Your business had a very challenging year. It incurred significant losses but you seemingly have the solace in knowing that you can offset your W-2 earnings and interest and dividend income with those losses. But then you receive unexpected news from your tax professional – you are unable to deduct your S Corp. losses because you lack basis.
What is “basis”? In a nutshell, a shareholder may not deduct expenses of an S corporation beyond the extent of his personal investment (basis) in the corporation.
The above scenario is what a married couple experienced in the Tax Court case of B.R. Harigs, TC Memo 2016-232, Dec. 60,765(M). Without going into a detailed analysis of the positive and negative adjustments as to how a shareholder’s basis is computed, two principal components of positive adjustments to basis are (1) capital contributions made by the shareholder and (2) loans made by the shareholder to the corporation.
What the Harigs learned is that no basis is created for a shareholder when funds are advanced (loans) to an S corporation by a separate entity, even one closely related to the shareholder. The husband structured the loans so that the operating companies borrowed from third-party lenders or other entities he controlled. The lenders issued the loan proceeds directly to the operating companies and took back notes from the operating companies. Moreover, the husband was never subjected to the burden of paying back the loans; there were no defaults on the loans and that he was never called on to personally make any payments on the loans. To the extent payments were made, they were made by the operating companies directly back to the lenders. Further, the husband never pledged any of his personal property as collateral for the loans. Mr. Harig claimed that under state (Arkansas) law as a co-borrower, he was directly liable for repayment of the loans and as such, those loans gave him basis.
The Court rejected that argument. Therefore, the IRS’s disallowance of the losses was sustained.
What Can Be Learned from this Story? If the Harigs wished to increase their basis in their S Corp., they should have borrowed from the lender and either contributed the loan proceeds as a capital contribution to the S Corp. or make a bon-a-fide loan to the S Corp. While it may sound inconsequential to most taxpayers, the tax law gives basis to the shareholder when the shareholder loans money to the S. Corp; but receives no basis if the S Corp. borrows the money from a third party lender and the shareholder personally guarantees the loan. The fact that in both cases the shareholder is ultimately responsible for the repayment is irrelevant when computing shareholder basis.
Action Required: Surprisingly to many shareholders, it is not the responsibility of the S Corp. to track shareholder basis. This is a shareholder responsibility. Accordingly, if you are a shareholder in an S Corp. you need to contact your tax professional ASAP and request that s/he compute your tax basis. This is a relatively easy task if the S Corp. is relatively new, but can become quite a challenge for those corporations who have been in business several years due to ownership changes, deaths, gifts of shares, and record retention issues.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
