The Perils of Suspended Losses

An S corporation typically exists to earn a profit for its shareholders, but it ends up losing money instead – maybe the business never takes off; key employees leave; or economic, market, and business conditions change. Since an S corporation is a pass-through entity, shareholders can sometimes use losses to offset other income. However, the tax treatment can be complex because special rules apply to S corporation losses. Here are a few things to know if your trust has a stake in an S corporation and you anticipate losses will offset future income upon the termination of the trust.

What is an S corporation?

Subchapter S corporations are a common structure for many types of small and medium-sized businesses with fewer than 100 shareholders.¹ An S corporation’s “pass-through” tax treatment means that, similar to a partnership, the corporation’s income, losses, and deductions will pass through to the corporation’s shareholders and are reported on their individual income tax returns.

IRS rules generally require that S corporation shareholders must be individuals, versus entities such as partnerships, limited-liability corporations (LLCs), corporations, or trusts. However, exceptions apply to certain types of trusts. Specifically, a Qualifying Subchapter S Trust (QSST) and an Electing Small Business Trust (ESBT) allow a properly drafted trust to own S corporation shares, which is often beneficial for tax, estate, succession, and other planning purposes.

For example, an individual with a trust and several businesses (one is structured as an S corporation) might want to elect QSST status for the trust in order to maintain pass-through treatment on the income from their S corporation, while providing for the S corporation shares to go to a specified beneficiary upon the owner’s death. Sometimes unexpected events – like the COVID-19 outbreak, economic recessions, or natural disasters – can derail the even best-laid business plans and can turn a successful company into an unprofitable one.

Tax basis considerations in S corporations

Basis is a fundamental concept in our income tax system. Basis generally refers to the original acquisition cost of an asset, adjusted by many factors throughout the life cycle of an asset, such as depreciation, capital improvements, and various types of losses. Special rules apply for situations where an asset is acquired other than by purchase, such as an item received as a gift or inheritance. Assets received as a gift will retain the same basis as the donor had in the item.  Inheritances receive what is known as a “basis step up.” This means that the basis of an inherited asset will generally be equal to the fair market value of the asset on the date of the decedent’s death. Basis is important because it is the reference point from which capital gain or loss is calculated when an asset is sold. If an asset is purchased for $50 and then sold for $200, the capital gain on the sale will be $150.

In the context of S corporation shares acquired by purchase, basis includes the initial investment and any additional stock purchased in the S corporation. The amount fluctuates based on any pass-through items. For example, income will increase basis while a loss, distribution, or deduction decreases it.²

Pass-through losses

When a trust is an S corporation shareholder, the corporation’s tax attributes pass through to the trust, just as they would to an individual shareholder. One of the common benefits of pass-through tax treatment is that S corporation shareholders are allowed to individually use any net operating losses generated within the corporation during its business operations.³ This benefit applies to trusts just as it does to individual shareholders.

When an S corporation’s losses pass through to a trust shareholder, that trust can then use the loss to offset its other income. Just as with individual shareholders, it is common for a trust to be unable to deduct some losses in a given year due to insufficient income for the loss to offset. Unused net operating losses can be carried forward indefinitely and used by the trust in a future tax year when it has sufficient income to offset.  However, most trusts will eventually terminate.  This may be due to the death of a beneficiary, a term of the trust that requires termination at a pre-defined time, the trust being diminished to a point where it becomes uneconomical, or other reasons. Fortunately, the tax code allows any unused loss carryforward to be distributed and used by the beneficiaries of a terminated trust.

When a trust is terminated

Trust property, including any S corporation shares, is distributed to the trust’s beneficiaries when the trust is terminated. In addition to the distribution of property, the IRS allows the trust to distribute certain tax attributes to the trust beneficiaries upon termination, including losses.

Code Section 642(h) provides that if, on suspension of a trust, the trust has an unused net operating loss carryover, an unused capital loss carryover, or excess deductions in excess of gross income, those unused losses are allowed as deductions to the beneficiaries of the trust and may be carried forward indefinitely by the beneficiaries on their personal income tax returns.⁴ This provision is quite helpful, since important non-tax considerations regarding trust termination can be addressed without worrying that these unused losses will be wasted. However, taxpayers should be aware of special rules that may prohibit an S corporation shareholder, including a trust, from using an otherwise allowable loss or loss carryforward.

Suspension of S corporation losses

While Code Section 642(h) allows the trust beneficiaries to utilize a terminated trust’s unused operating and capital losses, those losses can only be used by the beneficiaries if they existed within the trust at the time of termination. This is generally not an issue in the context of a loss carryforward, since the carryforward exists and is reported each year until it is fully used. However, special rules that apply to S corporations may prevent losses not only from being used, but also from being carried forward and even existing at trust termination. This is due to the loss limitation rules of Code Section 1366(d)(1), which prevents an S corporation shareholder from taking a pass-through loss that exceeds the shareholder’s basis in their S corporation shares.

Code Section 1366(d)(1) provides that the aggregate of losses and deductions available to an S corporation shareholder is limited to the shareholder’s basis in their S corporation shares. If the combination of net operating losses, capital losses, and deductions in excess of gross income are greater than the shareholder’s basis in their shares, then the excess loss is suspended. For example, if the sole shareholder of an S corporation has a basis of $100,000 in their shares, and that corporation realizes a $150,000 loss in a given year, the shareholder would be limited to a pass-through loss of $100,000 in that year. The remaining $50,000 of the loss is suspended until a future year in which the shareholder has sufficient basis to utilize it.

Code Section 1366(d)(2) goes on to say that the suspended loss is treated as having occurred in the next taxable year. However, if the shareholder still has insufficient basis to use the loss in that following year, it would be treated as having occurred in the next year, and so on, until the shareholder has sufficient basis. The result of the loss-limitation provision is that the loss never actually occurs for tax purposes until the shareholder has sufficient basis to absorb it. This means that the suspended loss may never occur before the shareholder sells their shares or passes away. When the shareholder is a trust, the question arises as to what happens to the suspended loss when the trust terminates. If the loss is still suspended due to insufficient basis in the year of termination, then there is no loss to be distributed upon termination because the loss never actually exists until it can be used.

While it may be tempting to think of a 1366(d) suspended loss as just another type of loss carryforward, this is not the case. Unlike a loss carryforward that exists within the trust and can be distributed to the beneficiaries upon trust termination under Code Section 642(h), a loss that is suspended under 1366(d) does not exist for tax purposes and therefore cannot be distributed to the beneficiaries upon termination, or to any other person in any way. This rule is expressed in Treas. Reg. 1.1366-2(a)(5)(i), which states that the suspended loss “is personal to the shareholder and cannot in any manner be transferred to another person…If a shareholder transfers all of the shareholder’s stock in the corporation, any disallowed loss or deduction is permanently disallowed.”⁵ In the context of a trust, the 1366(d) suspended loss is personal to the trust and cannot be transferred to any other person under any circumstance, not even to the trust beneficiaries upon termination. 

The bottom line is trustees who hold S corporation stock in trust should consider whether existing or potential losses are at risk of being wasted upon trust termination. Therefore, the provisions of Code Section 642(h) dealing with the distribution of operating and capital loss carryforwards to beneficiaries upon trust termination will not apply to a trust’s Section 1366(d) suspended losses. If that is the case, trustees should consider strategies to increase the trust’s basis to utilize the losses before the trust is terminated. As always, if you have questions about your S corporation or trust, feel free to reach out to one of our advisors for a consultation.