S-Corporations Loss-Deduction Danger
- Published: 07/23/2012
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In an earlier column, “S Corporations, the Good, the Bad, the Scary” I provided an overview of S Corporations and discussed several potential benefits of operating a business as an S Corporation. Today, we will continue our discussion of S Corporations by sharing a common pitfall that can land shareholders in hot water with the IRS. The Pitfall: deducting losses on their individual return to which they are not entitled.
Before we continue, however, please consider these words of warning: S Corporation taxation is highly complex. Any single article (or series of articles) will barely scratch the surface. This article is for informational purposes only and does not constitute tax advice.
S Corporation Losses are Limited: S Corporations are considered “pass through” entities for tax purposes. Each shareholder’s share of profits, losses, and other items are generally not taxed at the entity level. Instead, each shareholder receives a form, called a K-1, from the corporation showing their share of items that may (or may not) impact their individual return. Unfortunately, preparing the shareholder’s tax return is seldom as simple as copying the K-1 information onto their return. Such “copy and paste” tax preparation can result in serious mistakes. One of the most common mistakes is deducting S Corporation losses that exceed shareholder “basis.”
What is Shareholder Basis? A simplified way to view basis is to think of an investor buying a share of stock. If they pay $50 for a share of company X, they have a “basis” of $50 in that stock. They cannot lose more than the $50 paid for the stock. The same is true for S Corporation investors - they cannot lose more than the amount “invested.”
Calculating an S Corporation shareholders “investment” (basis), however, is much more complex. Because S Corporations are pass-through entities, a shareholder’s basis is fluid and constantly changing.
To determine stock basis we start with the purchase price and add in chronological order of occurrence:
- Additional cash and the fair market value of property the shareholder contributed to the company,
- The owner’s share of company profits, and,
- Money loaned directly to the company by the shareholder - loans merely guaranteed by the owner do not count.
We must also subtract:
- Distributions made to the shareholder,
- The shareholder’s “share” of company losses, and
- Certain other “flow-through” basis deductions.
This “basis,” however, cannot be negative. Once basis reaches zero, corporate losses cannot be deducted on the shareholders return. Instead, they must be carried forward until the shareholder obtains the positive basis needed to deduct them.
IRS Audit Target: The frequency of basis-loss errors, combined with an improved ability to cross-reference K-1 and individual returns has resulted in increased IRS scrutiny. The best way to avoid this scrutiny is to avoid these three common reasons basis-loss errors are made:
- Most shareholders do not know that basis-loss rules exist. By reading this article you lack this excuse.
- Others believe the corporation will track their basis and let them know if and when their losses are limited. Unfortunately, this is seldom the case and a near-impossible proposition for larger S Corps. If you are one of a few shareholders, ask the corporate return’s preparer to reconstruct and track your basis. The peace of mind will be well worth the investment.
- A final reason for basis-loss errors is the assumption that individual return preparers understand and track their client’s basis. Again, this is often wishful thinking. A surprising number of preparers lack sufficient training in basis-loss rules. Even those who have such training will often lack the information needed to properly calculate basis. To avoid this error, speak with your preparer regarding the basis rules. If they have the training and experience, provide them with any information they need reconstruct your basis. The headache and cost will be well worth it. If they do not, find a new preparer.
This article has discussed the potential pitfalls of deducting S Corporation losses on your individual tax return. If you would like to speak with a tax professional, please feel free to contact our office to make an appointment.