholders usually must report taxable income from an S corporation, there are several restrictions on the ability to deduct loss. Shareholders wanting to deduct their losses have three hurdles to clear, in order:

1. BASIS. The taxpayer can only deduct an S corporation loss to the extent of basis in the S corporation, or in direct loans by the taxpayer to the organization.

2. AT RISK AMOUNTS: Is the taxpayer's basis "at-risk" under the tax law?

3. PASSIVE LOSSES: Is the loss a "passive activity" loss, deductible only to the extent of passive activity income?

You may be relieved to know that we will only discuss basis issues today.

A taxpayer's initial basis in an S corporation is the amount paid for the stock. It is increased by capital contributions and by undistributed income of the S corporation. It is reduced by distributions of S corporation earnings and by S corporation losses.

A taxpayer can also deduct losses of an S corporation to the extent of taxpayer loans to the S corporation. The loans have to be loans made by the taxpayer; guarantees of debt do not work.

EXAMPLE: Wally starts an S corporation. He contributes $10,000 to the corporation in exchange for 100% of its stock. The corporation borrows $5,000 from Wally and $50,000 from the bank, guaranteed by Wally. The S corporation loses $20,000 in its first year. Wally can deduct $15,000 of losses this year, based on his $10,000 cash contribution and his $5,000 personal loan. The guarantee from the bank does nothing to enable Wally to deduct losses.

LESSON: Wally could have borrowed the bank loan personally and loaned it to the company; this "back-to-back" loan would have given him enough basis to deduct the remaining $5,000 S corporation loss.

Taxpayers need to be careful in dealing with S corporation basis. The basis is determined on the last day of the S corporation's tax year. This means that the taxpayer needs to project taxable income before year end to determine whether additional loans or capital contributions to the corporation are called for.

Taxpayers also need to pay careful attention to how year-end basis contributions are structured. The Oren case decided earlier this year showed the dangers of trying to shuffle basis among related S corporations. Now that S corporations can be organized with holding-company structures, brother-sister S corporations with identical ownership should normally be in a holding company structure.

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