S-corporation final year loss treatment

[Catherine]

New client has a small S-corp that has been moribund and he's finally closing it down. He's been taking his share of losses (~80+%) all along; other s/h has NOT been able to take losses as they had never put any money into the company so no basis. Client was told by original tax preparer, years ago, that *he* could claim all the unused losses in whatever the year the business eventually closed.

I can't find anything in the 1120-s or k-1 instructions or Tax Book or irs dot gov that confirms or denies this. Can anyone here point me in the right direction?

Basis is NOT an issue; every penny ever put in was his, and not the other shareholder's.

TIA,

Catherine

[Mr. Pencil]

*he* could claim all the unused losses in whatever the year the business eventually closed.

Presumably those losses have already been passed through to the other shareholders, with whatever tax effect each had. If losses were NOT distributed proportionately, the S-status was automatically terminated for having more than one class of stock.

[kcjenkins]

My question is how could the other person actually be a "stockholder' if they never invested anything? If your guy 'gifted' them some of the stock he bought, that's one situation. If they got their stock as 'compensation' for their labor or such, that's another situation. But I have a real problem with the 'advice' he supposedly got. It just does not work that way. More details, please.

[SaraEA]

Look at the at-risk limits. If you have nothing invested you have nothing to lose and can't deduct anything. If the first shareholder already deducted 80% of his investment with pass-through losses, he only has 20% left to deduct. Thus if he put $1000 into the business and deducted $800 in losses, he's only at risk to lose $200 and that his maximum deduction. The other shareholder has no risk because he didn't contribute anything so can't deduct anything. It's like if you just give me half of your tax practice and then sustain a loss. I didn't lose a thing. If there is recourse debt the amount at risk will increase.

[Catherine]

Look at the at-risk limits. If you have nothing invested you have nothing to lose and can't deduct anything. If the first shareholder already deducted 80% of his investment with pass-through losses, he only has 20% left to deduct. Thus if he put $1000 into the business and deducted $800 in losses, he's only at risk to lose $200 and that his maximum deduction. The other shareholder has no risk because he didn't contribute anything so can't deduct anything. It's like if you just give me half of your tax practice and then sustain a loss. I didn't lose a thing. If there is recourse debt the amount at risk will increase.

My question is how could the other person actually be a "stockholder' if they never invested anything? If your guy 'gifted' them some of the stock he bought, that's one situation. If they got their stock as 'compensation' for their labor or such, that's another situation. But I have a real problem with the 'advice' he supposedly got. It just does not work that way. More details, please.

Well, I've asked for the paperwork to investigate how it was originally set up but don't have it yet.

I have no idea how one person got stock with no investment -- possibly they had the connections to potential customers? Ideas but no know-how? Space to store parts? I do know that all the *money* put in was by my client, who owns 80-something percent of the shares.

He has been claiming his percentage of the losses all along, but the other owner has NOT been able to claim losses because they had no basis. It seems reasonable to me that those losses could go "poof" as they are only claimable by the other shareholder, who still has no basis.

Yet I have the client pushing hard on this information he claims he was given -- namely, that HE can claim those suspended losses in the closing year (and he has a point, it was his money) -- but I need chapter and verse before I will attempt that, and chapter and verse for HIM, as proof, if they are lost.

And I can't find guidance. I'm pretty good at searching for some stuff, but every search I've tried gets me nitty-gritty on apportionment and basis et cetera but nothing about final-year treatment of suspended losses. Just to put it on the final K-1 and make sure the K-1 and return are both marked final. That doesn't help me with this suspended loss issue.

Thanks to all.

[kcjenkins]

Well, as you say, if someone else got 20% "for nothing", I'd ask the client " WHY the other guy was given 20%", and that answer would then direct my response. If he contributed ANYTHING, "connections to potential customers? Ideas but no know-how? Space to store parts?" then the 20% should have been treated as "compensation", which opens up other issues your client probably does not want opened at this point, like payroll taxes, for example.

That aside, once the 20% loss was "distributed" it belongs to that person, whether it is used or suspended, it's still his. There is no way he can just take it back years later. HE does not have any 'suspended' loss to take now, those belong to the other guy.

But explaining to him the proper way they should have handled that 20% assigned to the other guy should be enough to make him see the wisdom of letting go of those losses.

[Mr. Pencil]

I can't find guidance.

See the Instructions for Form 1120S. Page 25, under Shareholder's Pro Rata Share Items, says, "Items of income, gain, loss, deduction, or credit are allocated to a shareholder on a daily basis, according to the number of shares of stock held by the shareholder on each day of the corporation's tax year." In other words, it's a pass-through entity. Those losses may have been suspended on the shareholder level, but they were not accumulated by the corporation.

If he insists that the losses were not distributed to the other shareholder because they couldn't be used, tell him you want to see the prior year returns. Be sure to warn him that when you see those losses weren't on the K-1's, he will have to amend his personal returns for all the prior years and pay back the losses he deducted. Because if losses weren't distributed to one shareholder, losses couldn't be distributed to the other shareholder. That's what one class of stock means.

By the way, did you ask why he is changing his tax preparer this year?

[Catherine]

See the instructions for form 1120-S. Page 25, under Shareholder's Pro Rata Share Items, says, "Items of income, gain, loss, deduction, or credit are allocated to a shareholder on a daily basis, according to the number of shares of stock held by the shareholder on each day of the corporation's tax year." In other words, it's a pass-through entity. Those losses may have been suspended on the shareholder level, but they were not accumulated by the corporation.

If he insists that the losses were not distributed to the other shareholder because they couldn't be used, tell him you want to see the prior year returns. Be sure to warn him that when you see those returns, if the losses weren't on the K-1's, he has to amend his personal returns for all the prior years and pay back the losses he deducted. Because if losses weren't distributed to one shareholder, they couldn't be distributed to any other shareholder. That's what one class of stock means.

By the way, did you ask why he is changing his tax preparer this year?

That's what I figured -- but this guy is an engineer and instead of taking my word he's going to want chapter and verse from the IRC. They're like that (and I sympathize as I am loath to take anyone's word for durned near anything; I want to do the research myself).

He's actually not "changing" preparers this year. He's been doing the returns himself for years, as he was instructed by the original guy who gave him the odd information on the suspended losses. Since he's actually shutting the business down this year, he now wants a pro to make sure he treats the losses properly.

Hence my query, as I could find nothing that supported his position -- but also nothing in the IRC (as opposed to 1120-S instructions) that specifically dealt with treatment of suspended losses, in final year, by other shareholders. Most likely because there is no such animal.

[Mr. Pencil]

this guy is an engineer and instead of taking my word he's going to want chapter and verse from the IRC.

Okay--26 USC Chapter 1 Subchapter S.

But I don't like to get into the actual code except maybe for an audit. For filing purposes, the instructions for the form he files under penalty of perjury should be enough. If he wants to know the actual law he needs to hire an actual lawyer. If he "wants a pro to make sure he treats the losses properly," that's what you are doing. Unless of course he makes you look at those prior years.

[Lion EA]

If HE had any suspended losses, he could now use them with a fully taxable disposition of his shares. But, HE doesn't have any suspended losses. And, S-corps don't have any suspended losses as they pass them through to the shareholders; that's what pass-through entities do. If the guy down the street has suspended losses, that has no effect on my tax return.

[cred65]

Have you considered a Business Bad Debt on Form 4797? Not knowing all the facts I have attached some case law of which I had sucess.


Business versus nonbusiness bad debt:
Dagres, 136 T.C. No. 12 Filed 3/28/2011

“Section 166 distinguishes between business bad debts and nonbusiness bad debts. Sec. 166(d); sec. 1.166-5(b ), Income Tax Regs. Business bad debts may be deducted against ordinary income and are deductible whether such debts become wholly or partially
worthless during the year. Nonbusiness bad debts may be deducted
only as short-term capital losses and only if the debts become
wholly worthless in the year claimed. Sec. 166(d). A bad debt
is characterized as business rather than nonbusiness if the debt
bears a proximate relationship to the taxpayer's trade or
business. Sec. 1.166-5(b ), Income Tax Regs. In determining
whether such relationship exists, the proper measure is the
taxpayer's dominant motivation; a significant motivation is not
sufficient.

The business nexus required for deducting a bad debt under
section 166(a) exists where the dominant motive in incurring the
debt was protecting or enhancing the taxpayer’s trade or
business.”

Dominant motivation is the key in determining the classification of the bad debt. If loans to the business can be documented as to keeping the business alive, this factor should serve to justify a business bad debt. “Protecting and enhancing the business” is cited in the court cases as substantial reasons.


Rezazazadeh, T.C. Memo, 1996-245 file 3/28/1996

“In determining the dominant business or nonbusiness motive of a shareholder lending money to a corporation in which the shareholder is also an employee, courts look primarily to three objective factors: The amount of the loan with the taxpayer's investment in the corporation, the amount of the taxpayer's after-tax salary, and other sources of gross income available to the taxpayer at the time of the loan. United States v. Generes, supra; Scifo v. Commissioner, 68 T.C. 714, 723 (1977); Shinefeld v. Commissioner, 65 T.C. 1092 (1976). The larger the taxpayer's investment, the smaller his salary, and the larger his other sources of gross income, the more likely the courts are to find a dominant nonbusiness motive for the loan. On the other hand the more significant the after-tax salary from this business is to the overall gross income of the taxpayer and in relationship to the amount loaned to the business, the better chances for a business bad debt.”

Edited January 13, 2014 by kcjenkins
to remove smilie

[Catherine]

Many thanks to all!

[Mr. Pencil]

I have attached some case law

Good point! We can't just look up "chapter and verse from the IRC." Corporate taxation is complicated! We also have to research court cases, and Revenue Procedures and Private Letter Rulings and everything. It takes a long time so it costs a lot to do. (Client pays in advance.)

Then what do we come up with? Either just what the instructions said anyway, or, if we want to go against the instructions, we have to attach a big old DISCLOSURE to the return telling the IRS they're full of beans. Or else get a PLR ourself, which costs up to $11,000 user fee just to ask.

So here's a compromise. You have to look at last year's return for any new client. If something seems wrong , you are required to explain potential penalty & interest. But you are not required to amend it, or even check it against source documents. Then you can do the current year based simply on the client's unaudited P&L, whatever he might put on it.