Case — S Corporation At-Risk Rules

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TL Case Summ

THE QUESTION

Does pledging stock in a loan transaction provide at-risk basis so an S corporation shareholder can deduct flow-through losses?

THE DISPUTE

Taxpayer Says: The stock represents an ownership interest in the business that can be sold or transferred without affecting corporate assets. Stock is separate and distinct from the activities of the corporation. Pledging the stock should allow an increase in at-risk basis in order to deduct flow-through losses.

Internal Revenue Service Says: The stock is property used in the business, so the taxpayer is not at risk of loss and the losses are not deductible.

THE LAW

From Internal Revenue Code Section 1366(a): A shareholder of an S corporation can directly deduct entity-level losses in accordance with the flow-through rules of subchapter S.

From Internal Revenue Code Section 1366(d)(1)(A) and (B): The losses cannot exceed the sum of the shareholder’s adjusted basis in the stock and the shareholder’s adjusted basis in any indebtedness of the S corporation to the shareholder.

From Internal Revenue Code Section 465(a): The at-risk rules ensure that a taxpayer deducts losses only to the extent he or she is economically or actually at risk for the investment.

From Internal Revenue Code Section 465(b)(2)(A): The amount at risk includes cash contributions and certain amounts borrowed with respect to the activity for which the taxpayer is personally liable for repayment.

From Internal Revenue Code Section 465(b)(2)(B): Pledges of personal property as security for borrowed amounts are also included in the at-risk amount. The taxpayer is not at risk, however, for any pledge of property used in the business.

THE CAUSE OF THE DISPUTE

When you’re a shareholder in a subchapter S corporation, income or losses generated by the corporation are reported on your personal tax return. In the case of losses, tax rules limit your ability to deduct the full amount on your return. Limitations include your basis in the corporation, the amount you are “at risk”, and the extent of your involvement in the business.

The at-risk rules mean you must have an economic stake that you can lose. In general, you’re considered at risk for money and the adjusted basis of other property you contribute to the business, as well as certain loans to the business for which you are personally liable or have pledged property.

Your at-risk basis is computed in a similar manner as your stock and debt basis, though the ending balance may differ. Even if you have stock and/or debt basis in your S corporation, your deductible loss may be limited by the at-risk rules.

One aspect of this case involves whether the taxpayer, who pledged shares of an S corporation as partial security for a loan, had at-risk basis and could deduct losses of $16 million over a five year period. The question centers on the meaning of “property used in the business”, because property meeting that definition–in this case, the pledged stock–is not included in the at-risk amount.

In order to expand, the taxpayer’s S corporation borrowed money from a commercial lender and advanced the money to related entities that were also owned by the taxpayer. The commercial loan was secured by the assets of those related entities, and those entities incurred the losses the taxpayer deducted on his return.

The taxpayer also pledged his stock in the S corporation as security for the commercial loan, though he did not personally guarantee it.

The taxpayer says the pledged stock is not “property used in the business” for at-risk purposes because the stock represents an ownership interest in the business that can be sold or transferred without affecting corporate assets. He argues the stock is therefore inherently separate and distinct from the activities of the business, and that pledging the stock to secure the loan should increase his at-risk basis in the related entities (who actually received the proceeds), allowing the losses.

The IRS says pledged property must be unrelated to the business in order to count as at-risk. Since the S corporation is related to the other entities, the pledged stock does not count, and the taxpayer is not at risk and cannot take the losses.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 51KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. The related entities were formed to expand the existing S corporation’s business and the S corporation used the assets of those entities to provide services. The S corporation stock is related to those entities. Further, the taxpayer was not economically or actually at risk with regard to the activities because he never personally guaranteed the loan, nor was he ever personally liable on the advances to the related entities. The structure of the transaction made it highly unlikely the taxpayer would experience a loss. The pledge of stock did not put the taxpayer at risk to allow pass-through losses. Editorial Note: Other issues in this case include depreciation allocations, debt basis, the definition of an active trade or business, and the starting date for amortization deductions.
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