handling passive losses in S corporation shareholder basis (Form 7203)

[taheri1]

Hello,

I am trying to understand the interplay between passive activity loss rules and basis limitation rules.

The S corp  in which I am a shareholder has a passive real estate activity which generates a loss year after year which is reported in Box 2 of my K-1.

In my individual tax returns, I have always carried these losses forward on Form 8582 (Passive Activity Loss Limitations).

Now comes along Form 7203 (S corp Shareholder Stock and Debt Basis Limitations) . Let's assume that my K-1 has a negative entry (i.e. loss) in Box 2 for the current tax year. Do I make an entry on Line 36 in Part III of this form (7203) or leave it blank? Please explain. 

Is the following statement true? If a shareholder cannot take advantage of Passive Losses in his individual tax return for a given year, those losses should NOT decrease his Basis in the S-corp.

Thanks.

[tagteam]

@Mike9241 

[Rick19744]

Your basis is reduced regardless of whether you are able to take the losses due to the passive activity limitations.

So you reflect the loss on form 7203 to the extent it does not cause basis to go below zero.

Form 7203 is the IRS attempt to have a consistent S corp basis reporting form.  

If you have no basis to take the loss, then the loss is not reported and does not even flow to the 8582.  These forms serve different purposes.

[Mike9241]

I thought I had responded previously. TURBOTAX PROGRAMMERS TAKE NOTE THE 7203 DOES NOT WORK TO LIMIT LOSSES TO BASIS. THIS REALLY SUCKS BECAUSE I CAN'T IMAGINE HOW MANY TAXPAYERS HAVE NOW FILED WITH INCORRECT RETURNS. HOPE INTUIT IS GOING TO FESS UP THAT IT SCREWED UP AND PAY TAXPAYER PENALTIES THAT RESULT.

there are actually three concepts that need to be dealt with to limit losses. One is at-risk - form 6198. Another is tax basis - form7203.  Finally, there is the passive loss limitation - form 8582. since the 7203 doesn't work but is required you must fill it out. you must also fill out form 6198.   the tax laws say your deductible losses, before taking into account any passive loss limits, are limited to the lesser of your tax basis or the amount at-risk, for most S-Corp shareholders their tax basis is the same as the at-risk amount at the beginning of the year. once the allowable loss is computed under either of these two concepts the the PAL rules come into play

some examples. 

1) you borrow $100 from a bank.  you personally guarantee the loan and put the money into the S-corp

result your at-risk amount increases by $100, your basis increases by zero

2) same as above but you borrow from the bank in your name and then you put the money in the S-Corp

result your at-risk and tax basis increase by $100

3) you borrow $100 from a bank on a nonrecourse basis pledging the S-Corp assets. you loan the $100 to the S-Corp

result your at-risk goes up zero your basis goes up $100 

these are complicated concepts because of all the rules, court decisiona and IRS pronouncements that must be considered. 

[taheri1]

I’m still not 100% clear. Let’s use numbers and let’s make the example a little more complicated by introducing capital gains. So, now we have the interplay of passive losses and capital gains to consider. I will try to show how passive losses can lead to double taxation of capital gains.

To simplify, let’s assume an S-corp with a single shareholder. Suppose that the S corp receives equity capital contributions from its shareholder totaling $1.1M. The shareholder’s Stock Basis is now $1.1M.

Suppose that the S-corp invests $1M in a real estate asset whose financials drive Box 2 of the shareholder’s K-1. Next, suppose that the S-corp invests the final $100K of cash into a publicly traded stock.

Everything so far has happened in year 1, by assumption, and the S-corp didn't exist before year 1.

Let’s assume that the real estate asset generates a Box 2 loss of $1.1M in year 2 and another loss of $1M in year 3 and then nothing for years 4 and 5. Let's assume that this activity is a passive activity for the shareholder.

Let’s assume that the publicly traded stock is sold for $1.1M in year 4 and that the proceeds ($1.1M) are distributed in year 5 (one year later) as a non-dividend distribution (reported in K-1, Box 16).

Now let’s follow what happens to Shareholder Basis. (There’s no loan basis, so I’ll just refer to Stock Basis as “Basis”.)

In year 1, Basis increases from zero to $1.1M. I.e. the shareholder’s capital contribution.

In year 2, Basis is reduced by $1.1M and falls to zero. (Why? Because of the Box 2 loss of $1.1M from the real estate asset.)  The shareholder also gets to increase  unallowed passive losses that he is carrying forward on Form 8582 by $1.1M. (For completeness, these unallowed losses change from -$X to -$X - $1.1M. They become more negative by $1.1M.)(Also, the shareholder's K-1 will show a Box 2 entry of -1.1M, which is what eventually leads to the increase in magnitude of unallowed passive losses on Form 8582.)

In year 3, Basis cannot fall below zero, so the new $1M of loss from Box 2 is carried forward; this happens on Form 7203 I believe.  (Does this mean that the shareholder doesn't report this Box 2 loss in his individual tax return? Sounds like it. Does it mean that because of this, the loss carryforward amount on Form 8582 doesn't change? Sounds like it. In previous years, i.e. before Form 7203 was introduced, TurboTax would ask me to enter my Box 2 loss and I would enter it without giving Basis matters any thought ... I.e. without having to INTERPRET the loss.)

In year 4, the sale of publicly traded stock generates capital gain of $1M. (i.e. $1.1M sale price minus $100K cost basis.) This causes basis to increase by $1M. But then the $1M of Box 2 loss that had been carried forward becomes “allowed” and reduces basis by $1M. The net effect is a basis of zero with no amount left to be carried forward anymore. (I'll ignore what happens to Form 8582, but the same ambiguity as in year 3 seems to be present. I'm guessing that the loss carryforward amount on that form would increase in magnitude by 1M.)

Also in year 4, the K-1 will report capital gains of $1M to the shareholder. The shareholder then reports a $1M capital gain on his individual tax returns and PAYS CAPITAL GAINS TAX ON THAT GAIN. (Assume that he doesn't have any capital loss carryovers or same-year capital losses to offset these gains.)

In year 5, the shareholder receives a (non-dividend) distribution of $1.1M. Because Basis is already zero, IT WOULD IMPLY THAT THIS $1.1M DISTRIBUTION IS TAXABLE. But doesn’t this equate to DOUBLE TAXATION? Let’s consider an alternative example where we would exclude the $1M real estate asset investment from start to finish, in which case there won't be any double taxation.

Let’s assume that in year 1, the shareholder contributes $100K to the S-corp which then buys a publicly traded stock and sells it in year 4 for $1.1M and makes a $1.1M distribution in year 5. 

In year 1, Basis would be $100K at the end of the year.

In year 4, upon the sale of publicly traded stock which generates a capital gain of $1M, Basis would rise to $1.1M. Meanwhile, the shareholder’s K-1 would pass this capital gain through and the shareholder would pay capital gains tax on this $1M of capital gains.

In year 5, the S-corp would distribute $1.1M thereby causing Basis to drop from $1.1M to zero. This non-dividend distribution would NOT be subject to any tax, contrary to the first example. It's not subject to any tax because the distribution doesn't cause Basis to fall below zero.

What am I missing?

In a nutshell, in my first example, the presence of huge passive losses seem to distort Basis in such a way that they cause double taxation of non-dividend distributions that are driven by unrelated capital gains. Surely, I have misunderstood something.  In case I haven't, then the only workaround would be to IGNORE the Box 2 passive losses form having any impact on Basis (until the real estate asset is sold).  And to let them continue to impact Form 8582 as I had done historically. Another workaround might be to let these passive losses enter Form 7203 BUT ONLY as carryover amounts and never as allowed amounts (until the real estate asset is sold).

My first example is an edge case.  In practice, the shareholder may actually have enough basis to cover the distribution. But I am still concerned about processing my taxes correctly, and by myself. And I wonder whether lawyers who wrote the tax law took into consideration difficulties such as this one. I also wonder whether there are superior software tools being used by CPA's.

Thanks.

[Mike9241]

as i see it you are supplying incomplete data

at the end of year 1, you have a tax basis/at-risk amount in the S-corp of $1.1M

The S corp has real estate with a tax basis of $1M and stock with a tax basis of $.1 M

you say that in year 2 the real estate loses $1.1M

how is this possible? the bookkeeping entries, in summary, would be a debit to expenses of $1.1M but what is credited to balance the books?  even if you credit the Real estate for $.1M for depreciation that leaves $1M unaccounted for. so there is a piece that is missing.  put another way, if the depreciation of the real estate is    $ .1M that leaves a cash loss of $1M. where did that cash come from? 

even worse is year 3 where there is another $1M loss

how is this possible?  say the real estate is reduced another $.1M for depreciation. the bookkeeping entry, in summary would be a debit to expenses of $1M,  a credit to accumulated depreciation of $.1M but where's the other $.9M credit,  in other words how is this $.9M loss funded? 

go see a tax pro where they can look over the actual transactions

[taheri1]

You asked, how is this possible?

The S-corp that I'm dealing with invested in an LLC which invested in real estate which generated the kinds of losses that I had described. The magnitudes in my example are all faithful to the real situation.

So, it is possible.  My dilemma is how to resolve the situation.

[Mike9241]

then the missing info is the K-1 for the real estate investment as i said see a tax pro because there might be basis limits at that partnership level. 

[Rick19744]

There are a number of issues here:

• The introduction of form 7203 does not change how the losses flow through the tax return
• form 7203 is only a form to show the IRS what your tax basis is.  Nothing more.  They just wanted to have some kind of consistent form for showing tax basis, instead of dozens of different methods of tracking tax basis presented by taxpayers.
• Your issue and comments for year 3 are not totally correct.  You are correct in that no additional losses are to be reflected on form 8582; and this is because you have no tax basis.  Your comment that in past years you just input the loss from box 2 was done incorrectly.  You, the taxpayer, needed to understand your tax basis and should not have been inputting this amount......you should have been tracking your tax basis on your own, how ever you wanted to track it, and then known that you had no basis and should not be inputting any loss from box 2.  However, see next bullet which would impact the input.
• In year 3, based on your facts, should have used form 6198.  This will limit any losses in TT and track them separately.
• There are 3 loss limitations; your tax basis (also your at-risk being an S corp), your passive loss limitation and the excess business loss limitations.  All are separate.  Nothing has changed in the tax world regarding reducing tax basis by losses even when they are not allowed due to some other reason; ie at-risk or passive activity.
• While I don't have a sufficient understanding of your situation, nor is this forum the place to dive into this type of a transaction / structure, I believe you may have a bad structure.
  • You are using an S corporation that invests in an LLC (taxed as a partnership) which then invests in real estate.  The LLC is a completely different structure and the tax basis and at-risk rules are also completely different.
  • The LLC is able to use nonrecourse debt for tax basis and can use qualified nonrecourse debt for at-risk purposes.  However, once those losses pass through to you at the shareholder level, that stops.
  • An S corporation does not get those same debt advantages for tax basis and at-risk.
  • You should also have a tax basis schedule at the S corporation level of its investment in the LLC.  If the S corp doesn't have sufficient basis in the investment, then the losses are suspended at the S corp level.
• I concur that you need to meet with a tax professional and visit your structure and goals for this investment.

[jlw0003]

I have spent hours working with the TurboTax reporting of S-Corp loss limitation interactions (admittedly a very complicated area of tax law--like most). I have not tested every possible situation, but I believe I have discovered the major problems a lot of users are having with this (many posts on this over the last few years), and solutions that TurboTax developers could change to fix it.

I have a situation with two consecutive years of S-Corp passive losses, the first year of which eliminated the stock basis (and no debt basis). In the second year (2023) I finally determined that I filled in the forms for the first year (2022) incorrectly; although the 2022 tax calculation was ultimately correct, Form 6198 was not completed and the proper non-allowable amounts did not carryover to 2023, causing a lot of confusion.

The problems and fixes:

1. The IRS instructions for the various rules and forms (K-1, 7203, 6198, 8582, and QBI) are certainly not easy to understand by the lay person, are disjointed and not well laid out. However,

2. The tax experts at TurboTax have not done anywhere near an adequate job of guidance in the interview sections of the application. The questions asked about All investment at risk and at-risk loss carryovers should be explained more clearly and completely, not just links to IRS verbiage, with guidance on how to answer them. Particularly explaining the connection with the basis limitation and the fact that if stock basis is zero one does have an at-risk loss limitation. If a loss wipes out the stock basis (determined on Form 7203), one must NOT check the box for the "ALL my investment in this activity is at risk. It is not at risk if the stock basis is zero! Also, if there is an at-risk limited amount, it should not be reported as a passive loss on Form 8582--it is carried over to the future to be reported when the loss becomes allowed under the basis and at-risk rules. No where that I can find is this connection made in the IRS instructions or TurboTax interview. If this box is checked, relevant follow-up questions in the interview will not appear and the unallowed loss will show up as a passive loss on Form 8582, potentially doubling up the passive loss eventually. Also, in the following year, the box in front of "I have at-risk losses carrying over..." MUST be checked to pick up this carryover.

3. The programmers could also make this process easier by integrating the forms better, especially 7203. Why can't this form be completed from the interview? Or at least explained better than just throwing it up in the interview with no guidance on how to complete it. It is a quite confusing form and not easy to complete manually.

I hope this is helpful and will be taken into consideration by TurboTax to make improvements.