Business & farm

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.