S Corp Bankruptcy and Passive Losses

[George18]

I have shares of an S Corporation that were purchased in 2010. In 2010,11, and 12 the company had unallowed losses that were carried over. The stock was purchased for $10,000; the total unallowed loss for the three years was $14,000. 

In 2019, the company abruptly stopped all operations and subsequently filed for bankruptcy. There is no chance of any compensation to the stockholders.

Usually I can figure out new situations, but this one is stumping me. IRS Topic 425 says that any previously disallowed passive activity loss may be deducted in full in the year the interest is disposed. It looks like Schedule D, Form 8949, and Schedule E can all come into play with this. Can anybody give me the right path to follow for this scenario? Thanks in advance.

[Rick19744]

Let's get some better facts:

• The S corp began in 2010 in which you contributed $10,000
• What were your share of the losses in each of 2010, 2011 and 2012?
• What has happened since 2012 as nothing has been mentioned about the gap years; from 2012 to 2019
• Have you received any K-1's since 2012?
• Do or did you materially participate in the S corp in any of the years since inception?
• Do you have a copy of the bankruptcy filing?
• Have you either contributed additional $$ or loaned $$ to the S corp subsequent to your initial capital contribution? 

[George18]

• The S corp began in 2010 in which you contributed $10,000
• What were your share of the losses in each of 2010, 2011 and 2012?

$2.500, $5,000, and $6,500 I'm using rounded figures. The math I can do; it's the concept and process I need.

• What has happened since 2012 as nothing has been mentioned about the gap years; from 2012 to 2019

There was no K-1 or other statement from the company until a they defaulted on some notes, the lenders came knocking, and the next day they were closed.

• Have you received any K-1's since 2012?

No

• Do or did you materially participate in the S corp in any of the years since inception?

No

• Do you have a copy of the bankruptcy filing?

Yes. Note that this all fell apart when the majority stockholder (I had 1%) has been indicted for federal fraud and other charges. The company was dissolved and equipment, etc. disposed.

• Have you either contributed additional $$ or loaned $$ to the S corp subsequent to your initial capital contribution? 

No

[Rick19744]

Good follow-up response.  Now for direction:

• You are only allowed to take a loss when the facts indicate that there is essentially no recovery possible.  Having a copy of the bankruptcy notice should substantiate no further recovery. 
• Based on the facts, you are a passive investor and the losses that passed through were disallowed as you did not have any other passive income to use the losses.  I am assuming this from the facts.  If this is not correct, please update.
• If bullet two is correct, then you are able to take losses up to the amount of capital you contributed; $10,000.  Even though you have $4,000 in additional losses, you do not have any "at-risk" to take those losses.  You can't take more losses than you were economically out of pocket.  The $4,000 in losses will be lost.
• Bullet number 3 could change if you guaranteed any debt and are legally required to contribute additional funds.  However, I assume this is not the case as a 1% shareholder.
• Sch D and form 8949 do not come into play.  Your losses will be ordinary losses.  As noted previously, since you have no remaining basis after taking the $10,000 in ordinary loss, there is neither capital gain or loss at this point.

[George18]

• You are only allowed to take a loss when the facts indicate that there is essentially no recovery possible.  Having a copy of the bankruptcy notice should substantiate no further recovery. Got it!
• Based on the facts, you are a passive investor and the losses that passed through were disallowed as you did not have any other passive income to use the losses.  I am assuming this from the facts.  If this is not correct, please update. Correct!
• If bullet two is correct, then you are able to take losses up to the amount of capital you contributed; $10,000.  Even though you have $4,000 in additional losses, you do not have any "at-risk" to take those losses.  You can't take more losses than you were economically out of pocket.  The $4,000 in losses will be lost. That sounds logical! But when I read IRS Topic No. 425 Passive Activities - Losses and Credits,  it says "Generally, you may deduct in full any previously disallowed passive activity loss in the year you dispose of your entire interest in the activity." It says Form 8582 applies. This is where I can't reconcile the issue.
• Bullet number 3 could change if you guaranteed any debt and are legally required to contribute additional funds.  However, I assume this is not the case as a 1% shareholder. Does Not Apply
• Sch D and form 8949 do not come into play.  Your losses will be ordinary losses.  As noted previously, since you have no remaining basis after taking the $10,000 in ordinary loss, there is neither capital gain or loss at this point. What form do I use to take the ordinary loss?
• Thank you so much for your help. It's beginning to come into focus.

[Rick19744 · Accepted solution]

Follow-up comments:

• IRS Topic 425 is correct, but it is way to general.
• What happens in the loss world with pass-through entities is that there is a hierarchy of rules that need to be addressed.  In order to be allowed to take losses, one must first look to basis, then at-risk rules and finally if both of those hurdles are cleared, you look to the passive activity rules.  In your case here, since you only have $10,000 in capital invested, you don't get past the basis or at-risk component.
• Enter your information in TT just like you would normally.  Answer all the questions, including if there was a full disposition and there should also be a question as to whether you are at risk.
• You had a full disposition, but you are not fully at risk.  This should ask some additional questions and complete form 6198.  This form will be what limits the loss to the $10,000 and will come through as ordinary loss. 
• Finally, in a perfect world, you should have only input $10,000 of losses in total previously since that is the extent of your basis.  In this case, you would have only had to indicated you had a full disposition and TT would have then taken the full $10,000.

[George18]

Thanks. Now I can forge ahead and render unto Caesar.