Unsuspend "suspended at-risk 6198 losses"? - Stock interest terminated

[phoenyx]

I have two clients who started an S-Corp together in 2000. One of them initially owned 60%, and the other 40%.

The minority shareholder sold all of his stock to the majority shareholder in 2004 for a token $20 payment.

The majority (now 100%) shareholder is going to be dissolving the S-Corp within the next few months.

I am preparing am amended 2004 return for the minority shareholder, just within his 3 year limit to obtain a refund. They weren't sure how to handle this situation, so the original return didn't have anything involving the S-Corp.

Both shareholders were material participants, so there is no issue of passive income or losses.

Question 1 - The minority shareholder has about $25,000 in disallowed/suspended losses on his 2003 and 2004 Form 6198. These losses were disallowed/suspended because he had zero adjusted basis at the beginning of 2003 and had no contributions. What should happen to these disallowed/suspended losses on his 2004 return, since he sold all of his stock for $20? I believe these losses are supposed to become current/unsuspended.

Question 2 - The majority (now 100%) shareholder has much more in disallowed/suspended losses on his 2003-2007 Form 6198 - to the amount of $275,000. These losses were also disallowed/suspended due to zero adjusted basis and no contributions. What should happen to these disallowed/suspended losses on the return when the S-Corp is dissolved, and his shares become worthless? I believe these losses are supposed to become current/unsuspended also.

Question 3 - If these losses are unsuspended, should that be happening through Schedule D, E, or somewhere else?

IRS Individual Complex Tax Law Department representatives have given conflicting information. They all seemed to agree that the losses would become unsuspended, but disagreed about which Schedule is used.

Using Schedule D would only allow $3,000 to trickle out per year, since they have no capital gains to offset. If 4797 needs to be used, the losses might be capped at $100,000 since the majority (now 100%) shareholder is filing married, jointly.

Using Schedule E would allow the entire amount to be deducted, and would cause a net operating loss which would apply two years retroactive and twenty years into the future, giving a much larger tax benefit.

[veritas]

Losses

How were the losses supported with no contributions from the shareholders? Loans from third parties? Payables?

When the corporation is dissolved how are the debts going to be paid?

[phoenyx]

How were the losses supported with no contributions from the shareholders? Loans from third parties? Payables?

When the corporation is dissolved how are the debts going to be paid?

The losses were primarily supported by bank loans and credit cards. The S-Corp is going to be dissolved without the debts being paid. The S-Corp has under $2,000 in assets at this point.

[veritas]

From what you are

saying they will never have any basis to take the losses.

Why should they if the are walking away from upaid debt scott free?

[Bees Knees]

Question 1 – the answer is you lose all suspended losses when the stock is sold.

Question 2 – the answer is you lose all suspended losses when the stock becomes worthless.

Question 3 – not applicable because at-risk losses do not become un-suspended by merely getting rid of the stock.

IRC §465(a)(2) says: “Any loss from an activity to which this section applies not allowed under this section for the taxable year shall be treated as a deduction allocable to such activity in the first succeeding taxable year.”

In other words, the only way to use a suspended loss under the at-risk basis rules is to treat as a deduction in the following year, allocable to the activity that generated the loss.

Example: Andy has zero stock basis in his S corporation. The S corporation sustains a loss of $1,000. Andy has an at-risk suspended loss of $1,000 in his S corporation due to lack of basis. The $1,000 suspended loss is thus treated as a loss in year 2.

Year 2: Andy contributes no additional money. The S corporation sustains a $3,000 loss. The $1,000 suspended loss from the previous year plus the $3,000 loss from the current year total a $4,000 total loss for year 2. Since Andy never increased his basis, he still cannot deduct any loss under the at-risk rules.

Year 3: Andy decides to go out of business for lack of funds. The $4,000 suspended loss from the previous 2 years is treated as a loss for year 3 under IRC Section 465(a)(2).

Can Andy deduct the $4,000 in year 3 simply because he decided to go out of business? No because going out of business does not increase basis. The $4,000 continues to be carried over from year to year and treated as a loss in each subsequent year, until Andy somehow increases his basis in the activity.

What if Andy were to sell his stock for $20? Nothing, because selling your stock for any amount of money does not increase your basis in the stock. If his basis is zero in the stock, he would have a $20 capital gain upon sale, and continue to have a $4,000 suspended loss being carried over for all eternity.

In other words, unlike the passive activity loss limitation rules were selling your activity frees up prior year suspended passive losses, losses suspended under the at-risk rules continue to be suspended until basis increases to free up the losses.

[JON]

I read briefly,

but if loans that caused the losses are not going to be paid you have income on discharge of indebtness, in the corporation. When you dissolve that will be income and carryover losses will be used up. Now because in 2000-2004 losses were split differently then the recapture in the year of dissolving-my guess is the 100% stockholder at the end will have more income at the end (debt discharge) then the suspended loss. How they got bank loans and business credit cards I do not know, but when you wipe out the balance sheet unless you have some information not presented you have some income. There could be other issues to also consider-I rambling-back to returns.

[phoenyx]

Bees Knees,
Thank you very much for your reply, it makes a lot of sense. It unfortunately contradicts advice given from the IRS, but it's not like IRS agents haven't lead me down the wrong path before.

Jon,
You bring up an interesting point. If none of the creditors issue a 1099-C, and the statue of limitations runs out, does that need to be reported as cancellation of debt income, even if the creditors never indicate to him that the debt is considered cancelled?

Everyone,
I created a new post titled "Insolvant S-Corp -- dissolve or keep for 10 years for possible tax benefit". It's related but a seperate question, so I decided to create a new post. I would appreciate it a ton if you would look at that also.

[Barnett]

Thanks

Jon , for an excellent reply to this post, The difference between a pure accounting background and one parrot fashion by the IRS is obvious all respondents need to look beyond what is a schedule and tax fact finding and exercise judgement , There is more to answering a question logically than be under the constant eye of penalities if you don't say the right thing tax-wise , IMO use your accounting knowledge and APPLY it to your tax questions ,don't try to make tax law fit your case. It doesn't always work.

[David1980]

To understand your situation I think you need to look only at the purpose for the at-risk loss limitations.

Say you invest $1 in an investment and then take $100,000 of losses to offset your other income. The company is structured such that you are not liable for those losses, so the only thing you really can lose is your $1 investment.

Can we say "Major loophole"? Yes... if you could do this, everyone would in order to evade taxes on their other income. Thus the purpose of at risk limitations.

With the at risk limitation you would only be able to deduct your losses upto $1, which is the true amount you lost in this. In my example the $100,000 does not represent a true loss to the individual because they didn't lose it.

Even if the company goes bankrupt and is dissolved, the amount of money that was really lost by the individual is $1. He will *never* get to deduct the $100,000 because he didn't lose the $100,000.