The basis limitation rule of Section 1366(d)(1) applies to limit the amount of creditable foreign income taxes paid or accrued by an S corporation that the S corporation's shareholder may take into account in computing the shareholder's allowable foreign tax credit under Section 901.

The IRS recently confirmed this view in emailed advice (ECC 201429025). Subchapter S corporation shareholders should be aware that they will be treated like partners in a partnership for purposes of applying foreign tax credits, under Section 1373(a).

Under Section 703(a), the taxable income is computed in the same manner for a partnership as for an individual, except that Section 702(a) items are separately stated and certain deductions, like the Section 901 foreign tax credit, aren't allowed to the partnership. Instead, the partner takes into account his or her distributive share of the partnership's creditable foreign income taxes under Section 702(a)(6).

Treas. Reg. Sec. 1.702-1(a)(6) allows for a partner to choose to claim either a foreign tax credit or an itemized deduction for foreign income taxes paid or accrued for the taxable year by virtue of Sections 164(a)(3), 275(a)(4), 901(a) and 901(b)(5). Similarly, Section 1366(a)(1) provides for an S corporation shareholder to take a pro-rata share of the corporation's items of income, loss, deduction or credit separately.

Section 1363(b)(2) provides that the deductions referred to in Section 703(a)(2), including foreign tax credits described in Section 703(a)(2)(B), aren't allowed as a deduction in computing the taxable income of the S corporation. However, Section 1366(a)(1) specifically confirms that separately stated items of Section 1366(a)(1)(A) include foreign tax credits described in Section 702(a)(6). Finally, Section 1363(c)(2)(A) confirms that the Section 901 election to take the foreign tax credit, rather than as an itemized deduction of the foreign taxes, is made by each shareholder separately, and not by the S corporation.

Section 1366(d)(1) provides that the aggregate amount of losses and deductions taken into account by a shareholder under Section 1366(a) for any taxable year should not exceed the sum of the shareholder's adjusted basis in the S corporation stock and the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder.

Because the flush language of Section 1366(a)(1) specifically confirms that the separately stated items of income, loss, deduction or credit taken into account under Section 1366(a)(1)(A) include creditable foreign income taxes, the Section 1366(d)(1) basis limitation applies to limit the shareholder's deduction or credit for its pro rata share of the S corporation's creditable foreign income taxes to the shareholder's basis in its stock at the end of the taxable year.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.