S corporation basis reductions for nondeductible expenses.

• Author: Traum, Sydney S.

AN S CORPORATION'S LOSSES AND DEDUCtions are allocated among its shareholders according to their proportionate ownership of the S corporation's stock. These losses and deductions reduce the shareholder's basis in his or her stock or, if there is none, in the shareholder's loans to the S corporation. However, these losses and deductions are currently deductible by each shareholder only to the extent that the shareholder has basis in his or her stock and loans to the corporation. Any excess amounts of such otherwise deductible losses and deductions over basis for stock and loans are not currently deductible and are treated as arising for that shareholder in his or her next tax year (the carryover provision).

However, there is confusion as to whether the carryover provision also applies to nondeductible, noncapital losses and expenses (e.g., nondeductible meal expenses and fines). When an S corporation has losses and deductions in excess of basis, some of which are nondeductible, noncapital expenses, will there be a carryover of the nondeductible items for purposes of reducing basis in a future year?

Increases and Decreases in Basis

Sec. 1366(d)(1) limits the amount of allowable losses and deductions flowing through to a shareholder under Sec. 1366(a) to the sum of the adjusted basis of the shareholder's stock in the S corporation (determined after giving effect to increases in basis for items of income and the excess of depletion deductions over the basis of the property being depleted) plus the shareholder's adjusted basis of any S corporation indebtedness to the shareholder.

Sec. 1366(d)(2) provides for a shareholder's indefinite carryover of otherwise deductible S corporation losses and deductions that are disallowed by reason of the basis limitation. Any loss or deduction disallowed for any tax year by reason of the basis limitation is treated as incurred by the S corporation in the succeeding tax year for that shareholder. The literal language of the section does not contain any carryover provision for nondeductible, noncapital expenses or for the oil and gas depletion deduction.

Sec. 1367 provides rules for adjustments to S corporation shareholders' basis in their stock. Generally, basis is increased for items of income (including tax-exempt income) and the excess of deductions for non-oil and gas depletion over basis of the property subject to depletion. It also allows for decreases in basis (but not below zero) by each of the...