By James M. Kehl, CPA, MST
Weil, Akman, Baylin & Coleman, P.A., Timonium, MD
One of the most important computations for S corporation shareholders is the shareholders' basis for their S corporation stock. This is a calculation that tracks activity with respect to the stock over a period that may encompass many years. There have been instances where an S corporation shareholder did not deduct the shareholder's proper share of an S corporation's losses for a specific year or reported an incorrect amount of income for a particular year from an S corporation. One issue that arises in these cases is the effect of these errors on the shareholder's stock basis. The Tax Court addressed this issue in Barnes v. Comr.1
Facts of Case
The taxpayers in Barnes v. Comr. acquired 50% of the stock of an S corporation in 1995 by making a capital contribution to the S corporation of $44,271, which was their initial basis in the stock before deducting their share of the S corporation's losses for 1995. The shareholders subsequently received a K-1 from the S corporation for 1995 confirming that their share of corporate losses was $66,553. These facts indicate that the taxpayers were entitled to deduct a loss of $44,271, had a suspended loss of $22,282 and had a basis of zero for their stock at the end of 1995.
For 1996, the taxpayers received a K-1 from the S corporation indicating that their share of the 1996 corporate loss was $136,229. The taxpayers did not deduct any portion of this loss on their 1996 return, due to insufficient tax basis. Instead, they reported a gain of $22,282 on their 1996 return. The reason this income was reported is not clear. The IRS speculated that the taxpayers picked up this gain in 1996 because they had incorrectly deducted a loss of $66,553 on their 1995 return. According to the taxpayers' calculation, reporting the $22,282 of income resulted in their stock basis being zero. The IRS contended that the taxpayers had a total suspended loss of $158,511 at the end of 1996, which consisted of the 1995 suspended loss of $22,282 and the 1996 suspended loss of $136,229, and that the taxpayers' stock basis was zero.
In 1997, the taxpayers made a capital contribution to the S corporation of $278,000, which increased their stock basis by an equal amount. The taxpayers' 1997 K-1 confirmed a loss of $52,594, which they deducted on their 1997 personal income tax return. However, the taxpayers claimed no deduction in 1997 for any portion of the suspended loss of $158,511. This was the crux of the case. The IRS contended that the taxpayers' basis in their S corporation stock at the end of 1997 should have been reduced by the $158,511 suspended loss, even though the taxpayers did not deduct this amount on their 1997 return.
The transactions for the years 1998 through 2002 consisted of capital contributions to the S corporation by the taxpayers and losses and income passed through by the S corporation for those years. At the beginning of 2003, the IRS contended that the taxpayers had a basis in their stock of $107,283. The taxpayers, however, contended that their stock basis was $265,793. The difference was that the government's calculation included a reduction in the stock basis equal to the $158,511 of suspended loss that should have been deducted in 1997.
For 2003, the taxpayers contributed $46,000 to the S corporation and received a K-1 that indicated a loss of $276,289. The taxpayers increased their opening basis for 2003 by their $46,000 capital contribution and deducted the entire $276,289 loss that year. In contrast, the IRS increased the taxpayers opening basis of $107,283 by the $46,000 capital contribution and allowed the taxpayers a deduction of $153,283 for their share of the S corporation's 2003 loss. The disallowance of $123,006 of the taxpayers' 2003 loss due to lack of basis was the issue litigated in the Tax Court.
Court's Holding and Reasoning
The Tax Court's held that the computation of the taxpayers' stock basis by the IRS and its disallowance of $123,006 of the taxpayers' 2003 loss from the S corporation were correct. It is important to understand the Tax Court's reasoning for its decision.
The Tax Court began its analysis by noting that an S corporation shareholder's deduction for losses is limited to the shareholder's adjusted basis in the shareholder's stock plus the shareholder's adjusted basis in any debt directly owed by the S corporation to the shareholder.2 Before deducting losses for a year, a shareholder's stock basis at the beginning of a tax year is increased by any contributions to the S corporation's capital made by the shareholder during the year.3 The S corporation is required to report each shareholder's share of the S corporation's pass through items of income and deduction for a specific year on the shareholder's Schedule K-1. If the items of income and deduction reported on the K-1 are incorrect, then the shareholder must report the correct amounts of those items on the shareholder's tax return.4 Any portion of a shareholder's loss for a particular year that exceeds a shareholder's basis is not deducted in the current year.5 Instead, this "suspended loss" is deemed to be incurred in the following year by the shareholder.6 A shareholder's stock basis is required to be reduced by the shareholder's pro rata share of the S corporation's loss required to be taken into account for a specific year; a shareholder's basis is not reduced by any suspended loss.
If a shareholder receives a K-1 that contains the correct amounts for the items of income and deduction, those are the amounts the shareholder is required to report on the shareholder's tax return. In the instant case, the $22,282 of income reported by the taxpayers in 1996 did not increase the Barnes's basis for their S corporation stock because an S corporation shareholder's stock basis is only increased by a shareholder's proper pro rata share of the S corporation's income.7 Contrary to the taxpayers' argument, the Tax Court pointed out that stock basis is not increased by erroneous items from the S corporation reported on their personal return. Thus, the taxpayers should have reported their $136,229 share of the S corporation's 1996 loss as a suspended loss on their 1996 return. Consequently, at the end of 1996, the taxpayers had suspended loss of $22,282 for 1995 and $136,229 for 1996 (for a total of $158,511) and a stock basis of zero.
The suspended loss of $158,511 was treated as a loss incurred in 1997. The taxpayers' capital contribution of $278,000 in 1997 permitted them to deduct their $52,594 share of the S corporation's loss that year, as well as the suspended loss of $158,511. Therefore, the Tax Court concluded that the taxpayers' stock basis at the end of 1997 must be reduced by any losses required to be taken into account by the taxpayers for 1997, notwithstanding the fact that they did not claim any portion of the suspended loss on their 1997 return. In so concluding, the Tax Court rejected the taxpayers' contention that their stock basis need not be reduced by the suspended loss because they did not deduct it on their return. The stock basis calculated by the Tax Court and the IRS was the basis the taxpayers carried over to future years. As a result, the taxpayers could not deduct $123,006 of their share of the S corporation's 2003 loss because they did not have sufficient basis.
The Tax Court's decision in the Barnes case stands for the proposition that the rules for computing basis in S corporation stock must be timely and properly applied, regardless of the activity reported by the individual shareholders on their personal returns. If this were not the rule, then shareholders could effectively choose the years they want to recognize income and deduct losses. Barnes also indicates that a taxpayer cannot arbitrarily decide to recognize income from an S corporation and increase his or her stock basis by an equal amount.
Basis is a calculation that must be correctly computed for each year that a shareholder owns S corporation stock. The correct computation of stock basis must be made regardless of the activity on the shareholder's return.
For more information, in the Tax Management Portfolios, see Starr and Sobol, 731 T.M., S Corporations: Operations, and in Tax Practice Series, see ¶4280, Bais of Stock and Debt.
1 T.C. Memo 2012-80.
3 §§1012, 351(a) and 358(a)(1).
4 See Henn v. Comr., T.C. Memo 2002-261. The court noted in its opinion that it is unreasonable for a taxpayer to believe that he or she is legally required "to mechanically deduct a loss which was improper."