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

[phoenyx]

In Michigan...

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.

 

[tranquility]

At the proposed regs in Prop. Reg. 1.465-66(a) the same at risk rules apply when an S corporation redeems a shareholder's interest. At Prop. Reg. 1.465-67 and 68, if the transferee's basis in the activity or the entity conducting the activity is determined in whole or in part by reference to the basis of the transferor, any suspended losses are added to the transferee's basis in the property, and if the taxpayer has an amount at risk greater than the losses from the activity, the excess is added to the transferee's amount at risk.

In a true bona fide sale, we would adjust the basis of the stock. It must be adjusted by the shareholder’s pro rata share of income, loss, and deduction items for the year of sale. Your problem is that, on a bona fide complete disposition, the suspended losses are freed up. Here, you still have at risk rules to follow. At Prop. Reg. 1.465-1(e), we know the at loss rules only affect what loss can be passed through the limitation does not affect the rules determining the basis of stock. if a shareholder of an S corporation has basis in that stock, losses passed through from the corporation will decrease that basis under Code Section 1367(a)(2)(B) even though the shareholder may be prevented from deducting the losses by the at-risk rules.

So, with all that, we have the winding up of the S-corp and the hope the losses are freed up in some way. When an S election ends, any losses suspended under the at-risk rules are carried forward to the last day of the S corporation's post-termination transition period so going back to amend would not be appropriate. Code Section 1366(d)(3)(A).

So, I'm not sure they do become "unsuspended". But, what I do know is that you ain't going to get a better answer than the rubbish I just wrote here on the forum without a search of the case law. When you do, please post back as it is an interesting question.

 

[phoenyx]

Tranquility,

Thank you so much for your reply. It is very detailed, and gave me a starting point to do some research.

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.