Allocating S corp. losses to acquiring and terminating shareholders.

• Author: Ellentuck, Albert B.

Passthrough items are generally allocated to shareholders on a pro rata basis (i.e., per share, per day). However, if a shareholder's entire interest in an S corporation is disposed of, the corporation can elect to allocate passthrough items based on the actual transactions that occurred before and after the stock disposition took place. This election is referred to as the "specific accounting election," and can also be made when a qualifying disposition occurs.

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Example 1: B Inc. is a cash-method hog-raising venture operating as a calendar-year S corporation. It is owned by four shareholders, each with 25% of the stock. Two of the shareholders have exhausted their stock basis via prior S corporation losses and are not willing to inject additional capital into the corporation. On Nov. 25, these two shareholders sell all of their stock to C, a new shareholder. Shortly after acquiring this stock and in recognition of earlier capital contributions by the remaining shareholders several months before, C injects $100,000 of capital. The corporation then expends these funds for supplies, feed, fuel, and other operating expenses. The overall tax loss for the full 12 months is $10,000. C expects a large tax loss to be allocated to him from B, in view of the large amount of capital he injected and the expenditures made by the corporation at year end. C estimates that from Nov. 25 to Dec. 31, the corporation had a tax loss of $90,000. How is the taxable loss of B allocated among the shareholders in view of the changes in ownership that occurred during the year?

If the general pro rata allocation method were used in this case, C would be allocated a loss of less than $500. This amount is calculated as follows: $10,000 overall loss x 36 days / 365 days x 50% of stock = $493.

The corporation can elect (with the consent of affected shareholders) to use specific accounting when there is a complete termination of stock ownership by one or more shareholders. Under this method, the corporation is treated as if it had two tax years for purposes of computing the allocations to each shareholder (Sec. 1377(a)(2)). Assuming C is correct in his estimate that the corporation would have a $90,000 loss during his period of ownership, his allocation under the specific accounting election would be $45,000 computed as follows: $90,000 specific accounting period loss x 50% of stock = $45,000 allocable loss.

These facts illustrate the dramatic...