December 18, 2017

IRS Campaign: S Corporation Losses Claimed in Excess of Basis

By Katy Daiell, Senior Manager, Tax & Business

IRS Campaign: S Corporation Losses Claimed in Excess of Basis Tax & Business

Earlier this year, the Large Business and International Division of the IRS (“LB&I”) announced 13 campaigns aimed at specific compliance issues. One of these campaigns is directed at S corporation shareholders incorrectly claiming losses and deductions in excess of their stock and debt basis in the corporation.  On April 26, 2017, an interview was conducted with three directors of the LB&I to discuss the new campaign. All three emphasized that the intent of the campaign was to educate taxpayers to correctly track basis in the future, as well as to evaluate prior year basis calculations and loss deductions. 

The LB&I is focusing on taxpayers who have claimed losses on tax returns, to verify if basis schedules are attached to IRS Form 1040 Schedule E, which is required if a shareholder is reporting losses from the S corporation.  LB&I is in the process of developing and implementing a plan of action to ensure losses are taken only to the extent of a shareholder’s basis.

Items of income and deduction are not taxable at the S corporation level but are passed-through to shareholders and are reported on individual tax returns.  When losses are passed-through, the shareholder can recognize losses on a personal tax return only to the extent there is sufficient stock basis.  Once basis in the stock has been reduced to zero, losses can be taken to the extent the shareholder had bona fide debt basis in the corporation.  Debt is considered to be bona fide if the shareholder has made an economic outlay by loaning money to the corporation.  Guaranteeing debt of the corporation does not create debt basis.  Any losses in excess of basis are carried forward to be used in future years, once the shareholder has basis restored.

During the interview, the directors discussed the action steps the IRS will implement in order to ensure losses are not being taken in excess of shareholder basis.  Possible courses of action could include IRS examinations, soft letters, tax return form changes, and working with tax preparation software vendors to assist in applying the new reporting requirements.  Lack of basis calculation reporting will not automatically generate an IRS examination; however, select individuals who do not report basis may receive a soft letter from the IRS. 

While the language of these soft letters is not yet definitive, the directors provided some guidance as to what taxpayers can expect.  Letters will request that the taxpayer respond by attaching basis calculations that refer to amounts reported on schedule E of the tax return.  If the taxpayer realizes losses were taken in excess of basis in a prior year, an amended return should be considered to correct the error.  Replying to these letters is not mandatory, and lack of response by the taxpayer will not automatically trigger an audit.  However, LB&I is encouraging a response to mitigate possible selection for audit.   Taxpayers can also expect tax return form changes, as well as additional forms to be required to be filed with the tax return to facilitate the basis reporting requirement.

The new campaign is not intended to be a scare tactic on the part of the IRS but is aimed at educating taxpayers on loss limitations regarding S corporation basis.  Although the mechanics are still in the development stages, taxpayers should evaluate their basis schedules now, to see if there are potential issues regarding loss deductions in excess of basis. 

The tax professionals at Marcum can assist you in reconciling your tax basis to ensure it is properly computed and that current and prior year losses were properly allowed.

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