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Treatment of S losses suspended under basis and/or at-risk rules when shareholder disposes of corporation's stock.

Since the repeal of the General Utilities doctrine, many tax advisers have recommended S status to clients. Perhaps the most influential factor is the future benefit of only a single tax at the shareholder level on the sale of the corporation--in contrast to the possibility of taxation at both the corporate and shareholder levels on a C corporation's sale.

Sec. 1366d)(1) allows shareholders to deduct S losses up to, but not in excess of, their basis (stock and debt) in the corporation. Such losses are not deductible by the shareholder after the bases in stock and debt are reduced to zero.

Losses that exceed stock and debt basis are suspended and carried over indefinitely under Sec. 1366(d)(2). These losses are deductible in any subsequent year in which the shareholder has adequate basis in stock or debt.

One way of restoring a shareholder's basis is through corporate income that is taxed to the shareholder. However, questions arise as to whether S losses suspended under the basis and/or at-risk rules may be used against the shareholder's gain from the disposition of his stock in the corporation.

Prop. Regs. Sec. 1.465-12 allows gains recognized on dispositions to be treated as income from an activity. Prop. Regs. SEc. 1.465-66 allows amounts disallowed by Sec. 465 in previous tax years to be allowed for the year of disposition.

Sec. 465 and its proposed regulations deal with losses suspended due to the at-risk limitations. Generally, a shareholder is at risk for the amount of money (or basis of property) contributed to the corporation, as well as for debts for which the shareholder is personally liable (Sec. 465(b)).

The amount at risk may or may not be the same as a shareholder's basis; however, because of the S corporation basis rules, the disparity generally is not as common as in partnerships.

One clear illustration of this difference is an owner's guarantee of an entity's debt. Under Sec. 465, neither an S shareholder nor a partner would be considered at risk. It also is well-settled that shareholder guarantees of corporate debt do not result in increased basis for the shareholder. (For example, see Woolley, TC Memo 1991-131.) However, under certain conditions, a partner's basis in his partnership may be increased for personal guarantees of partnership debts (see Regs. Sec. 1.752-2).

In Allen, TC Memo 1988-166, the Tax Court allowed suspended partnership losses to be used against the gain from disposition of a partner's interest. The partnership had incurred losses attributable to nonrecourse debt for which the partner was not at risk. The partner subsequently realized a gain under Sec. 357 through contribution of his partnership interest to a newly created corporation in a Sec. 351 transaction. The suspended losses were allowed to offset the partner's gain. However, a detailed analysis of the Tax Court's decision reveals that the suspended losses used at disposition came from years in which the partner had basis but no amount at risk. The suspended losses were generated by the difference between the partner's basis and his amount at risk. See the chart above.

Although Allen dealt with suspended partnership losses, Sec. 465 also applies to S losses (Prop. Regs. SEc. 1.465-10). Accordingly, suspended S losses should be available for use by a shareholder against any gain arising from disposition of his stock--if the shareholder previously had adequate basis, but was denied a deduction for the corporation's losses because he was not at risk. However, suspended losses exceeding the shareholder's basis cannot be used against such gain.

From Steven T. Petra, CPA, Associate Professor of Accounting and Business Law, State University of New York, Old Westbury, N.Y.
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Author:Petra, Steven T.
Publication:The Tax Adviser
Date:May 1, 1992
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