Key Takeaways

  • Stock Basis and Debt Basis: Losses are deducted by reducing stock basis first, and then debt basis if needed. Contributions, such as cash or property, can help restore these bases.
  • At-Risk Limitation Rules: Losses cannot exceed the shareholder's at-risk basis, and must pass an additional test to be deductible.
  • Tax Basis for Loss Deduction: Tax basis includes stock and debt basis, and shareholders need to have sufficient tax basis to deduct losses.

S Corp Taxation

S corporations are taxed as pass-through entities, which means each shareholder reports a percentage of the business's income, credits, and deductions on his or her individual tax return. This should be done during the year in which the corporation's fiscal year concludes.

Items that are passed through to shareholder returns are allocated on a pro rata basis in most cases.

Stock Basis and Debt Basis

When the shareholder reports S corp losses and deductions, they are initially used to reduce stock basis. Once stock basis is eliminated, additional losses are applied to the debt basis. However, the latter is not reduced if the debt in question was forgiven, discharged, or satisfied during the corporate tax year.

When stock and debt bases are both reduced to zero, the basis must be increased for the shareholder to deduct losses for the year. This step must be taken before the tax year of the corporation ends.

The initial stock basis is calculated for each shareholder depending on how his or her interest is acquired: the property or money he or she contributed to the corporation or the number of shares purchased. When shares are gifted, the giver's basis amount is also donated. However, this is adjusted to fair market value.

Tax basis is calculated by adding the debt basis to the stock basis. Only a sufficient tax basis will result in deductible S corp losses.

Understanding S Corp Loss Limitations

When reporting S corp losses, shareholders face a set of loss limitations that control how and when these losses can be deducted. The fundamental rules are tied to the shareholder's stock and debt basis, and the at-risk limitations also come into play.

The "S corp loss limitations" rule dictates that a shareholder can only deduct losses up to the amount of their basis in the corporation, meaning the stock and debt basis must be sufficient to cover the loss. Losses that exceed the basis cannot be deducted in the current tax year and will carry over to future years, provided the shareholder's basis increases.

There are two primary categories to be aware of:

  • Stock Basis: This is the original and adjusted amount a shareholder has invested into the S corporation, including contributions of cash, property, or services.
  • Debt Basis: This represents loans made to the corporation by the shareholder, which must also be considered when determining loss deduction eligibility.

Establishing Additional Stock and Debt Basis

When debt or stock basis is increased before the S corp's tax year ends, it can be used to deduct both previous and current losses.

To increase the stock basis, S corp shareholders can take one or more of the following steps:

  • Donating cash to the business
  • Buying more stock shares
  • Giving real estate or property in payment for stock

Debt basis can be increased by:

  • Giving the business a loan
  • Paying off a portion or all corporate debt guaranteed by the S corporation, a step that may be required by certain lenders and banks
  • Substituting an S corp loan with a loan from the corporation to a secondary lender
  • Creating open account debt to shareholders, which can be treated as a single debt provided that it equals less than $25,000 at the end of the fiscal year

When additional debt or stock basis is obtained or when the corporate income effectively increases the basis, the basis is restored.

Shareholders who loan money to an S corp for this purpose should be aware that if the loan cannot be collected, they may be subject to a bad debt loss. Making capital contributions to increase basis to deduct losses is not necessarily the best path, particularly if the S corp is at risk for going under. For example, if you make a capital contribution of $20,000 that can't be recovered in case of insolvency. Assess both nontax and tax factors closely before taking any of the actions described above.

If you do plan to make a capital contribution to increase basis, do so by buying S corp stock shares if at all possible. If the S corp becomes insolvent, this will be considered a capital loss rather than the ordinary loss constituted by a cash contribution.

Both nonbusiness and business bad debt losses can be deducted by shareholders. The former are considered short-term capital losses and the latter as ordinary losses. If a worthless debt is incurred in the course of business operations, this can also be claimed by the shareholder. He or she can also establish that a loan made to an S corporation constituted a business loan if it was made to enhance income, employee status, or business reputation or relationship.

At-Risk Limitation Rules

For losses to be used to offset shareholder income, they must pass the at-risk limitation test in addition to the stock basis test described above. This test is also based on the loss funding method. This was established by the 10th Circuit Court case of Litwin in 1993.

Interaction Between Loss Limitations and At-Risk Rules

The interaction between the S corp’s loss limitations and at-risk rules can significantly impact a shareholder’s ability to deduct losses. The "at-risk" rule, designed to prevent taxpayers from claiming losses greater than the amount they have personally invested, must be applied before any deductions for stock or debt basis are allowed.

A loss deduction is limited to the amount the shareholder has invested in the company at risk—i.e., the amount they could lose if the corporation were to fail. This is particularly important when the shareholder has made loans to the company or contributed property, as these elements can increase their at-risk basis and enable further loss deductions.

Frequently Asked Questions

  1. What are S Corp loss limitations?
    S Corp loss limitations refer to the rules that restrict the amount of loss shareholders can deduct based on their stock and debt basis, as well as the at-risk rules.
  2. How do I increase my basis to deduct S Corp losses?
    Shareholders can increase their basis by contributing cash or property, buying additional shares, or making loans to the corporation.
  3. What is the at-risk limitation for S Corp losses?
    The at-risk limitation prevents shareholders from deducting more losses than the amount they have personally invested in the S corp, including loans or capital contributions.
  4. Can I deduct losses if my basis is zero?
    No, you must restore your basis before you can deduct losses. This could involve making additional contributions or loans to the S corp.
  5. How do S corp losses carry over?
    Losses that exceed the shareholder’s basis can carry over to future years, but they can only be deducted when the basis increases in those years.

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