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YEAR-END PLANNING FOR S CORPORATIONS: BEWARE OF BASIS!

December 07, 2006

For most businesses, 2006 has been a good year. Yet even in the best of times, life in business can be hard, and somebody is going to lose money. When this happens, an S corporation's tax return can be the silver lining to the dark financial cloud. The tax law often allows S corporation owners to deduct their share of the company's losses on their tax return, allowing them to claim tax refunds for some much-needed cash.

The tax law has important limits on your ability to deduct losses from an S corporation. They apply in the following order:

1. You have to have basis in your S corporation stock, or in debt that you have personally loaned to the S corporation.

2. Your basis must be "at-risk"; and

3. You have to get past the "passive activity" rules.

BASIS AND THE "AT-RISK" RULES

The tax law allows S corporation owners to deduct losses only to the extent of their basis in S corporation stock. That basis normally starts at what you pay for the stock. Your share of corporation taxable income and your capital contributions increase your basis; it goes down for your share of corporation losses and your S corporation distributions.

If you loan money to the S corporation, you can count the loan as basis. While this can be a handy way to get your year-end losses, it is fraught with danger. The tax law requires such loans to have "substance" and to be "at-risk." The courts have been tough in the last few years in enforcing these standards.

For example, Donald Oren, the owner of the Dart trucking companies, had multiple S corporations. He borrowed money from one corporation and loaned it to another one with tax losses so he would have basis. That corporation sent the money right back to the first corporation in another loan. The courts said the loan had no substance and was not "at-risk," and losses of about $14 million disappeared from his tax returns.

GETTING GOOD BASIS

Here are some things you can do to make sure you have good basis for your losses:

- If you own multiple S corporations, you should consider holding them in a holding company structure. This structure, which wasn't available in the years when Mr. Oren had his losses, allows you to combine the basis of all of your S corporations while still preserving their separate legal identities.

- If you must get cash for your basis from a related entity, get it in the form of a distribution instead of a loan, and contribute it to the capital of the loss company. And for good measure, don't loan it right back to the first company.

- If you insist on loaning funds to the loss corporation to get your basis, get the loan from a bank or some other unrelated third party. Loans from relatives or business associates may not be "at-risk," as one central Iowa farmer learned the hard way. Borrow the funds personally and then loan them to the company. A guarantee of a third party loan to your S corporation does nothing to get you additional basis.

We will talk about dealing with the passive activity limits on S corporation issues in another post.

Related:

DOING THE BASIS HOKEY POKEY

WHEREVER YOU ARE, S CORPORATION LOAN GUARANTEES DON'T WORK

S CORPORATION SHAREHOLDER WINS BASIS CASE IN TAX COURT

S CORPORATION OWNERS TEMPT FATE, WIN

RING AROUND THE ROSEY FAILS AN S CORPORATION SHAREHOLDER

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