IRS Issues Practice Aid on S Corporation Stock Basis Ordering Rules

October 1, 2018

In early January 2018, the IRS issued a practice unit on the S Corporation stock basis ordering rules. A practice unit is issued by the IRS’ large business and international group and consists of training materials and job aids to educate IRS agents on specific issues. While practice aids cannot be relied upon to support a position taken on a tax return, they do provide insight into how the IRS is instructing their agents to interpret and apply the tax law.

Stock basis ordering rules are important to determine the deductibility of pass-through losses and whether or not a distribution is tax-free. These rules are described in Treas. Reg. 1.1367-1. Debt basis also plays a role on the treatment of pass-thru loss deductibility and is beyond the scope of this article.

The default ordering rules adjust stock basis as follows:

  1. Increased for income items
  2. Decreased for distributions
  3. Decreased for non-deductible expenses
  4. Decreased for loss and deduction items

The major effects of the default ordering rule are:

  • Distributions are tax-free to the extent of the stock basis at the beginning of the year plus current year income items.
  • Deductible losses may be partially or fully suspended if the basis is eaten up by non-deductible expenses.
  • Non-deductible expenses in excess of remaining basis are not carried over to the following year.

However, an election can be made under Treas. Reg. 1.1367-1(g) to reverse the order of items 3 and 4, above. Thus, the optional ordering rules become the following:

  1. Increased for income items
  2. Decreased for distributions
  3. Decreased for loss and deduction items
  4. Decreased for non-deductible expenses

The effect of this is to allow loss deductions that may have otherwise been suspended in a situation where a corporation has large non-deductible expenses that eat up basis. Making this election may seem like a good idea for everyone to do. However, the downside is that any nondeductible expenses in excess of basis are carried over to the following year. Unlike the default ordering rules, they are not forgiven.

This election is made by filing it with the tax return for the year the election is to take effect. A return can also be amended to make this election, which in effect permits a taxpayer to make this election to change the ordering rules even during the course of an IRS audit. Once the election is made, the taxpayer must continue to use the alternate ordering rules for all subsequent years. This election can be revoked by obtaining permission from the IRS.

The IRS continues to fine tune their audit process and better train their agents to look for specific issues. It is important that you are proactive and document your basis in your S Corporation will serve you well in the event of an IRS examination.

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