Can you deduct the loss from your S Corporation?

Basis and at-risk basis rules for S Corporations.

S Corporations are flow-through tax entities meaning their income, deductions, credits and other activity is allocated to the shareholders to be reported on their tax returns.  When a shareholder is allocated a loss from an S Corporation they can use the loss to offset income from other sources if they pass three tests.  The first two tests, discussed here, examine how the loss was funded.  To use the loss the shareholder must (1) have stock basis and (2) be considered “at-risk.”  The third test deals with passive and non-passive income which will be addressed in a future article.

A shareholder’s initial stock basis is determined by how they acquire their interest in the S Corporation.  The money and other property a shareholder contributes to start an entity or the amount paid to purchase shares in the corporation is their initial basis.  If S Corporation shares are gifted the recipient is also gifted the donor’s basis in the shares.  The basis of inherited shares is adjusted to the fair market value at the decedent’s date of death.  From there, a shareholder’s basis is generally increased by capital contributions, personal loans to the corporation, and income allocated to the shareholder.  Basis is decreased by distributions, repayment of loans from the shareholder, and losses allocated to the shareholder.  So long as a shareholder has stock basis in excess of their loss at the end of the tax year they will pass the first test in determining whether or not they can deduct the loss.

The second test for deducting a loss requires a taxpayer to be sufficiently at-risk.  Simply stated, a shareholder’s amount at-risk is the extent they have dipped into their own pocket to fund operations.  In a Partnership, partner tax basis includes their share of the partnership debt, including loans from third parties and banks.  This often results in differences between partner basis and at-risk basis because the partners have basis for partnership debt but are not at-risk.  In an S Corporation stock basis and at-risk basis are often the same because shareholders typically do not receive stock basis for their share of S Corporation debt.  However, there is one significant exception.  An S Corporation shareholder’s basis includes money loaned by the shareholder to the corporation.

While an S Corporation shareholder receives stock basis for loans made to the corporation they are not always at-risk for the debt basis. A shareholder is only at-risk for loans it makes to the corporation if the shareholder is at-risk for the funds loaned to the corporation.  We often encounter scenarios where a shareholder personally borrows money and loans the proceeds to the S Corporation (referred to as a back-to-back loan).  A shareholder is not at-risk for back-to-back loans unless they are personally liable for the repayment of the loan, or if they have pledged property other than S Corporation property or their S Corporation stock, as security for the loan.  If the loan to the shareholder is non-recourse, meaning they are not personally liable for the repayment, they will not receive at-risk basis by loaning the proceeds to their S Corporation.

The goal of the stock and at-risk basis rules is to limit a shareholders use of losses to those which have been personally funded by the shareholder.  An S Corporation shareholder can take losses to the extent of their personal investment in the corporation.  Losses funded by loans from unrelated parties and loans from the shareholders of funds which are not at-risk cannot be deducted.  Instead, the losses are suspended and carried forward until the shareholder increases their stock basis and amount at-risk.

About the Author(s)

Ben is a Principal in the Tax Advisory Group (TAG) of HBK and works in the Youngstown, OH office. He has been with the firm since 2009 and has focused extensively on entity tax issues, entity planning, and flow-through taxation. Additionally, he has experience with many of our real estate, manufacturing, and cannabis clients.

As a member of TAG, Ben frequently teaches tax-related training courses both internally for the firm and externally for clients and the public. Ben provides research and expert counsel on complex tax issues for our clients. He also regularly appeared on the mid-day news broadcast of Youngstown, Ohio's NBC affiliate station in a segment called “Smart Money” which highlights personal financial planning tips.

Hill, Barth & King LLC has prepared this material for informational purposes only. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.