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

• Author: Arthur, Charles C.

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 $4,500 of the corporation's ordinary loss, reducing basis to zero. The $1,000 portion of the ordinary loss not deducted in 1995 would be carried forward to 1996 under Sec. 1366(d)(2).

This example shows that the result of the general ordering rule of Regs. Sec. 1. 1367-1 (e) is to postpone the deduction of otherwise deductible expenses in situations in which the sum of NDNC and deductible expenses exceeds the shareholder's basis.

Elective ordering rule

As an alternative to the general ordering rule, Regs. Sec. 1.1367-1(f) provides an elective ordering rule under which the sequence under the general rule is reversed (i.e., basis is reduced first by deductible expenses and then by NDNC expenses). By electing this rule, however, the shareholder agrees to carry forward...