The transfer loss property between an S corporation and its shareholder.

• Author: Schnee, Edward J.

The S corporation tax rules were designed for small corporations, and even though there can now be 100 shareholders (even more if the shareholders are related), the majority of S corporations are still closely held. As a result, there are often transactions between S corporations and their shareholders. One type of transaction that occurs frequently is when the shareholder or the corporation holds property with a basis greater than its fair market value (FMV) and there are good business and tax reasons to transfer the property between the shareholder and the corporation.

When these transactions are done, various rules, including loss disallowance rules, can affect both the shareholder making the transfer and the corporation. Moreover, the nontransferring S corporation shareholders' taxable income and bases can also be affected. The discussion below surveys the various possible results of the loss property transfers.

Sec. 351 Transfers

When a shareholder transfers property that has depreciated in value to a controlled corporation, the transaction may be a nontaxable Sec. 351 transfer. (1) The shareholder's basis in the stock received is usually his or her basis in the transferred property, but, under Sec. 362(0(2), the corporation's basis will become the property's FMV, not its carryover basis. The shareholder will have a built-in loss on the stock received that will not be recognized until the stock is sold. This treatment will yield the correct result if the S corporation has other shareholders that did not transfer depreciated property, because the basis rules will prevent these other shareholders from benefiting from the built-in loss.

The shareholder can elect to limit the stock basis to the contributed property's FMV, and the corporation will have the higher carryover basis in the asset. (2) When this election is made and the corporation later sells the property to an unrelated party, a loss may be realized, recognized, and allocated to the shareholders in proportion to their ownership when the property is sold. While the shareholder's ownership when the transfer occurred must be at least 80% to qualify under Sec. 351, it may be more or less than 80% when the asset is sold. It seems that the goal of these rules is to prevent a double deduction for the built-in loss, and Congress is not too concerned about who gets the loss--the corporation or the shareholders.

S Corporation Distributions of Loss Property

The IRS Office of Chief Counsel recently reviewed the taxation of an S corporation's distribution of depreciated property to its shareholder in Chief Counsel Advice (CCA) 201421015. According to the CCA, since the S corporation Code sections do not include any special provisions addressing this type of transaction, the general corporate tax rules apply. (3) Specifically, Sec. 311(a) dictates the taxation of gain at the corporate level, but a loss (the amount of basis in excess of the value of the distributed property) is nondeductible.

The first item the CCA addresses is the effect of this distribution transaction on the shareholder's stock basis. It is no surprise that the CCA states that the shareholder must reduce the stock basis by the value of the property received. The basis of the property in the hands of the shareholder will also be FMV.

Sec. 1367(a)(2) requires the shareholder to reduce stock basis by distributions, losses, and "any expense of the corporation not deductible in computing its taxable income and not properly chargeable to capital account." (4) The regulations state that fines, penalties, and expenses related to tax-exempt income qualify as nondeductible, noncapital expenditures. (5) The regulation does not mention the Sec. 311 denied loss. Since the S corporation regulations are silent about this nonrecognized loss, the IRS turned to the consolidated return regulations. Regs. Sec. 1.1502-32 specifically states that the Sec. 311 denied loss is a nondeductible, noncapital item. Therefore the CCA states the Sec. 311 denied loss is a nondeductible, noncapital item for the S corporation and that the taxpayer must reduce her stock basis by the amount of the denied loss.

As additional support for the IRS's conclusion, the CCA also points out that this treatment maintains the equality of inside and outside basis. The corporation's asset basis is reduced by the basis of the distributed property. The shareholder must reduce the basis of the stock by the value of the property and the denied loss. The value of the property plus the denied loss equals the corporation's basis in the property Therefore, the inside and outside bases are reduced by the same amount, maintaining consistency. The CCA clarifies the effect of the non-recognized loss on the stock basis.

The CCA next turned to the effect, if any, that the Sec. 311 denied loss has on the accumulated adjustments account (AAA) of former C corporations. Sec. 1368(e)(1)(A) states that the AAA is an account of the S corporation that is adjusted for the S period in a manner similar to the stock basis adjustments under Sec. 1367 except that tax-exempt income is not taken into account. Regs. Sec. 1.1368-2(a)(3) expands this statement by providing that AAA is reduced by any nondeductible, noncapital expenditures, other than federal taxes attributable to any tax year in which the corporation was a C corporation, and expenses related to income that is exempt from tax. Given that the CCA ruled that the denied Sec. 311 loss is a nondeductible, noncapital expenditure, the CCAs conclusion that AAA was required to be reduced by the denied loss was expected.

A potential question is whether the regulation is correct. Since AAA is not increased by tax-exempt income, why is it reduced by nondeductible items? To be consistent, AAA should either be increased by tax-exempt items and decreased by nondeductible, noncapital items, or both should have no effect on AAA. However, the chance that the regulation would be ruled invalid is very small. Given that AAA only applies to S corporations that have earnings and profits, it is doubtful that the regulation...