Tax Losses and Their Effect on Basis of S-Corporation Shareholders

Tax Loss Implications for S Corporation Shareholders, A court decision highlights the necessity of careful analysis of tax losses available in any given year.

Any income of an S corporation flows though to it’s shareholders who report their share of such income or loss on their respective individual tax returns. Usually, in order to be able to take a tax loss in any year, the taxpayer must have cost basis in the corporation. Cost basis is comprised of any capital contributions to the company plus any loans to the company and, in some cases, recourse debt assumed by shareholders on behalf of the corporation. Losses to the extent of basis are generally deductible. Losses can also be carried forward and back in some circumstances. Any losses that exceed basis are disallowed based on vague legislative theory that a taxpayer should only be able to deduct looses to the extent of the amount he or she has at risk in the business. A couple owned an S corporation that incurred losses that exceeded their tax basis.

The losses were carried forward to later years. In a later year the taxpayers increased their stock basis by making additional cash contributions to the company. However, they chose not to deduct the losses on their individual tax returns. The taxpayers also chose not to decrease their basis for the losses not taken. The IRS argued that although the taxpayers had not deducted the losses on their individual return the losses should decrease their stock basis. The court agreed with the Service and ruled to reduce the loss the taxpayers took later. The implications of the decision for the taxpayer-shareholder in an S corporation are that all losses must be accurately accounted for every year, whether by taking deduction in that year or via carryovers. Occasionally, losses carried forward or back are lost due to poor record keeping or incompetent tax preparation.

Stock basis should be reduced and maintained to prevent similar scenario of reduced basis for losses not deducted due to error, negligence, oversight or lack of proper knowledge or advise. Business owners and investors should careful analyze their losses and the effects on basis in order to prevent reduced basis and higher tax burden in the future. This post contains only general information and O’Brien & Panchuk LLP is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for professional advice, nor should it be used as a basis for any decision or action that may affect your business or individual financial position. Before you make any decision or take any action that may affect you or your business, you should consult a qualified professional advisor.

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