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Year-end planning: Make sure you have enough basis to deduct your S corporation losses.

December 09, 2009

S corporations are popular for many good reasons.  One of them is the ability to deduct corporate losses on the owners' 1040s.  It's been a rough year for a lot of folks and many taxpayers are looking forward to a nice tax refund from their 2009 business losses.  If you are one of them, make sure you don't lose your loss deduction for lack of basis in your S corporation; shareholders can only deduct losses to the extent of their basis.

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 shareholder can also deduct losses of an S corporation to the extent of 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. A few points to keep in mind:

• 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. If a shareholder borrows money from one S corporation and loans it to the money-losing corporation to get basis, the money-losing corporation shouldn't send the money right back where it came from; the IRS will disregard all of the transfers.

Basis is only one hurdle S corporation shareholders need to clear before they can deduct losses.  Taxpayers also need to be "at-risk" for their basis and the losses can't be "passive" under the "passive activity" rules.  It's time to project your year end income and visit your tax pro to make sure you can deduct those 2009 tax losses.

This post originally appeared at IowaBiz.com. It is part of the Tax Update's series of 2009 year-end planning tax tips.

Tags: basis.iowabiz.com.s corporations.year-end tax planning.

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