Effect of nondeductible, noncapital expenses on S stock basis and taxable income.

• Jurisdiction: United States
• Author: Arthur, Charles C.
• Date: 01 November 1995

Basic rules

Under Sec. 1367(a)(2), an S shareholder's basis in an S corporation is decreased by each of the following items:

* Distributions by the corporation not includible in income under Sec. 1368 (i.e., not treated as dividends from earnings and profits (E&P)).

* Separately stated loss and deduction items.

* Nonseparately computed loss.

* Nondeductible expenses not properly chargeable to capital account (NDNC expenses).

* The amount of a shareholder's depletion deduction with respect to oil and gas wells, to the extent the deduction does not exceed the shareholder's proportionate share of the property's adjusted basis allocable to the shareholder.

* Final regulations under Sec. 1367 have now been adopted, effective for S years beginning in 1994. The final regulations contain both a general rule and a special elective rule for the order in which NDNC expenses and deductible expenses reduce basis.

General ordering rule

Regs. Sec. 1.1367-1(e) provides the general ordering rule for the calculation of shareholder basis. This rule requires S shareholders to reduce their bases first by NDNC expenses and then by deductible expenses.

Example 1: Individual S is a shareholder in an S corporation. On jan. 1, 1995, S's basis in the corporation is $5,000. In 1995, S's share of the corporation's ordinary loss is $4,500, and S's share of the disallowed portion of entertainment expenses (an NDNC expense) is $1,500. For 1995, the corporation has no other items of income, deduction or loss, and makes no distributions. Under the general ordering rule, S would first reduce basis from $5,000 to $3,500 for the disallowed portion of entertainment (NDNC) expenses. Next, S would deduct $3,500 of the...