United States: Court Disallows S Corporation Losses

The U.S. Court of Appeals for the District of Columbia has agreed with the Tax Court and held in Barnes v. Commissioner (No. 12-1248) that the taxpayers could not deduct certain losses from an S corporation, because the taxpayers lacked sufficient basis.

Marc and Anne Barnes owned stock in Whitney Restaurants, an S corporation for U.S. federal income tax purposes. The Barneses claimed $279,289 in losses on their 2003 individual income tax return as their pro rata share of losses from Whitney Restaurants. The IRS contended that the Barneses lacked sufficient basis in Whitney Restaurants and accordingly disallowed $123,006 of the claimed losses.

The Tax Court ruled against the Barneses (T.C. Memo 2012-80), finding that they failed to properly reduce their stock basis in Whitney Restaurants stock in 1997. Specifically, the Barneses failed to reduce their basis for suspended losses that could have been claimed in 1997 even though the Barneses never claimed such losses on their 1997 individual income tax return. The Barneses then appealed to the U.S. Court of Appeals for the District of Columbia, which sustained the Tax Court. In addition, the Circuit Court sustained substantial understatement penalties against the Barneses.

In general, Section 1366(a) provides that a shareholder of an S corporation must take into account such shareholder's pro rata share of the corporation's items of income, loss, deduction or credit. Section 1366(d)(1) provides that the aggregate amount of losses and deductions taken into account by a shareholder for any taxable year cannot exceed the sum of the shareholder's basis in the S corporation stock and the shareholder's basis of indebtedness of the S corporation to the shareholder. Suspended losses disallowed under this provision are carried forward and treated as incurred by the S corporation in the succeeding taxable year under Section 1366(d)(2). Section 1367(a)(1) provides that the basis of each shareholder's stock in an S corporation is increased by items of income under Section 1366(a)(1). Similarly, Section 1367(a)(2) provides that the basis of each shareholder's stock in an S corporation is decreased, but not below zero, by items of loss and deduction under Section 1366(a)(1).

In the Barnes case, the IRS argued that a shareholder must reduce basis in an S corporation by the amount of any suspended losses in the first year the shareholder's basis is adequate to absorb the losses, regardless of whether the shareholder claims a deduction for the losses on the shareholder's individual income tax return in that year. The Barneses, on the other hand, argued that if no deduction is claimed, no adjustment to basis is required. The Circuit Court agreed with the IRS and relied on the statutory language in Sections 1366 and 1367.

First, the Circuit Court noted that Section 1367(a)(2)(B) requires taxpayers to reduce basis for items of loss taken into account under Section 1366(a)(1)(A) and that any losses suspended because of a lack of basis must be treated as incurred in the succeeding taxable year. Second, the Circuit Court observed that nothing in these provisions provides that a shareholder's basis is not reduced if the shareholder fails to report the previously unabsorbed loss in the first year the shareholder has sufficient basis. The Circuit Court noted the language in Section 1367(b)(1), which specifically mandates that a shareholder's basis is increased by S corporation income only to the extent such income is included in gross income on the shareholder's return. The Circuit Court reasoned that the absence of similar language related to the treatment of losses should be interpreted to mean that Congress intended disparate treatment for items of income versus of items of loss. In other words, basis is adjusted only for items of income reported by the taxpayer but basis must be adjusted for items of loss, irrespective of whether such items of loss are reported by the taxpayer on his or her individual income tax return.

Importantly, the IRS was able — in 2003 — to adjust the Barneses' basis in their S corporation stock for items in 1997, even though the statute of limitations had closed related to 1997. The Barneses were not permitted, however, to amend their 1997 return and claim the suspended losses that became allowable in 1997 because of sufficient basis. Thus, as the Circuit Court noted, the Barneses ended up paying more in taxes than they otherwise would have owed had they properly claimed allowable losses on their original 1997 return or on an amended 1997 return filed before the statute of limitations expired.

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