The Transfer of Loss Property Between an S Corporation and Its Shareholders S Corporations
by Edward J. Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D.
Published January 01, 2015
SUMMARY
Illustrations by Adriana3d/iStock
· The IRS Office of Chief Counsel recently advised that disallowed Sec. 311(a) losses resulting from a distribution of loss property to an S corporation shareholder will be treated as nondeductible, noncapital expenses and will reduce shareholders' bases in S corporation stock and the S corporation's accumulated adjustments account.
· If an S corporation sells property at a loss to a shareholder who qualifies as a related party under Sec. 267, the loss is disallowed to the S corporation, but the shareholder may be able to use the loss to offset gain from a subsequent sale of the property.
· Under Sec. 267(f), a loss on a sale of property between members of a controlled group will be deferred and will be recognized when appropriate under the matching and acceleration rules for intercompany transactions in the consolidated return regulations.
The S corporation tax rules were designed for small corporations, and even though there can now be 100shareholders (even more if the shareholders are related), the majority of S corporations are still closely held. As a result, there are often transactions between S corporations and their shareholders. One type of transaction that occurs frequently is when the shareholder or the corporation holds property with a basis greater than its fair market value (FMV) and there are good business and tax reasons to transfer the property between the shareholder and the corporation.
When these transactions are done, various rules, including loss disallowance rules, can affect both the shareholder making the transfer and the corporation. Moreover, the nontransferring S corporation shareholders' taxable income and bases can also be affected. The discussion below surveys the various possible results of the loss property transfers.
Sec. 351 Transfers
When a shareholder transfers property that has depreciated in value to a controlled corporation, the transaction may be a nontaxable Sec. 351 transfer.1 The shareholder's basis in the stock received is usually his or her basis in the transferred property, but, under Sec. 362(e)(2), the corporation's basis will become the property's FMV, not its carryover basis. The shareholder will have a built-in loss on the stock received that will not be recognized until the stock is sold. This treatment will yield the correct result if the S corporation has other shareholders that did not transfer depreciated property, because the basis rules will prevent these other shareholders from benefiting from the built-in loss.
The shareholder can elect to limit the stock basis to the contributed property's FMV, and the corporation will have the higher carryover basis in the asset.2 When this election is made and the corporation later sells the property to an unrelated party, a loss may be realized, recognized, and allocated to the shareholders in proportion to their ownership when the property is sold. While the shareholder's ownership when the transfer occurred must be at least 80% to qualify under Sec. 351, it may be more or less than 80% when the asset is sold. It seems that the goal of these rules is to prevent a double deduction for the built-in loss, and Congress is not too concerned about who gets the loss—the corporation or the shareholders.
S Corporation Distributions of Loss Property
The IRS Office of Chief Counsel recently reviewed the taxation of an Scorporation's distribution of depreciated property to its shareholder in Chief Counsel Advice (CCA) 201421015. According to the CCA, since the S corporation Code sections do not include any special provisions addressing this type of transaction, the general corporate tax rules apply.3 Specifically, Sec. 311(a) dictates the taxation of gain at the corporate level, but a loss (the amount of basis in excess of the value of the distributed property) is nondeductible.
The first item the CCA addresses is the effect of this distribution transaction on the shareholder's stock basis. It is no surprise that the CCA states that the shareholder must reduce the stock basis by the value of the property received. The basis of the property in the hands of the shareholder will also be FMV.
Sec. 1367(a)(2) requires the shareholder to reduce stock basis by distributions, losses, and "any expense of the corporation not deductible in computing its taxable income and not properly chargeable to capital account."4 The regulations state that fines, penalties, and expenses related to tax-exempt income qualify as nondeductible, noncapital expenditures.5 The regulation does not mention the Sec. 311 denied loss. Since the S corporation regulations are silent about this nonrecognized loss, the IRS turned to the consolidated return regulations. Regs. Sec. 1.1502-32 specifically states that the Sec. 311 denied loss is a nondeductible, noncapital item. Therefore the CCA states the Sec. 311 denied loss is a nondeductible, noncapital item for the S corporation and that the taxpayer must reduce her stock basis by the amount of the denied loss.
As additional support for the IRS's conclusion, the CCA also points out that this treatment maintains the equality of inside and outside basis. The corporation's asset basis is reduced by the basis of the distributed property. The shareholder must reduce the basis of the stock by the value of the property and the denied loss. The value of the property plus the denied loss equals the corporation's basis in the property. Therefore, the inside and outside bases are reduced by the same amount, maintaining consistency. The CCA clarifies the effect of the nonrecognized loss on the stock basis.
The CCA next turned to the effect, if any, that the Sec. 311 denied loss has on the accumulated adjustments account (AAA) of former C corporations. Sec.1368(e)(1)(A) states that the AAA is an account of the S corporation that is adjusted for the S period in a manner similar to the stock basis adjustments under Sec. 1367 except that tax-exempt income is not taken into account. Regs. Sec. 1.1368-2(a)(3) expands this statement by providing that AAA is reduced by any nondeductible, noncapital expenditures, other than federal taxes attributable to any tax year in which the corporation was a C corporation, and expenses related to income that is exempt from tax. Given that the CCA ruled that the denied Sec. 311 loss is a nondeductible, noncapital expenditure, the CCA's conclusion that AAA was required to be reduced by the denied loss was expected.
A potential question is whether the regulation is correct. Since AAA is not increased by tax-exempt income, why is it reduced by nondeductible items? To be consistent, AAA should either be increased by tax-exempt items and decreased by nondeductible, noncapital items, or both should have no effect on AAA. However, the chance that the regulation would be ruled invalid is very small. Given that AAA only applies to S corporations that have earnings and profits, it is doubtful that the regulation will be challenged. Therefore, a shareholder must reduce the stock basis, and the corporation must reduce the AAA by the loss denied under Sec. 311.
Instead of distributing the property as a dividend, the corporation may use the property to redeem some stock. Under Sec. 302, the shareholder will treat the redemption as either a sale or a dividend. Whether the transaction is a sale or dividend, the corporation must apply Sec. 311 to the distributed property.6 If the property is appreciated, gain is recognized. If the property is depreciated, no loss is recognized, and the denied loss will follow the dividend rules discussed above.
Property Sales
If the S corporation sells property to a shareholder and realizes a gain, the gain is recognized. The character of the gain may be reclassified as ordinary under Sec. 1239 if the property is depreciable in the shareholder's hands.
A loss from the corporation's sale of property to its shareholder may be nondeductible under the related-party rules of Sec. 267(a)(1). Under Sec. 267(b)(2), a corporation and a shareholder are related if the shareholder owns directly or indirectly more than 50% of the value of the outstanding stock. Indirectly owned stock is stock the shareholder owns as a result of the constructive ownership rules of Sec. 267(c).
Although the loss is not recognized, Sec. 267(d) allows the loss to potentially be used in the future. When the purchaser sells the acquired property, the purchaser can reduce the gain realized from the property's resale by the previously disallowed loss. If that gain is less than the previously disallowed loss, the amount of gain is zero, and the remaining amount of disallowed loss expires without being recognized. If the resale of the property produces a realized loss, that second realized loss is recognized by the property's purchaser, and the original disallowed loss expires. If the initial sale is at FMV, it is unlikely that the resale will generate gain equal to the disallowed loss, especially if the resale occurs shortly after the initial sale. Therefore, it is usually recommended that an S corporation not sell property to a shareholder at a loss.
When a shareholder disposes of the purchased loss property in a nontaxable transaction, the application of Sec.267(d) may vary. If the shareholder gifts the property to another person, Sec.267(d) will not apply, and the loss will expire. Therefore, if the donee sells the property at a gain, the full amount of the realized gain will be recognized.7 If, instead of making a gift, the shareholder exchanges the purchased property for like-kind property in a nontaxable Sec.1031 transaction, then Sec. 267(d) will apply when the shareholder sells the property acquired in the like-kind exchange. In other words, the replacement property will be treated the same as the purchased property.
Secs. 351, 721, and 267
The seller may have a disallowed loss, but the purchaser transfers it to a new entity, either a new corporation or partnership, in a nontaxable Sec. 351 or 721 transaction in exchange for an ownership interest. If this occurs, the entity will take the property with a carryover basis. The loss will continue to come under Sec. 267(d) with the ownership interest the shareholder received treated as the purchased property. Therefore, when the new entity sells the property, the entity will recognize any realized gain or loss. On the other hand, the ability to use a loss against a subsequent gain is retained by the shareholder: The shareholder will be able to apply the disallowed loss to reduce any gain realized on a sale of the new corporation's stock or the partnership interest received in the Sec. 351 or 721 transaction.
The S Corporation's Disallowed Loss
When the S corporation is denied a loss from a sale to the shareholder, the shareholder will be affected beyond the Sec. 267 loss denial rule. Regs. Sec. 1.1367-1(c)(2) states that losses denied by Sec. 267(a)(1) are nondeductible, noncapital items. Therefore, the loss will reduce the shareholders' basis in their stock, and the corporation will reduce the AAA. At first glance, it might appear that the loss is deferred and not nondeductible since it may offset a future gain and therefore should not affect basis and AAA. However, a realized gain that is reduced by the loss is a gain realized by the shareholder, not the corporation. A nondeductible, noncapital item is an expenditure that will not affect the computation of the corporation's income. The Sec. 267(a)(1) denied loss will never affect the corporation's income. Therefore, it is correctly labeled as a nondeductible, noncapital item with the stated results.
The classification of the loss as nondeductible and noncapital can also be supported by a basis analysis. As stated under the Sec. 311 discussion, adjustments to inside and outside basis should be equal. Since the sale of the property at a loss will reduce the inside basis of the corporation's assets by an amount equal to the loss, an equal reduction in the outside stock basis is reasonable and correct because it maintains the equality of the inside and outside basis.
A potential question is how to allocate the denied loss among the shareholders.8 All items of income, gain, and loss are allocated among the shareholders based on the percentage of stock owned and whether the items are separately stated or not. Although these nondeductible items are not discussed, it would be reasonable to conclude that they are also allocated among all shareholders based on stock ownership percentage. A shareholder who did not buy the property could question the fairness of allowing the buyer to reduce future gain by the full amount of the denied loss, given the fact that the purchaser did not reduce his or her stock basis by the full amount of the loss. This potential question does not affect the actual application of the existing allocation rules. It does reinforce the recommendation that depreciated corporate property should not be sold to a related shareholder.
The procedures for adjusting stock basis are discussed in the regulations. Regs. Sec. 1.1367-1(f) contains the order of these adjustments. Basis is increased by income items, then decreased by distributions; noncapital, nondeductible items; and deductible losses and expenses. Sec. 1366(d) states that deductible losses and expenses are limited to the basis of the stock and shareholder debt. Given this order, a loss denied under Sec. 267(a)(1) will reduce the shareholder's stock basis and then debt basis before the deductible items reduce the shareholder's basis. The result is that these denied losses may prevent the deductible losses and expenses from reducing the shareholder's income in the year incurred. In these cases, the deferred deductions are carried forward and are deducted in a future year in which the shareholder's stock or debt has a positive basis.