Lesson 6.3.1 Shareholder Loss Limitations: Concepts

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From the course by University of Illinois at Urbana-Champaign

Taxation of Business Entities II: Pass-Through Entities

10 ratings

University of Illinois at Urbana-Champaign

Taxation of Business Entities II: Pass-Through Entities

10 ratings

Course 4 of 5 in the Specialization U.S. Federal Taxation

This course provides an introduction to the U.S. federal income taxation of pass-through business entities, including Subchapter S corporations, partnerships, and limited liability companies. The course focuses on the relevant provisions of Subchapters S and K of the Internal Revenue Code, as well as related Treasury Regulations and judicial opinions, governing the formation, operation, and termination of pass-through entities. Practical in-class study problems facilitate self-discovery of technical tax knowledge along with the development of a variety of professional skills and attitudes.

From the lesson

Module 6 S Corporation Operations

In this module, we will further examine the specifications of electing S corporation status. We will explore income measurement and allocation methods followed in passing through the earnings to the shareholders; including the differentiation between ordinary items and separately stated items. Next, we will discuss the calculation of the shareholder’s basis in the S corporation and how it is adjusted in accordance with company earnings. We will also explore loss limitations with respect to the shareholder’s tax basis and at-risk basis. Accordingly, you will be introduced to the implications of distributions from the company to the shareholder with special tax consequences. Finally, we will discuss the exceptions that subject the pass-through to entity level tax.

Lesson 6.3.1 Shareholder Loss Limitations: Concepts5:19

Lesson 6.3.2 Shareholder Loss Limitations: Applications4:15

Meet the Instructors

Michael P Donohoe, PhD, CPA
Associate Professor of Accountancy and PwC Faculty Fellow
Department of Accountancy, Gies College of Business

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S corporation income, as well as losses,

pass through the entity to shareholders' pro rata based on the number of

shares each shareholder owns on the last day of the tax year.

While income and gains are almost always recognized,

there are limits on the extent to which shareholders can recognize losses.

In this lesson, you will examine three different loss limitations that apply to S

corporation shareholders.

These limitations largely mimic those of partnerships,

which are covered in another module.

After learning the concepts, you will apply them to Sunchaser Shakery.

Like partners in a partnership, S corporation shareholders must clear three

separate hurdles or limitations before Congress will allow them to deduct a loss

from the entity in the following order, basis limitation, at-risk limitation,

and passive activity loss limitation.

Let's examine each in turn.

First, the basis limitation provides that S corporation shareholders cannot deduct

losses from the corporation in excess of their stock basis.

Because losses can occur on an annual basis, this is another reason why

a shareholder's stock basis in an S corporation is adjusted annually.

In a prior lesson, you learned that unlike partners in a partnership, S corporation

shareholders do not include corporate debt in their stock basis computations.

Consequently, S corporation shareholders are more likely than similarly situated

partners to have loss recognition hindered by the basis limitation.

But if losses are not deductible because of the limitation,

they do not necessarily vanish.

The losses are suspended until such time that the shareholder generates sufficient

stock basis,

which can occur with future profitability and/or contributions of property.

However, if shareholders sell their stock before creating sufficient basis,

suspended losses are lost forever.

Although the basis limitation is restrictive by design,

S corporation shareholders can mitigate its effect somewhat

by loaning money to the corporation.

In other words, while S corporation shareholders cannot include corporate debt

in their basis computations, a shareholder loan to the S corporation

creates debt basis that is separate from the notion of stock basis.

As a result, losses are limited, first to the shareholder's tax basis in their share

of stock, and then to their basis in any direct loans made to their S corporation.

Specifically, if items other than distributions that decrease

the shareholder's basis for the tax year exceed the shareholder's stock basis,

the excess amount decreases the shareholder's debt basis.

Similar to stock basis, debt basis cannot be negative.

In later years, any net increase in basis for

the year first restores the shareholder's debt basis

up to the outstanding debt amount, and then the shareholder's stock basis.

If the S corporation settles the loan from the shareholder before the shareholder's

debt basis is restored, any loan repayment in excess of the shareholder's

debt basis triggers a taxable gain to the shareholder.

Second, the at-risk limitation provides that losses that

are deductible under the basis limitation are deductible only to the extent

the S corporation shareholder is at-risk in the corporation.

In general, the at-risk amount is the sum of the shareholder's stock and debt basis.

However, recall that in the case of non-recourse debt, risk of loss for

the debt is born by the lender.

Thus, the at-risk limitation, which is detailed in section 465,

has an important exception for non-recourse debt to help ensure that

shareholders are only deemed at-risk when the risk of personal loss exists.

Specifically, S corporation shareholders using non-recourse

debt to make capital contributions to the S corporation

creates stock basis in the S corporation because of the contribution.

But such debt only increases the at-risk amount by the net fair market value of any

property used as collateral to secure the non-recourse debt.

If shareholders use non-recourse debt to make a loan to the S corporation,

the loan creates debt basis, but only increases the amount at-risk by the net

fair market value of any property used as collateral to secure the loan.

As before, losses limited by the at-risk amount are carried forward indefinitely

until the shareholder generates additional at-risk amounts or sells the stock.

Finally, losses that surpass both the basis and

at-risk limitations may be subject to the passive activity loss limitation,

which provides that passive activity losses can only be deducted to the extent

they offset passive activity income.

Recall that passive activity income is that which is from a trader business

activity that the shareholder does not materially participate on a regular,

continuous, and substantial basis or income from many rental activities.

Said another way, the passive activity loss rules limit the ability of

S corporation shareholders to deduct losses,

unless they were involved in actively managing the business.

Overall, much like partnership losses, S corporation losses are deductible by

a shareholder only to the extent they surpass the basis,

at-risk and passive activity loss limitations.

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