Here is a quick summary of a recent US TAX COURT case against the Internal Revenue Service to challenge the taxpayer’s right to deduct tax losses from a “S” Corporation. The tax case involves an attorney who claimed a loss from his incorporated law practice on his individual IRS Form 1040 tax return. IRS charged taxpayer with penalties and interests based on improper tax deduction.
R.WEISBERG et al v. COMMISSIONER OF Internal Revenue Service
Is a taxpayer entitled to deduct a loss from his S corporation as a shareholder?
APPLICABLE TAX CODE SECTION
Internal Revenue Code §1363(a). A qualifying small business corporation that makes the proper election is generally not subject to income tax. Rather, its items of income, deductions, credits, and losses pass through to its shareholders, Internal Revenue Code §1366(a)(1), who then claim those items on their own income tax returns.
Internal Revenue Code §1366(d)(1). However, an S corporation shareholder may not claim a loss deduction greater than his basis in the S corporation, with “basis” in this context consisting essentially of his investment in the corporation. A taxpayer who claims a loss from a S corporation must establish his basis in the S corporation.
Internal Revenue Code §61 (a) includes in gross income “all income from whatever source derived” unless excluded by a specific provision of the Code.
CAN YOU DEDUCT LOSSES FROM YOUR CORPORATION?
Taxpayer, who is an attorney, owned shares in an S corporation and in 2000 personally guaranteed a line of credit to the corporation. The S corporation incurred losses in 2003, and taxpayer deducted part of those losses on his 2003 IRS Form 1040 Income Tax return. In March 2004 taxpayer took out a loan and paid off the corporation’s line of credit in the amount. The IRS disallowed the 2003 loss on the grounds that taxpayer had insufficient basis in the S corporation and determined a tax deficiency, a late-filing addition to tax, and an accuracy-related penalty.
TAXPAYER NEEDS TO ESTABLISH TAX BASIS IN THE CORPORATION BEFORE ANY DEDUCTIONS FOR TAX LOSSES ON IRS INDIVIDUAL TAX RETURN
The US Tax Court and tax audit records contained no information concerning taxpayer’s basis in his S corporation before 2000. In that year he personally guaranteed a line of credit for the firm. Under certain conditions, debt can contribute to a shareholder’s basis in an S corporation, but those conditions are not satisfied in this tax court case. US Tax Court has held that mere shareholder guaranties of S corporation indebtedness generally fail to satisfy the requirements of section Internal Revenue Code §1366(d)(1).
No form of indirect borrowing, including a guaranty, gives rise to indebtedness from the corporation to the shareholders for such purpose until and unless the shareholders pay part or the entire obligation. US Tax Court also held that the mere guaranty of a loan does not involve any economic outlay. Until the guarantor pays the obligation, the guarantor does not have an actual investment.
Taxpayer’s guaranty of the line of credit did not, by itself, increase his basis in the S corporation. Consequently, US Tax Court had no evidence that in 2003 he had a basis in any amount. In 2004 taxpayer incurred his own personal loan and used it to pay off the firm’s line of credit. It may assumed that by doing that act taxpayer did increase his basis in the S corporation per Internal Revenue Code §1366(d)(1). However, the year in issue here is 2003, and that act in 2004 did not increase his basis in 2003. Consequently, taxpayer has not shown that he is entitled to claim any portion of the loss in 2003. Overall, taxpayer’s guaranty of the S corporation’s line of credit did not increase his basis in the S corporation per Internal Revenue Code §1366(d)(1) during the year in issue. Taxpayer was not allowed to deduct the losses from his corporation on his individual tax return in 2003. The decision was entered for the Internal Revenue Service .