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IRS Rejects Basis Harvesting by S Corp Shareholders Attempting to Recognize Built-in Losses
(Parker's Federal Tax Bulletin: October 6, 2012)

A recent trend with certain S corporations is the conversion of these corporations to a single member LLC or an LLC taxable as a partnership. The new entity then continues the business of the S corporation. According to the IRS, it is seeing these conversions where the S corporation's primary business is property development or homebuilding. Often the current fair market value of the property is lower than the outstanding liability associated with the property. The major reason for converting to a pass-through entity is to allow the S corporation to recognize any built-in loss associated with the asset and pass the loss onto the S shareholder. The shareholders attempt to increase their basis in the S stock by the amount of liabilities assumed, thus allowing the deduction of losses that would otherwise be suspended.

In CCM 201237017, the Office of Chief Counsel was asked whether, in such situations, an S shareholder can increase stock basis upon the distribution of encumbered assets to the shareholder. According to the Chief Counsel's Office, while the liabilities associated with the distributed assets are accounted for in calculating the S corporation's gain or loss on the assets distributed in the liquidation, no adjustment to the shareholder's stock basis is allowed for any liability assumed on the liquidation.

Tax Treatment of S Corporation Liquidations

Under Code Sec. 1371, except as otherwise provided in the Code, and except to the extent inconsistent with subchapter S, the provisions relating to C corporations apply to an S corporation and its shareholders. C corporation rules provide that amounts received by a shareholder in a distribution in complete liquidation of a corporation are treated as full payment in exchange for the stock. Generally, the rules relating to corporate distributions of property being treated as a dividend do not apply to any distribution of property by an S corporation in complete liquidation.

Upon the complete liquidation of an S corporation, the S corporation recognizes gain or loss on the distribution of property to its shareholders as if it sold that property for its fair market value. To the extent any of the property is subject to a liability or a shareholder assumes a liability of the liquidating corporation, fair market value is presumed to be not less than the amount of the outstanding liability. Gain or loss associated with the liquidating sale is accounted for at the corporate level. However, no loss is allowed to the S corporation if it distributes property to a related person and the distribution is either not pro rata or the liquidating corporation acquired the property in a Code Sec. 351 transaction, or as a contribution to capital, within the five-year period ending on the date of distribution. Any resulting corporate-level gain or loss is then passed through to the shareholder.

Tax Treatment of S Shareholders upon a Complete Liquidation of the S Corporation

In determining a shareholder's tax for the tax year in which the S corporation's tax year ends (or for the final tax year of a shareholder who dies, or of a trust or estate that terminates, before the end of the corporation's tax year), the shareholder's pro rata share of the following are taken into account: (1) the S corporation's items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder; and (2) the S corporation's nonseparately computed income or loss. If, during the last tax year of an S corporation, a loss or deduction is disallowed because it exceeds a shareholder's basis in the stock, then the loss or deduction is treated as incurred by the shareholder on the last day of the post-termination transition period.

An S shareholder can increase S stock basis for any period by the sum of the following items determined with respect to that shareholder for such period: (1) the items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder; (2) any nonseparately computed income or loss; and (3) the excess of the deductions for depletion over the basis of the property subject to depletion.

The basis of each shareholder's stock in the S corporation is decreased for any period (but not below zero) by the sum of: (1) distributions by the corporation that were not includible in the S shareholder's income; (2) the items of loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder; (3) any nonseparately computed loss; (4) any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account; and (5) the amount of the shareholder's deduction for depletion for any oil and gas property held by the S corporation to the extent such deduction does not exceed the proportionate share of the adjusted basis of such property allocated to the shareholder.

Generally, when an S shareholder does not have enough basis to take a loss or deduction, the loss or deduction is suspended until the shareholder has enough basis. This disallowed loss is personal to the shareholder and cannot be transferred to another person. If a shareholder transfers some but not all of the shareholder's stock in the corporation, the amount of any disallowed loss or deduction is not reduced and the transferee does not acquire any portion of the disallowed loss or deduction. If a shareholder transfers all of his stock in the S corporation, any disallowed loss or deduction is permanently lost.

Adjustments to an S shareholder's stock basis are determined as of the close of the corporation's tax year, and the adjustments generally are effective as of that date. However, if a shareholder disposes of stock during the corporation's tax year, the stock adjustments are effective immediately before the disposition. Generally, adjustments to stock basis are made in the following order: (1) any increase in basis attributable to items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder and any increase in basis due to excess depletion deductions; (2) any decrease in basis attributable to distributions by the corporation that were not includible in the income of the shareholder by reason of Code Sec. 1368; (3) any decrease in basis attributable to noncapital, nondeductible expenses and the oil and gas depletion deduction; and (4) any decrease in basis attributable to certain loss items.

Liquidating distributions received by an S corporation shareholder are treated as in full payment for the exchange of stock. The shareholder takes into account its portion of the corporate-level gain or loss to adjust his stock basis before calculating shareholder-level gain or loss.

Chief Counsel's Opinion

Citing Ford v. U.S., 311 F.2d 951 (Ct. Cl. 1963) and Rev. Rul. 58-228, the Office of Chief Counsel said that the shareholder of a liquidating S corporation must reduce its amount realized by the amount of any liability assumed. The shareholder's basis in the asset received in liquidation, however, is not affected by the assumption of a liability or receipt of property subject to a liability. To the extent the amount of the liability assumed exceeds the fair market value of the asset, the shareholder may recognize either a short-term or long-term capital loss on the complete liquidation of the S corporation.

Before determining gain or loss from liquidating distributions, the Chief Counsel's Office noted, a shareholder's stock basis is first adjusted for current-year pass-through items. Pass-through losses suspended because of the basis limitation rules that remain after the basis of the redeemed stock has been reduced to zero, do not reduce gain or increase loss resulting from liquidation. If a shareholder is going to increase basis to use up suspended losses, this must be done before the final distribution through additional capital contributions or loans. Otherwise, the loss is permanently disallowed. The Chief Counsel's Office concluded that there is no authority allowing a shareholder to restore basis after liquidation is completed as can be done under the post-termination transition period rules.

Barbara Bryniarski CPA, MST Executive Editor at Parker Tax Publishing

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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