S corporation losses: you snooze, you lose.

March 22nd, 2012 by Joe Kristan

Losing money stinks, but it can have its consolations at tax time.  That’s one reason S corporations are popular.  S corporation shareholders can, under the right circumstances, deduct corporate losses on their 1040s.  But one of the “right circumstances” is that the shareholder has to have “basis” in their S corporation stock.  Basis starts with your investment in the corporation, and  it is increased by capital contributions and your share of S corporation income.  It is reduced by losses and distributions — even if you don’t bother to deduct them on your 1040.

A couple, the Barnses, learned that lesson the hard way in Tax Court yesterday.  Their business, Whitney Restaurants, Inc., struggled over a period of years, with recurring losses and continuing capital contributions.  The Tax Court summarizes their K-1 loss and capital contribution history:

For reasons not clear in the case, the sharholders didn’t deduct any of the 1996 loss of $136,228.50 on their 1997 1040, even though they had made a big capital contribution; they instead reported income of $22,283.  The taxpayers thought that meant they had an extra basis of $158,511.50 to enable them to deduct losses in 2003.  The IRS thought otherwise and disallowed the $123,006.07 in losses (they used pennies on their returns?).

The Tax Court sided with the IRS, ruling that with S corporation losses, it’s use them or lose them.  First, the court ruled that reporting S corporation income you didn’t earn doesn’t increase your basis:

The IRS takes the position that the Barneses’ basis in the Whitney stock did not increase by $22,282 in 1996. It contends that, under section 1367, there is no upward basis adjustment for amounts that are erroneously reported by the shareholder as passthrough income but that do not correspond to the shareholder’s actual pro rata share of passthrough income. The Barneses seem to argue, without citation of authority, that the upward basis adjustment was appropriate because they reported $22,282 in passthrough income on their 1996 return. We agree with the position of the IRS.

What about the loss they didn’t use?

Basis is reduced, the IRS contends, even if the shareholder does not actually claim the passthrough losses on his or her return. Therefore, the IRS argues, the Barneses’ basis was reduced by $136,228.50 for 1997 because of the $136,228.50 loss suspended in 1996 that the Barneses were required to take into account as a deduction for 1997.27 The Barneses’ basis calculations did not incorporate this reduction. Therefore, says the IRS, their basis calculations for subsequent years were inaccurate.

The Barneses offer a different interpretation of the applicable statutes. Section 1367(a)(2)(B), they argue, requires basis reduction only for losses that the S corporation shareholder reports on his or her tax return and claims as a deduction when calculating tax liability. …

The plain language of sections 1366 and 1367 supports the IRS’s interpretation.

The moral?  Somebody – either the taxpayers or their preparers — dropped the ball in 1996 and 1997.  Maybe they thought that they couldn’t use the losses then so they would “save” them until they were needed.  It doesn’t work that way.  If you can deduct your K-1 losses in the year they happen, that’s when you have to deduct them.

Cite: Barnes, T.C. Memo. 2012-80

UPDATE: Anthony Nitti has more.

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