Taking advantage of a corporation's early losses by electing S status.

• Author: Ellentuck, Albert B.

A newly formed corporation often realizes operating losses during the first years of operation. Even though the shareholders may anticipate positive cashflow, tax losses may occur because of rapid depreciation deductions or other differences between book and tax reporting.

Limits on Use of Passthrough Losses An S corporation passes through corporate losses to be deducted on the shareholders' personal returns. However, three limits could prevent immediate use of such losses.

Tax basis limit: A shareholder's current use of S losses is limited to the shareholder's adjusted basis in stock and direct loans to the corporation, under Sec. 1366(d)(1). Before recommending S status to allow the use of anticipated initial tax losses, the tax adviser must verify that the shareholders have sufficient basis, via either direct investment in stock or direct loans to the S corporation. It is not unusual for small, closely held corporations to secure their initial capital entirely from a bank or other third-party financing, secured by the shareholders' personal guarantees. These guarantees alone do not provide tax basis to the shareholders; this circumstance would restrict their use of initial losses.

At-risk limit: An S shareholder may be restricted from using passthrough losses to the extent the shareholder is not "at risk" This limit is measured at the shareholder level and is similar to basis limits.

PAL limit: An S shareholder may face restrictions on the current deductibility of a passthrough S loss if it is deemed to arise from a passive activity. Passive activity losses (PALs) may be deducted only to the extent of current income and gains from other passive activities, under Sec. 469. Unless a shareholder materially participates in the business via regular, continuous and substantial involvement, the activity is deemed to be passive.

According to Temp. Regs. Sec. 1.469-2T(d)(6), passthrough losses are limited by the various loss limit rules, in the following order:

1. Sec. 1366(d) basis limits.

2. Sec. 465 at-risk rules.

3. Sec. 469 PAL rules.

Example

Ellen and Jean form a calendar-year corporation, X Corp., in which each owns 50% of the stock. Each. shareholder will materially participate in the corporation's business activity. They expect to have annual losses of about $20,000 for the first several years. X has sufficient working capital for the first year, but Ellen and Jean project they will need additional working capital in the second year. The...