S Corporation –Partnership Basis

Vicki H. Meyer CPA

Thomas Howell Ferguson, PA
vmeyer@thf-cpa.com 850-668-8100
 WHY

FIRM RISK MECHANICS

STRATEGIES
What Basis Does …

Limits the amount of loss that can be
deducted.

Determines gain or loss on disposal.

Determines the amount of tax-free
distributions that can be received.

For a partnership, may determine allocation
of income and deductions among the
partners.
Why all this headache?

Tax
Savings

State
Law

Liabilities
Loss Limitations
Bucket O’ Loss
BASIS

A taxpayer can never deduct

more than the amount that
AT RISK
flows through from the prior
limit.
PAL

Deduction
 Basis – At Risk – Passive Loss Rules
ALL DIFFERENT

Different basis rules - IRC Sec. 704(d) and 1361.

Different at risk rules – IRC Sec. 465 Similar to
basis, but disallows certain related party
liabilities. Liabilities and related parties are
defined differently, therefore different results.

Different passive loss rules – IRC Sec. 469 .
Material participation. Defined differently
depending on state law treatment of LPs and
LLCs.
 Liabilities
S Corporations Partnerships

Not technically
General partners and
considered basis but LLP holders get basis in
a device that can recourse loans.

Other partners can have
offset losses.
basis with deficit.

Only direct loans, no restoration obligations
guarantees. (DROs).

Special rules on open
Special rules for
account debt. nonrecourse loans.
 Back to back loans

This approach is termed a back-to-back loan, which in the S corporation context has caused some tax uncertainty. In a back-to-back
loan, a shareholder borrows the funds and then lends them to the S corporation. A number of courts have approved back-to-back
loan arrangements where the loans are valid debt and the shareholder documents them appropriately and makes payments in a
manner that is consistent with the loan documents. Therefore, if A had borrowed the funds from a bank, had documented the loan
from the bank and the loan to B Inc. appropriately, and all payments were made in accordance with the loan documents (i.e., from B
Inc. to A and from A to the bank), it is likely (although not certain) that under current case law A would have debt basis in her loan to
the S corporation.

For example, in Raynor, the court allowed the shareholder basis for borrowed funds that the shareholder then lent to the S
corporation. In Gilday,30 the shareholder obtained basis when he exchanged his note for the S corporation’s note with the lender
bank. Nevertheless, the IRS has successfully attacked back-to-back loans in certain circumstances. The courts have found that a
shareholder cannot claim basis credit where there is no actual economic outlay. This is most frequently the case where there are
related-party debt restructurings that the taxpayer intends to create basis and where the form of the transactions is not consistent
with the substance the taxpayer claims.31

Restructuring existing debt increases the risk that the shareholders’ new debt basis will not be respected under Sec. 1366(d). In
Oren,32 the court did not accept a circular flow of cash that the taxpayers intended to create basis because no one’s economic position
was changed in the process.33 In Kaplan,34 the taxpayers accomplished the circular cash flow with a third-party bank, and the court
disregarded the restructured loans. In Kerzner, however, the shareholder borrowed from a bank and contributed the proceeds to the S
corporation, which then paid the proceeds to related entities, and the related entities lent the proceeds to the shareholder to repay
the original bank loan.

Thus, the story of basis comes full circle. Properly structured, the cost basis in the land (partially funded by debt) can be reflected in
A’s S corporation basis (also partially attributable to debt). However, as was previously noted, basis can be elusive and can disappear if
not carefully watched.
Open account loans

Can be netted if less than 25K

If net of advances and repayments, is more than
$25,000 at the close of the S corporation's tax
year, then beginning with the next tax year, the
principal amount of the open account debt is no
longer considered to be open account debt.
Rather, it is treated as if it were indebtedness
evidenced by a separate written instrument for
purposes of the debt basis rules.
 Must be real stock or debt…

The shareholder must experience an actual economic
outlay to acquire stock or debt basis. This means that,
before basis can be increased, “there must have
occurred some transaction which when fully
consummated left the taxpayer poorer in a material
sense” (Rev. Rul. 81-187;

Giving only a note to the corporation or subscribing
for more stock without making payment does not
increase basis.( Silverstein).

The partner's basis generally is increased only as the
contribution obligation is fulfilled (Rev. Rul. 80-235
and Oden).
 S Corporation Partnership

BOY
BOY
Basis Calculation

Capital contributions
Capital contributions

Income and gain items
Income and gain

Less distributions items

Loss and deduction
items not to exceed
Increase in liabilities
income
Less distributions

EOY (cannot be below
zero).
Decrease in Liabilities

Loss and deduction
items

EOY
 Initial Basis if Purchased:

S Corporation Partnership

Cost of the shares.
Carryover of selling
Contributions

partner's tax-basis
capital account (inside
basis) plus

FMV difference
(outside basis).
Partnership Basis Accounts

Inside Outside Economic

Basis Basis Basis
Inside and Outside
S Corporations Partnership

Just one basis. (Even
though debt can be used
Inside basis carries over
to absorb losses after to new partner.
stock basis is reduced to
Outside basis can be
zero.) brought inside with Sec

Cannot amortize 754 and deducted. Large
through current negative adjustments are
deductions the increase required.
attributable to FMV over
basis to the corporation.
 Initial capitalization with property
S Corporations

Do not have to keep
Contributions

Must have >80%

ownership to be tax track of built in gain.
free.
No disguised sale

Possible gain if rules.
liabilities are in excess
of basis (IRC Sec.
357).
 Contributions - Initial capitalization
with property
Partnerships

Do have to keep track
Contributions

Can have any

ownership and be tax of built in gain IRC
free. 704(c).

Typically no gain if
Disguised sale rules if
liabilities exceed distributed within 2
basis. yrs.
 Basis acquired by Gift
S Corporation Partnership
Contributions

Donor's basis
The transferee

Plus Gift tax partner assumes the
attributable transferor's tax-basis

Limited to FMV for capital account.
Loss Purposes.
Section 754 basis
adjustments,
mandatory for large
built in losses.
 Basis acquired by Inheritance
S Corporation Partnership

The transferee
Contributions

FMV at date of death

partner assumes the
transferor's tax-basis
capital account.

Section 754 basis
adjustments,
mandatory for large
built in losses.
 Basis acquired for services
S Corporation Partnership
Contributions

Stock’s FMV rather
Liquidation value of

than FMV of services the capital interest
received.

Future profits in
exchange for
contributing services
is generally not a
taxable event.
 Conversion from a C Corp
S Corporation Partnership
Contributions

C corporation electing S
Considered a taxable

status. Initial basis in S liquidation followed
stock is the basis in C by a contribution of
stock at the time of net assets to the
conversion. Some partnership.
immediate tax (LIFO
reserves) but typically
built in gains can be
deferre.)
 Income and Gain Items
S Corporation Partnership

Includes page 1 and
Same
Net income

separately stated items

on K-1

Tax Exempt Income-
increase basis.

Special depletion rules.
Increases in Liabilities
S Corporation Partnership

Only increases in
Increases in liabilities
direct loans, not as determined under
entity loans. IRC Sec. 752, based
on a zero value
liquidation, who
would perform on the
debt.
Distributions Partnerships

S Corporations
Can be

Cannot be
disproportionate.
disproportionate
Reduce basis for a
(second class of stock distribution made on
rules). the date it is made

Taken into effect at
If nonliquidating, can
the end of the year. be EOY to the extent

Should not be
of the parnter's share
“draws” but follow of income for the year
corporate form, (advance or draw
rule).
Decreases in Liabilities
S Corporation Partnership

Can trigger income in
Decreases in
in xcess of basis.. liabilities as
determined under
IRC Sec. 752.

Can trigger income if
in excess basis.
STOP HERE
S Corporations Partnerships

If after distributions
No gain on
and decreases in distributions unless
liabilities, the number distributions are in
is negative, than cash or marketable
income to securities.
shareholder.
 Loss and Deduction Items
S Corporation Partnership

Includes page 1 and
Same

Net income

separately stated items

on K-1

Tax Exempt Income-
increase basis.
Non Deductible Expenses
S Corporation Partnership

Decrease basis to
Same
ensure that
expenditures that, for
income tax purposes,
are neither deductible
nor capitalizable,
cannot be deducted
when the interest is
disposed.
 STOP HERE
S Corporations Partnerships

If after negative items the
Same.
number is negative, than
losses carry forward to
future years.

Loss is prorated over the
Same
the character of income.

Special election for
Check rules.
treatment of
nondeductible items.
Loss carryovers
S Corporations Partnerships

Lost if (1)the shareholder S
Sennett v. Commissioner 80
corporation election is A partner’s suspended
terminated; (2) the
deductions under IRC
shareholder disposes of all of
section 704(d) expire upon
his or her stock to someone
other than a spouse or former the sale of his partnership
spouse incident to a divorce; interest.
or (3) the shareholder dies.

Allocated to each share of
stock.
Allocations When a Interest Changes
S Corporations Partnerships

per-share, per-day basis
interim closing of the books
allocated equally to each day method.
of the tax year and then are

proration of annual income
allocated equally among the
shares of stock outstanding
any other reasonable
on each day of the tax year. method.

special rules required when
the S election terminates or
an election to use specific
accounting is made.
Other S Corporation items

Gain on Sale of S Corporation Stock Does Not Increase Basis

If a shareholder with a suspended loss carryover sells his S corporation stock, he will
have a gain reportable from the disposition. However, gain on the disposition of stock
does not increase basis for purposes of using S corporation carryover losses. (See Key
Issue 30D.) The adjusted basis of stock sold or otherwise disposed of during the year is
determined immediately prior to the sale or disposition, as discussed in Key Issue
19D.Domestic Production Activities Deduction Does Not Affect Basis

Information necessary to calculate the Section 199 domestic production activities
deduction is reported on each shareholder's Schedule K-1. The deduction is claimed by
the shareholder and does not affect the shareholder's stock basis [Reg. 1.199-9(c)(1)(i)].
The Section 199 deduction is covered in Key Issue 18A.Effect of Credits on Basis

The basis limitations do not apply to credits. For example, an S corporation shareholder
with a zero stock basis who receives a $3,000 disabled access credit pass-through on
Schedule K-1 can claim the credit even though his stock basis is zero. (See Key Issue
28D.)
Responsibility
S Corporation Partnership

The shareholder's
The partners. As a
(not the practical matter,
corporation's) partnership return

AAA, PTI, and AE&P preparers have a
maintained at the responsibility to make
corporate level. it as easy as possible
for partners to do so.

Slow down…invest time upfront

Firm Best Practices
S Corporations Partnerships

Copy of debt
Copy of partnership
instruments. agreement.

Basis schedules.
Copy of debt
instruments and
underlying guarantees.

Basis schedules.