1. Adjustments to Basis of Stock and Indebtedness.
    1. In General.
      1. The basis of a shareholder's stock in an S corporation and of the S corporation's indebtedness to a shareholder (S corporation debt) is relevant for determining:
        1. The amount of the shareholder's gain, loss, or tax-free return of capital on the disposition of stock or indebtedness;
        1. The limitation on the deductibility of losses and deductions passed through from the corporation to the shareholder under § 1366. The basis of a shareholder's stock in an S corporation is also relevant for determining the tax effect of distributions made by the corporation to the shareholder. Section 1367 provides special rules for adjusting the basis of a shareholder's stock in S corporation debt, to take into account the shareholder's share of the corporation's income, losses and deductions, and distributions made by the corporation to the shareholder.
    1. Shareholder's Basis in Stock.
      1. The taxpayer's basis in his S corporation stock is equal to the purchase price of the stock (if § 351 does not apply) (See § 1012).
        1. Section 351 Basis - If § 351 applies, the stock basis is derived from the basis of the property transferred to the corporation, increased by any gain recognized by the shareholder on the transfer, and decreased by any loss recognized by the shareholder on the transfer and by any cash and the value of any property (other than stock) received (See § 358(a)(1)).
      1. Under § 1367(a)(1), the basis of each shareholder's stock is increased by the sum of the shareholder's pro rata share of the following:
        1. All items of income which are required to be separately stated in computing the S corporation's taxable income, including nontaxable income;
        1. Any net income of the corporation excluding separately-stated items (i.e., the nonseparately - computed income); and
        1. Deductions for depletion on mineral property, other than oil and gas property, in excess of the basis of the property.
          1. The basis of a shareholder's stock is not increased for any depletion with respect to oil and gas property because each shareholder computes that deduction separately pursuant to § 613A(c)(11)(B).
        1. A shareholder increases stock basis for items of income that are required to be included in gross income only if the shareholder in fact includes the item in gross income on the shareholder's return (§ 1367(b)(1)).
      1. Under § 1367(a)(2), the basis of each shareholder's stock is decreased (but not below zero) by the sum of the shareholder's pro rata share of the following:
        1. Corporate distributions to the extent excluded from the shareholder's income under § 1368;
        1. All items of loss and deduction which are required to be separately stated in computing the S corporation's taxable income;
        1. Any nonseparately-computed loss;
        1. Any expenses of the corporation not deductible in computing its taxable income and not properly chargeable to capital account (e.g., life insurance premiums under § 264, illegal bribes and kickbacks, § 274(n) reduction of 50% of meals and entertainment expenses, § 265 expenses incurred in earning tax-exempt income); and
        1. The shareholder's deduction for depletion under § 611 for oil and gas wells, to the extent the deduction does not exceed the adjusted basis of the property allocated to the shareholder.
          1. The basis of a shareholder's stock is decreased by the amount of any loss or deduction that is allowed for the taxable year under § 1366(d), regardless of whether the loss or deduction is disallowed or deferred under another provision, such as the passive loss rules of § 469 or the limitation on the deductibility of capital losses under § 1211.
      1. The adjustments to basis required for the shareholder's pro rata share of the corporation's items of income, loss, or deduction, are made to each share of stock on a per share, per day basis under the principles of § 1377(a). If the amount of the loss or deduction attributable to a share exceeds its basis, the excess is applied to reduce (but not below zero) the remaining basis of all other shares of stock owned by the shareholder in proportion to the remaining basis of each of those shares. Shares acquired at different times that have different original bases must be kept track of separately for basis adjustment purposes.
      1. If the basis reductions (other than a basis reduction attributable to a distribution) exceed the shareholder's stock basis, the excess reduces the shareholder's basis in any indebtedness of the S corporation to the shareholder (but not below zero) (§ 1367(b)(2)(A)).
        1. Under § 1271(a)(1), to the extent a shareholder's basis in such indebtedness is reduced, the corporation's repayment of the obligation may generate capital gain or loss provided the debt is a capital asset in the hands of the shareholder.
      1. Any net increase in basis in subsequent years resulting from the basis adjustment rules is first applied to restore any prior reduction in the basis of indebtedness before it is used to increase stock basis (§ 1367(b)(2)(B)).
        1. Basis adjustments for losses, deductions, and expenditures not deductible in calculating taxable income and not properly chargeable to a capital account are taken into account after distributions during the year taxable under § 1368 if losses, deductions and distributions exceed the shareholder's basis.
      1. The amount of a loss deduction for worthless S corporation stock under § 165(g) or for a bad debt deduction under § 166(d) is determined after the shareholder's stock basis adjustments have been made for the year (§ 1367(b)(3)).
        1. For example, if stock in an S corporation is determined in a year to be worthless, any loss sustained by the corporation for that year will reduce the shareholder's basis in the stock before determining the amount of the shareholder's worthless stock deduction under § 165(g).
      1. Section 1366(d)(2) allows an indefinite carryover of losses and deductions which are disallowed in any taxable year because of the basis limitation.
        1. Such losses and deductions are allowed if and when the shareholder's basis in stock and/or debt is restored (See § 1366(d)(1)).
        1. A shareholder may take into account a disallowed amount to the extent of his stock basis (though not his basis in indebtedness) on the last day of a "post termination transition period" (See § 1366(b)(3)).
      1. Ordering Rules - Under Reg. § 1.1367-1(e), adjustments are made to the basis of a share of stock in the following order:
        1. Increases for income items and the excess of deductions for depletion;
        1. Decreases for distributions;
        1. Decreases for nondeductible, non-capital expenses and certain oil and gas depletion deductions; and
        1. Decreases for items of loss or deduction.
      1. Under Reg. § 1.1367-1(f), a shareholder may elect to decrease basis for items of loss or deduction before decreases in basis for non-capital, nondeductible expenses and oil and gas depletion deductions if the shareholder agrees that non-capital, nondeductible expenses in excess of basis and certain oil and gas depletion deductions will reduce basis in succeeding taxable years. A shareholder makes the election by attaching a statement to the shareholder's timely filed original or amended return that states that the shareholder agrees to the carryover rule. Once a shareholder makes an election under Reg. § 1.1367-1(f) with respect to an S corporation, the shareholder must continue to use the rule for that S corporation in future taxable years unless the shareholder receives the permission of the Commissioner to change. As a result, once the election is made, the shareholder is considered to have made the election for all future taxable years and decreases for items of loss or deduction automatically precede the decreases for non-capital, nondeductible expenses and oil and gas depletion deductions.
      1. Time at Which Adjustments to Basis of Stock are Effective.
        1. The adjustments to the basis of a shareholder's stock are determined as of the close of the corporation's taxable year (Reg. § 1.1367-1(d)(1)). However, if a shareholder disposes of stock during the corporation's taxable year, the adjustments with respect to that stock are effective immediately prior to the disposition.
        1. An adjustment for a nontaxable item is determined with respect to the taxable year in which the item would have been includable or deductible under the corporation's method of accounting for Federal income tax purposes if the item had been subject to Federal income taxation (Reg. § 1.1367-1(d)(2)).
        1. If an election under § 1377(a)(2) (to terminate the year in the case of the termination of a shareholder's interest) or under Reg. § 1.1368-1(g)(2) (to terminate the year in the case of a disposition of a substantial amount of stock) is made with respect to the taxable year of a corporation, the adjustment to the basis of stock applies as if the taxable year consisted of separate taxable years, the first of which ends at the close of the day on which the shareholder either terminates the shareholder's interest in the corporation or disposes of a substantial amount of stock, whichever the case may be (Reg. § 1.1367-1(d)(3)).
      1. Non-Capital, Nondeductible Expenses.
        1. Under Reg. § 1.1367-1(c)(2), expenses of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account are only those items for which no loss or deduction is allowable and do not include items the deduction for which is deferred to a later taxable year.
        1. Examples of non-capital, nondeductible expenses include (but are not limited to the following):
          1. Illegal bribes, kickbacks, and other payments not deductible under § 162(c);
          1. Fines and penalties not deductible under § 162(f);
          1. Expenses and interest relating to tax-exempt income under § 265;
          1. Losses for which the deduction is disallowed under § 267(a)(1);
          1. The portion of meals and entertainment expenses disallowed under § 274(n); and
          1. Two-thirds of treble damages paid for violating anti-trust laws not deductible under § 162.
        1. Expenses not deductible in computing its taxable income and not properly chargeable to a capital account do not include such items as charitable contributions under § 170, investment interest under § 163(d), investment expenses, and additional first year depreciation under § 179.
      1. Basis in Each Individual Share.
        1. The regulations require that a shareholder keep track of his or her basis in each share of stock owned in the S corporation, determined on a per share, per day basis in accordance with § 1377(a) (Reg. § 1.1367-1(c)(3)). Shares acquired at different times that have different original bases must be kept track of separately for basis adjustment purposes.
        1. However, if the amount attributable to a share exceeds its basis (such as an allocable share of loss or deduction or a distribution), the excess is applied to reduce the remaining basis of all shares of stock in the corporation owned by the shareholder in proportion to the remaining basis of each of those shares.
          Example 4: On December 31, 2001, A owns a block of 500 shares of stock in S Co., with an adjusted basis of $60 per share. On January 1, 2002, A purchases for $4,000 an additional block of 500 shares of stock with an adjusted basis of $80 per share. Thus, A holds 1,000 shares of stock for each day of the 2002 taxable year. Assume that for 2002, A's pro rata share of the income is $3,000, and A's pro rata share of S Co.'s losses is $5,000. In addition, S Co. makes a distribution to A in the amount of $1,000 during 2002.
          Pursuant to the ordering rules of Reg. § 1.1367-1(e), A increases the basis of each share by $30 ($3,000/100 shares) and decreases the basis of each share by $50 ($5,000/100 shares). A then reduces the basis of each share by $10 ($1,000/100 shares) for the distribution. Thus, on January 1, 2003, A has a basis of $30 per share in his original block of 500 shares ($60 + $30 - $50 - $10) and a basis of $50 per share in the second block of 500 shares ($80 + $30 - $50 - $10).
          Example 5: On December 31, 2002, B owns 1 share of S Co.'s 10 outstanding shares of stock. The basis of B's share is $300. On July 2, 2003, B purchases from another shareholder, 2 shares for $250 each. During 2003, S Co. has no income or deductions, but incurs a loss of $3,650. Under § 1377(a)(1), the amount of loss assigned to each day of S Co.'s taxable year is $10 ($3,650/365 days). For each day, $1 is allocated to each outstanding share ($10 of loss assigned to each day/10 shares).
          B owned one share for 365 days and, therefore, reduces the basis of that share by the amount of loss attributable to it, i.e., $365 ($1 x 365 days). B owned two shares for 182 days and, therefore, reduces the basis of each of those shares by the amount of the loss attributable to each, i.e., $182 ($1 x 182 days).
          The basis of the shares are decreased as follows:

Share

OriginalBasis

Decrease

AdjustedBasis

Excess BasisReduction

1

$300

$265

$0

$65

2

250

182

68

0

3

250

182

68

0

          Because the decrease in basis attributable to share #1 exceeds the basis of share #1 by $65 ($365 - $300), the excess is applied to reduce the bases of shares #2 and #3 in proportion to their remaining bases. Therefore, the bases of share #2 and #3 are decreased by an additional $32.50 ($65 x ($68/$136)). After this decrease, share #1 has a basis of $0, share #2 has a basis of $35.50, and share #3 has a basis of $35.50.
          Example 6: On January 1, 2003, individuals B and C each owned 50 of the 100 shares of issued and outstanding stock of S Co. B's adjusted basis in each share is $1,200, and C's is $800. On June 30, 2003, S Co. distributes $60,000 to B and $60,000 to C. On June 30, 2003, B sells all of her S Co. stock for $100,000 to D. S Co. elects under § 1377(a)(2) to treat its 2003 taxable year as consisting of two taxable years, the first of which ends at the close of June 30, the date on which B terminates her interest in S Co.
          For the period January 1, 2003 - June 30, 2003, S Co. has income of $60,000 and deductions of $40,000. Therefore, on June 30, 2003, B and C, pursuant to the ordering rules of Reg. § 1.1367-1(e), increase the basis of each share by $600 ($60,000/100 shares) and decrease the basis of each share by $400 ($40,000/100 shares). B and C then reduce the basis of each share by $1,200 ($120,000/100 shares) for the distribution.
          The basis of B's stock is reduced from $1,200 to $200 per share ($1,200 + $600 - $400 - $1,200). The basis of C's stock is reduced from $800 to $0 per share ($800 + $600 - $400 - $1,200).
          The net reduction in the basis of B's shares of the S Co. stock required by § 1367 is effective immediately prior to B's sale of her stock. Thus, B's basis for determining gain or loss on the sale of stock is $200 per share, and B has a gain of $1,800 ($2,000 - $200) per share.
      1. Treatment of Distributions During Loss Years.
        1. The amount of loss an S corporation shareholder may take into account for a taxable year cannot exceed the sum of the shareholder's adjusted basis in his or her stock of the corporation and the adjusted basis in any indebtedness of the corporation to the shareholder. Any excess loss is carried forward.
        1. Any distribution to a shareholder by an S corporation generally is tax-free to the shareholder to the extent of the shareholder's adjusted basis of his or her stock. The shareholder's adjusted basis is reduced by the tax-free amount of the distribution. Any distribution in excess of the shareholder's adjusted basis is treated as gain from the sale or exchange of property.
        1. If the S corporation has accumulated earnings and profits, any distribution in excess of the amount in an "accumulated adjustments account" is treated as a dividend (to the extent of the accumulated earnings and profits). A dividend distribution does not reduce the adjusted basis of the shareholder's stock. The "accumulated adjustments account" generally is the amount of the accumulated undistributed post-1982 gross income less deductions.
        1. The Small Business Job Protection Act of 1996 (SBA) provides that the adjustments for distributions made by an S corporation during a taxable year are taken into account before applying the loss limitation for the year. Thus, distributions during a year reduce the adjusted basis for purposes of determining the allowable loss for the year, but the loss for a year does not reduce the adjusted basis for purposes of determining the tax status of the distributions made during that year. (§ 1368(d)).
        1. The SBA also provides that in determining the amount in the accumulated adjustment account for purposes of determining the tax treatment of distributions made during a taxable year by an S corporation having accumulated earnings and profits, net negative adjustments (i.e., the excess of losses and deductions over income) for that taxable year are disregarded. This means that if the S corporation has a AAA account and accumulated earnings and profits, and losses for the year, the distribution reduces the AAA account before the gains and losses are taken into account, thereby reducing the amount that may be characterized as a dividend distribution.
          Example 7: X is the sole shareholder of corporation A, a calendar year S corporation with no accumulated earnings and profits. X's adjusted basis in the stock of A on January 1, 2003, is $1,000 and X holds no debt of A. During 2003, A makes a distribution to X of $600, recognizes a capital gain of $200 and sustains an operating loss of $900. X's adjusted basis in the A stock is increased to $1,200 ($1,000 plus $200 capital gain recognized) pursuant to § 1368(d) to determine the effect of the distribution. X's adjusted basis is then reduced by the amount of the distribution to $600 ($1,200 less $600) to determine the application of the loss limitation of § 1366(d)(1). X is allowed to take into account $600 of A's operating loss, which reduces X's adjusted basis to zero. The remaining $300 loss is carried forward pursuant to § 1366(d)(2).
          Example 8: The facts are the same as in Example 7, except that on January 1, 2003, A has accumulated earnings and profits of $500 and an accumulated adjustments account of $200. Because there is a net negative adjustment for the year, no adjustment is made to the accumulated adjustments account before determining the effect of the distribution under § 1368(c).
          As to A, $200 of the $600 distribution is a distribution of A's accumulated adjustments account, reducing the accumulated adjustments account to zero. The remaining $400 of the distribution is a distribution of accumulated earnings and profits (E&P) and reduces A's E&P to $100. A's accumulated adjustments account is then increased by $200 to reflect the recognized capital gain and reduced by $900 to reflect the operating loss, leaving a negative balance in the accumulated adjustment account on January 1, 2004, of $700 (zero plus $200 less $900).
          As to X, $200 of the distribution is applied against X's adjusted basis of $1,200 ($1,000 plus $200 capital gain recognized), reducing X's adjusted basis to $1,000. The remaining $400 of the distribution is taxable as a dividend and does not reduce X's adjusted basis. Because X's adjusted basis is $1,000, the loss limitation does not apply to X, who may deduct the entire $900 operating loss. X's adjusted basis is then decreased to reflect the $900 operating loss. Accordingly, X's adjusted basis on January 1, 2004, is $100 ($1,000 plus $200 less $200 less $900).
        1. This provision applies to taxable years beginning after December 31, 1996.
          1. Under prior law, in Williams v. Comm'r, 104 T.C. 75 (1998), an S corporation's accumulated adjustments account (AAA) was first reduced by losses that it incurred for the tax year prior to determining the tax treatment of distributions made to its sole shareholder during the year. Thus, part of the distributions resulted in a taxable dividend to the shareholder. Section 1368, rather than § 1367, controlled the timing or order of adjustments to the AAA. Section 1367 merely lists the adjustments to basis of a shareholder's stock and does not prescribe the order in which those adjustments are to be made.
          1. In Williams, a shareholder received a distribution from an S corporation. The amount of the distribution in excess of the balance of the S corporation's AAA would be a taxable dividend to the shareholder to the extent that it did not exceed the accumulated earnings and profits of the predecessor's C corporation. The IRS first subtracted the S corporation's loss for the tax year from the AAA before considering the distribution, which resulted in taxable dividend income. The shareholder argued that the distribution should be subtracted from the AAA prior to any adjustments for losses or deductions of the S corporation for the tax year.
          1. The Court agreed with the IRS's position and held that the S corporation's AAA first had to be reduced by losses that it incurred for the tax year prior to determining the tax treatment of distributions made to the sole shareholder during the year. Thus, part of the distributions resulted in a taxable dividend to the shareholder.
          1. In accordance with the position taken by the IRS, § 1368, rather than § 1367, controlled the timing or order of adjustments to the AAA. Section 1367 merely lists the adjustments to basis of shareholder's stock and does not prescribe the order in which those adjustments are to be made. Pursuant to the legislative history of § 1367 and § 1368, adjustments to the AAA for current year losses are made before adjustments for distributions during the year. Moreover, regulations issued under both provisions require taxpayers to decrease the AAA by current year losses prior to determining the tax consequences of any distribution made during the tax year.
          1. Finally, the Tax Court noted that an amendment to § 1368 made by the Small Business Job Protection Act of 1996, which applies to tax years after the year in question, provides the results sought by the taxpayer. Section 1368(e)(1)(C), as amended, provides that the AAA is adjusted for distributions made during the year without regard to any net negative adjustment for the year. A net negative adjustment is the excess of reductions in the AAA for losses and deductions for the year over any increase in the AAA for the year. The amendment applies to tax years beginning after December 31, 1996.
      1. Adjustments to Basis of Inherited Stock to Reflect IRD Items.
        1. Income in respect to a decedent (IRD) generally consists of items of gross income that accrued during the decedent's lifetime but were not includable in the decedent's income before his or her death under his or her method of accounting. IRD is includable in the income of the person acquiring the right to receive such item. A deduction for the estate tax attributable to an item of IRD is allowed to such person (§ 691(c)). The cost or basis of property acquired from a decedent is its fair market value at the date of death (or alternate valuation date if that date is elected for estate tax purposes). This basis is often referred to as a "stepped-up basis." Property that constitutes a right to receive IRD does not receive a stepped-up basis.
        1. The basis of a partnership interest or corporate stock acquired from a decedent generally is stepped-up at death. The basis of a partnership interest acquired from a decedent is reduced to the extent that its value is attributable to items constituting IRD (Reg. § 1.742-1). This rule insures that the items of IRD held by a partnership are not later offset by a loss arising from a stepped-up basis. Although S corporation income is taxed to its shareholders in a manner similar to the taxation of a partnership and its partners, no comparable regulation requires a reduction in the basis of stock in an S corporation acquired from a decedent where the S corporation holds items of IRD.
        1. Section 1367(b)(4) provides that a person acquiring stock in an S corporation from a decedent would treat as IRD his or her pro rata share of any item of income of the corporation that would have been IRD if that item had been acquired directly from the decedent. Where an item is treated as IRD, a deduction for the estate tax attributable to the item generally will be allowed under the provisions of § 691(c). The stepped-up basis in the stock in an S corporation acquired from a decedent is reduced by the extent to which the value of the stock is attributable to items consisting of IRD. This basis rule is comparable to the present-law partnership rule (§ 1367(b)(4)).
      1. Final Regulations on Pass-Thru Basis Adjustments and Distributions.
        1. Background - In 1998, IRS issued proposed regulations affecting the pass-thru of an S corporation's tax items to its shareholders, limitation on losses and deductions, family groups, basis adjustments to shareholders' stock, and distributions to shareholders. IRS has now finalized the regulations with a few modifications and clarifications. The final regulations generally apply for S corporation tax years beginning after August 17, 1998. For tax years beginning after 1996 and before August 18, 1998, the regulations require that adjustments to the basis of a shareholder's stock and the treatment of distributions by an S corporation must be determined in a reasonable manner, taking into account the Code and the legislative history.
        1. Statutory Background - Section 1366(a)(1) provides rules under which an S shareholder takes into account his pro rata share of the S corporation's items of income, loss, deduction, or credit. For most items that must be separately stated by an S corporation, the statutory provisions for passing through items to S shareholders parallel those for passing through items from a partnership to its partners under § 702.
        2. Pass-Thru Regulations - The regulations provide rules outlining the general pass-thru scheme for S corporations and fill in gaps left by the Code (see Reg. § 1.1366-1).
          1. Tax-Exempt Income - The regulations define tax-exempt income as income that is permanently excludable from the gross income of an S corporation and its shareholders in all circumstances in which the relevant Code section applies. For example, tax-exempt income includes proceeds of life insurance contracts that are payable by reason of an individual's death and that are excludable from gross income under § 101, and interest on state and local bonds that is excludable from gross income under § 103 (see Reg. § 1.1366-1(a)(2)(viii)).
            1. Income from improvements by a lessee on a lessor's property that is excludable from the lessor's gross income under § 109 is not tax-exempt income nor is income from the discharge of indebtedness that is excludable from gross income under § 108 (see Reg. § 1.1366-1(a)(2)(viii)).
          1. Character of Item Passed Through - The regulations provide that the character of a corporate item that is passed through to and reported by a shareholder is generally determined at the corporate level (see Reg. § 1.1366-1(b)(1)). However, exceptions apply for contributions of noncapital gain property (see Reg. § 1.1366-1(b)(2)), and capital loss property (see Reg. § 1.1366-1(b)(3)), if an S corporation is formed or availed of by any shareholder or shareholders for a principal purpose of selling or exchanging the property to alter the character of the gain or loss. In such a case, the character of the gain or loss is the same as it would have been if the property were in the hands of the shareholder or shareholders at the time of the sale or exchange.
          1. Pass Through of Gross Income - Where it is necessary to determine the amount or character of the gross income of a shareholder, the shareholder's gross income includes the shareholder's pro rata share of the gross income of the S corporation. This is the amount of gross income of the corporation used to derive the shareholder's pro rata share of S corporation taxable income or loss (see Reg. § 1.1366-1(c)).
        1. Limitation on Losses and Deductions - In general, the amount of losses and deductions taken into account by a shareholder for any tax year may not exceed the sum of the shareholder's adjusted bases in his S stock and in any S corporation debt owed to the shareholder. Any loss or deduction for the tax year not taken into account by a shareholder by reason of the basis limitation rule is treated as incurred by the corporation with respect to that shareholder in the corporation's first succeeding tax year, and subsequent tax years (see Reg. § 1.1366-2).
          1. Gifts of Loss Stock - For purposes of the basis limitation rule, the basis of stock acquired by gift is the basis of the stock for determining loss under § 1015 (see Reg. § 1.1366-2(a)(6)). Thus, where an individual makes a gift of stock that has gone down in value, the donee's basis for purposes of applying the basis limitation is the fair market value of the stock at the time of the gift. However, if the fair market value of the stock equals or exceeds the donor's basis on the date of the gift, the donee's basis for purposes of applying the basis limitation is the donor's basis.
          1. Allocation of Items - If a shareholder's aggregate pro rata share of the items of loss and deduction exceeds the sum of the shareholder's adjusted bases in stock and debt, the limitation on losses and deductions must be allocated among the shareholder's pro rata share of each loss or deduction. This allocation is determined by taking the proportion that each loss or deduction bears to the total of all losses and deductions, including those previously disallowed (see Reg. § 1.1366-2(a)(4)).
          1. Losses are Personal - A shareholder's disallowed losses and deductions are personal to him and cannot be transferred. Thus, if a shareholder transfers all of his stock in an S corporation, any disallowed loss or deduction is permanently disallowed (see Reg. § 1.1366-2(a)(5)).
          1. Special Rules - The regulations provide rules for a shareholder to carry over disallowed losses and deductions to any post-termination transition period (see Reg. § 1.1366-2(b)) and rules for the carryover of disallowed losses and deductions in corporate reorganizations (see Reg. § 1.1366-2(c)).
        1. Family Groups - Section 1366(e) requires a determination of whether an individual family member who renders services for or provides capital to an S corporation has received reasonable compensation. In determining a reasonable allowance for services rendered for, or capital furnished to, the S corporation, all the facts and circumstances are considered, including the amount that ordinarily would be paid to obtain comparable services or capital from a person who is neither a member of that family nor a shareholder in the corporation. Similar rules apply to services rendered, or capital furnished, to an S corporation by a pass-thru entity in which a member of a shareholder's family holds an interest. If the pass-thru entity does not receive reasonable compensation for the services rendered or capital furnished, IRS may prescribe adjustments to the pass-thru entity and the corporation as necessary to reflect the value of the services rendered or the capital furnished (see Reg. § 1.1366-3(a)).
        1. Basis Adjustments - Adjustments to the basis of a share of stock are made in the following order: (1) increases for income items and the excess of deductions for depletion over the basis of the property subject to depletion; (2) decreases for distributions; (3) decreases for noncapital, nondeductible expenses, and certain oil and gas depletion deductions; and (4) decreases for items of loss or deduction (see Reg. § 1.1367-1(f)).
        1. Effect of Excess Net Passive Income Tax on Pass-Through Items - Each item of passive investment income passed through to shareholders is reduced by a prorata portion of any corporate level tax on excess passive income. Under Reg. § 1.1366-4(c), the reduction allocable to an item of passive investment income equals the tax multiplied by the ratio of the amount of such item to the total net passive income (rather than the total passive income) for the tax year.
        1. Adjustment of AAA When There Is a Net Negative Adjustment - When there is a "net negative adjustment" (i.e., the loss and deduction pass-through items exceed the income and gain pass-throughs), Reg. § 1.1368-2(a)(5) continues the rule that the accumulated adjustments account (AAA) is adjusted in the following order:
          1. Decreased for nontaxable distributions;
          1. Increased for items of income and gain; and
          1. Reduced by items of loss or deduction.
        1. Adjustment of AAA When Aggregate Pass-Through Adjustments are Positive - Final Reg. § 1.1368-2(a)(5) provides that (as long as there is no net negative adjustment) the AAA is adjusted in the following order:
          1. Increased by pass-through income and gain items;
          1. Decreased by pass-through nondeductible expenses and loss and deduction items; and
          1. Decreased by distributions.
        1. Normally, there is no difference in the taxation of pass-through items or distributions regardless of the order in which the AAA is adjusted. However, the adjustment order can affect the treatment of distributions and pass-through losses when the corporation has accumulated earnings and profits (AE&P) and the ending balance in AAA is reduced to zero or a negative amount.
          Example 9: Tom owns 100% of TM, a company that incorporated in 1986 but that did not become an S corporation until January 1, 2003. At the date of the S election, the corporation had AE&P of $50,000 and Tom's stock basis was $30,000. At the end of its first S corporation tax year (2003), TM passed through $49,000 of ordinary business income and a § 1231 loss of $16,000. It also distributed $45,000 of cash to Tom.
          The $16,000 of pass-through losses is not limited by the passive income, at-risk, or § 1231 recapture rules. In addition, there is no net negative adjustment [i.e., the income and gain items ($49,000) exceed the loss and deduction items ($16,000)], so TM's AAA and AE&P are determined under Reg. § 1.1368-2(a)(5) as follows:

AAA

AE&P

Balances, beginning of year

$0

$50,000

Nonseperately stated income

49,000

0

Section 1231 loss

(16,000)

         0

Balances, before distribution

33,000

50,000

Distribution

AAA

(33,000)

0

AE&P

           0

(12,000)

Balances, end of year

         $0

$38,000

          Tom's stock basis is determined as follows:

Basis

Basis, beginning of year

$30,000

Nonseperately stated income

49,000

Basis before distribution and loss items

79,000

Distribution

(33,000)

Basis before loss and deduction items

46,000

Section 1231 loss

(16,000)

Basis, end of year

$30,000

          The distribution of $33,000 reduces stock basis and AAA and is nontaxable. Tom received a $12,000 taxable dividend. The $16,000 § 1231 loss is fully deductible on Tom's Form 1040. Note: Losses, but not distributions, can reduce the AAA below zero.
      1. Discharge of Indebtedness Income and Stock Basis.
        1. Background.
          1. Under § 1367(a)(1), the basis of an S corporation shareholder's stock shall be increased by the items of income described in § 1366(a)(1)(A), which include "items of income (including tax-exempt income)" which could affect the tax liability of any shareholder.
          1. Under § 61(a)(12), discharge of indebtedness (COD) income is included in gross income, but § 108(a) provides that gross income does not include COD income if the discharge occurs in a Title 11 bankruptcy case or when the taxpayer is insolvent. If such exclusion applies, however, § 108(b) requires the taxpayer to reduce tax attributes such as net operating losses, certain credits, capital loss carryovers, and the basis of property.
          1. Under §108(b)(4), those reductions "shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge."
          1. Section 108(d)(7) provides that in the case of an S corporation, the above rules "shall be applied at the corporate level."
          1. Under these provisions, an issue arose as to whether an S corporation shareholder is entitled to an increase in stock basis when the S corporation receives COD income which is excluded from gross income because the corporation is insolvent or bankrupt, and if so, whether the shareholder may deduct suspended losses due to the basis increase. The common fact pattern in cases involved a shareholder who had a zero basis in his stock and suspended losses. The corporation then became insolvent and received COD income that was excluded from gross income under § 108(a) due to the insolvency. The shareholder then claimed that the COD income (as tax-exempt income under § 1366(a)(1)(A)) increased the stock basis, which enabled him to deduct the suspended losses and/or to realize a loss if he sold his stock for less than the increased basis. Essentially this position allowed the shareholder a "double" benefit by avoiding tax on the COD income, but using it to increase basis.
        1. Lower Court Decisions. The Tax Court, in Nelson v. Comm'r, 110 T.C. 114 (1998), held that the excludable COD income of an insolvent S corporation simply does not pass through to the shareholders, and therefore there is no basis increase. This result was consistent with regulations the IRS later adopted which provide that "tax-exempt income" which increases basis under § 1366(a)(1)(A) does not include COD income excluded from gross income under § 108. See Reg. § 1.1366-1(a)(2). The Circuit Courts of Appeal, however, disagreed with that result and split on reasoning and statutory interpretation concerning the issue. Two Circuits found that the unambiguous language of the Code allows a basis increase and a resulting deduction of suspended losses. See U.S. v. Farley, 202 F.3d 198 (3d Cir. 2000); and Pugh v. Comm'r, 213 F.3d 1324 (11th Cir. 2000). Two others concluded that suspended losses of shareholders should be deemed NOLs of the S corporation for purposes of the reduction of tax attributes under § 108(b), and that the COD income should first be reduced by the amount of such suspended losses before increasing basis. See Witzel v. Comm'r, 200 F.3d 496 (7th Cir. 2000); and Guadiano v. Comm'r, 216 F.3d 425 (6th Cir. 2000). In Gitlitz v. Comm'r, 182 F.3d 1143 (10th Cir. 1999), the Court concluded that no basis increase was appropriate because suspended losses and other tax attributes first absorbed the COD income, and any "excess" COD income should be ignored.
        1. Supreme Court.
          1. In Gitlitz v. Comm'r, 2001-1 USTC ¶50,147, the Supreme Court reversed the Tenth Circuit to hold that, in a case where shareholders of an insolvent S corporation sought to increase their bases in the stock of the corporation by their pro rata shares of the corporation's excludable discharge of indebtedness income, the plain language of § 108(a) requires that a discharge of indebtedness constitutes an "item of income" that passes through to the shareholders.
          1. In so holding, the Supreme Court relied upon the plain meaning of the statute and the sequencing issue - whether passthrough is performed before or after the reduction of the S corporation's tax attributes under § 108(b).
            1. The statute's plain language establishes that excluded discharged debt is an "item of income," which passes through to shareholders and increases their bases in an S corporation's stock. Section 61(a)(12) states that discharge of indebtedness is included in gross income. And § 108(a) provides only that the discharge ceases to be included in gross income when the S corporation is insolvent, not that it ceases to be an item of income. Not all items of income are included in gross income, see § 1366(a)(1), so an item's mere exclusion from gross income does not imply that the amount ceases to be an item of income. Moreover, § 101 through § 136 employ the same construction to exclude various items from gross income, but not even the Commissioner encourages a reading that would exempt all such items from passthrough. Instead the Commissioner asserts that discharge of indebtedness is unique because it requires no economic outlay on the taxpayer's part, but can identify no statutory language that makes this distinction relevant. On the contrary, the statute makes clear that § 108(a)'s exclusion does not alter the character of discharge of indebtedness as an item of income. Specifically, § 108(e) presumes that such discharge is always "income," and that the only question for § 108 purposes is whether it is includable in gross income. The Commissioner's contentions that, notwithstanding the statute's plain language, excluded discharge of indebtedness is not income, and specifically, that it is not "tax-exempt income" under § 1366(a)(1)(A) do not alter the conclusion reached.
            1. Passthrough is performed before the reduction of an S corporation's tax attributes under § 108(b). The sequencing question presented is important. If attribute reduction is performed before the discharge of indebtedness is passed through to the shareholders, the shareholders' losses that exceed basis are treated as the corporation's net operating loss and are then reduced by the amount of the discharged debt; in this case no suspended losses would remain that would permit petitioners to take deductions. However, if it is performed after the discharged debt income is passed through, then the shareholders would be able to deduct their losses (up to the amount of the increase in basis caused by the discharged debt). Any suspended losses remaining then will be treated as the S corporation's net operating loss and reduced by the discharged debt amount. Section 108(b)(4)(A) expressly addresses the sequencing question, directing that the attribute reductions "shall be made after the determination of the tax imposed...for the taxable year of the discharge." (Emphases added.) In order to determine the "tax imposed," a shareholder must adjust his basis in S corporation stock and pass through all items of income and loss. Consequently the attribute reduction must be made after the basis adjustment and passthrough. The taxpayers must pass through the discharged debt, increase corporate bases, and then deduct their losses, all before any attribute reduction could occur. Because their basis increase is equal to their losses, they have no suspended losses remaining and thus have no net operating losses to reduce. The primary arguments made in Courts of Appeals against this reading of the sequencing provision were rejected.
        1. Job Creation and Worker Assistance Act of 2002.
          1. The Job Creation and Worker Assistance Act of 2002 provides that income from the discharge of indebtedness of an S corporation that is excluded from the S corporation's income is not taken into account as an item of income by any shareholder and thus does not increase the basis of any shareholder's stock in the corporation.
          1. Effective Date - This new provision generally applies to discharges of indebtedness after October 11, 2001. The provision does not apply to any discharge of indebtedness before March 1, 2002, pursuant to a plan of reorganization filed with a bankruptcy court on or before October 11, 2001.
    1. Basis in Debt.
      1. Old law governing when an individual has loaned money to the corporation for creation of basis in debt apparently still applies.
        1. The lending of credit to the corporation in the form of a guaranty or accommodation endorsement does not give rise to indebtedness from the corporation to the shareholder unless and until the shareholder is called upon to fulfill his obligation (See William A. Perry, 47 T.C. 159 (1966), aff'd, 392 F.2d 458 (8th Cir. 1968); Milton T. Raynor, 50 T.C. 762 (1968); Rev. Rul. 75-144, 1975-1 C.B. 277; Rev. Rul. 70-50, 1970-1 C.B. 178).
        1. In addition, the shareholder must actually create debt to him from the corporation (See Rev. Rul. 81-187, 1981-2 C.B. 167). However, the Service has ruled that a shareholder's promissory note given to a third party creditor in satisfaction of the shareholder's guaranty constitutes sufficient payment under the guaranty to increase the shareholder's basis (See Rev. Rul. 75-144, 1975-1 C.B. 277).
        1. The indebtedness must be directly between the shareholder and the corporation (See E.G. Frankel, 61 T.C. 343 (1973), aff'd, 506 F.2d 1051 (3rd Cir. 174); Ruth M. Praskher, 59 T.C. 172 (1972); Robertson v. U.S., 73-2 USTC ¶ 9645 (1973)).
      1. Repayment of Debt - Upon repayment of the debt, the application of § 1271 should be analyzed. The corporation's repayment of the entire obligation constitutes a sale or exchange under § 1271(a), which may generate capital gain or loss provided the debt is a capital asset in the hands of the shareholder. Repayment of an open account indebtedness generates ordinary income (§§ 1271(a) and 1275(a)(1)(A)).
      1. In addition, in certain situations, "loans" to the S corporation from the shareholders may be reclassified as capital contributions (See Segel v. Comm'r, 89 T.C. 816 (1989) and Fin Hay Realty Co. v. U.S., 398 F.2d, 694, (3rd Cir. (1968)).
      1. Under § 1366(d)(1), a shareholder whose stock basis has been reduced to $0 may take into account losses and deductions (but not distributions) allocated to the shareholder to the extent of the shareholder's basis in S corporation debt. If the amount of the items that decrease the basis of a shareholder's stock (other than distributions) exceed the basis of all of the shareholder's shares of stock (after adjustment for items that increase stock basis), the excess is applied to reduce (but not below $0) the shareholder's basis of any S corporation debt.
        1. The reduction of basis of S corporation debt only applies to those debts held by the shareholder at the end of the corporation's taxable year and does not apply to debts satisfied, disposed of, or forgiven during the taxable year (Reg. § 1.1367-2(b)(1)).
        1. If the shareholder holds more than one debt at the end of the corporation's taxable year, the reduction of basis applies to each debt in the same proportion that the basis of each debt bears to the aggregate bases of all S corporation debt (Reg. § 1.1367-2(b)(3)).
        1. If a shareholder terminates his or her interest in the corporation during the taxable year, the above rules are applied with respect to any indebtedness of the S corporation held by the shareholder immediately prior to the termination of the shareholder's interest in the corporation (Reg. § 1.1367-2(b)(2)).
      1. Under Reg. § 1.1367-2(c), if for any taxable year there has been a reduction of the shareholder's basis of an S corporation debt, any net increase for any subsequent taxable year must be used to restore the basis of the debt before it may be used to increase the basis of the shareholder's stock.
        1. The net increase is the amount by which the sum of the shareholder's items of income and excess deductions for depletion exceeds the sum of the items of loss, deduction, nondeductible, non-capital expenses, distributions, and certain oil and gas depletion deductions.
        1. The basis restoration rules apply to S corporation debt held by the shareholder on the first day of the taxable year in which the net increase arises, and the basis restoration is limited to the outstanding balance of the S corporation debt as of that day.
        1. In addition, if the shareholder holds more than one S corporation debt during the taxable year, any net increase is applied first to restore the reduction of basis of any debt repaid in whole or in part during the taxable year.
          1. In the case of a debt that is repaid in part during the corporation's taxable year, the basis is restored only to the extent necessary to offset any gain that would otherwise be realized on repayment.
          1. The remaining net increase, if any, is applied to restore the basis of each outstanding debt in proportion to the amount that the basis of each debt has been reduced under the basis reduction rules of § 1367(b)(2)(A) and not restored.
      1. In Reg. § 1.1367-2(a), shareholder advances not evidenced by separate written instruments and repayments on the advances (open account debt) are treated as a single indebtedness. If the open account debt is repaid in whole or in part during the taxable year, any restoration of basis with respect to that debt is effective immediately before the first payment on the debt is made during the year. (Reg. § 1.1367-2(b)).
        Example 10: A has been the sole shareholder in S Co. since 1998. In 1999, A loans S Co. $10,000 (debt #1), which is evidenced by a 10 year promissory note, in the face amount of $10,000. In 2002, A loans S Co. $50,000 (debt #2), which is evidenced by a demand promissory note. On December 31, 2002, the basis of A's stock is $0; the basis of debt #1 has been reduced to $0; and the basis of debt #2 has been reduced to $10,000. On January 1, 2003, A loans S Co. $40,000 (debt #3), which is evidenced by a demand promissory note. For S Co.'s 2003 taxable year, the sum of the amounts increasing A's basis is $60,000, and the sum of the amounts decreasing A's basis is $100,000. S Co. makes no payments to A on any of the loans during 2003.
        The $40,000 excess of loss and deduction items is applied to reduce the basis of each indebtedness in proportion to the basis of that indebtedness over the aggregate bases of the indebtedness to the shareholder. Thus, the basis of debt #2 is reduced in an amount equal to $8,000 ($10,000/$50,000 x $40,000). Similarly, the basis in debt #3 is reduced in an amount equal to $32,000 ($40,000/$50,000 x $40,000). Accordingly, on December 31, 2003, A's basis in his stock is $0 and his basis in the three debts are as follows:

1/1/03

12/31/03

1/1/04

Debt

Basis

Reduction

Basis

1

$0

$0

$0

2

10,000

8,000

2,000

3

40,000

32,000

8,000

        Example 11: Assume the same facts as above, and that on July 1, 2004, S Co. completely repays debt #3 and for S Co.'s 2004 taxable year, the net increase with respect to A equals $45,000.
        The net increase is applied first to restore the basis in debts held on January 1, 2004, before any of the net increase is applied to increase A's basis in his shares of S Co. stock. The net increase is applied to restore first the reduction of basis in indebtedness repaid in 2004. Any remaining net increase is applied to restore the basis of the outstanding debts in proportion to the amount that each of these outstanding debts would have been reduced previously and have not been restored. As of December 31, 2004, the total reduction in A's debts held on January 1, 2004 equals $90,000. Thus, the basis of debt #3 is restored by $32,000 (the amount of the previous reduction) to $40,000. A's basis in debt #3 is treated as restored immediately before that debt is repaid. Accordingly, A does not realize any gain on the repayment. The remaining net increase of $13,000 is applied to restore the basis of debt #1 and debt #2. As of December 31, 2004, the total reduction in these outstanding debts is $58,000 ($90,000 - $32,000). The basis of debt #1 is restored in an amount equal to $2,240 ($10,000/$58,000 x $13,000). Similarly, the basis in debt #2 is restored in an amount equal to $10,760 ($48,000/$58,000 x $13,000). On December 31, 2004, A's basis in his S Co. stock is $0 and his basis in the two remaining debts are as follows:

OriginalBasis

AmountReduced

1/1/04Basis

AmountRestored

12/31/04Basis

$10,000

$10,000

$0

$2,240

$2,240

50,000

48,000

2,000

10,760

12,760

        Example 12: Assume that C has been a shareholder in S Co. since 1997. In 2002, C loans S Co. $10,000. S Co. issues its note to C in the amount of $10,000, of which $9,500 is payable on March 1, 2003, and $500 is payable on March 1, 2004. On December 31, 2002, C's basis in all her shares of S Co. stock is $0, and her basis in the note has been reduced to $9,000. For 2003, the net increase with respect to C is $3,000. Because C's basis of indebtedness was reduced in a prior taxable year, the net increase for 2003 is applied to restore this reduction in an amount that does not exceed the outstanding balance of the debt on the first day of 2003. The outstanding balance of the debt on January 1, 2003 was $10,000. Therefore, $1,000 of the $3,000 net increase is applied to restore the basis of the debt from $9,000 to $10,000 effective immediately before the repayment. The remaining net increase of $2,000 increases C's basis in her stock.
        Example 13: D has been the sole shareholder in S Co. since 1990. On January 1, 2001, D loans S Co. $100,000 in return for a note from S Co. in the amount of $100,000, of which $50,000 is payable on each of January 1, 2004 and January 1, 2005. On December 31, 2002, the basis of D's shares of the S Co. stock is $0 and his basis in the note has been reduced to $80,000. During 2003, the sum of the items relating to increases in basis of stock with respect to D equals $100,000, and the sum of the items relating to decreases in basis of stock with respect to D equals $0. During 2003, S Co. also makes distributions to D totaling $110,000. The distribution is an item that reduces basis of stock and must be taken into account for purposes of determining whether there is a net increase for the taxable year. Thus, for 2003, there is no net increase with respect to D because the amount of the items provided in § 1367(a)(1) (i.e., relating to increases in basis of stock) do not exceed the amount of the items provided in § 1367(a)(2) (i.e., relating to decreases in basis of stock).
        Because there is no net increase with respect to D for 2003, none of the 2002 reduction in D's basis in the indebtedness is restored. The $100,000 increase in basis under § 1367(a)(1) is applied to increase D's basis in his stock. The $110,000 distribution with respect to D's stock reduces D's basis in his shares of S Co. stock to $0. The additional $10,000 distribution is treated as a capital gain if S Co. has no Subchapter C E&P.
        Example 14: Assume the same facts as in Example 13 above, except that in 2003, S Co. makes distributions to D totaling $80,000. On these facts, for 2003, there is a net increase with respect to D of $20,000.
        Because there is a net increase of $20,000 with respect to D for 2003, $20,000 of the $100,000 increase in basis under § 1367(a)(1) is first applied to restore D's basis in the indebtedness to $100,000 ($80,000 + $20,000). Accordingly, on December 31, 2003, D has a basis in his shares of stock of $0 ($0 + $80,000 (increase in basis remaining after restoring basis in indebtedness) - $80,000 (distribution)) and a basis in the note of $100,000.