IRS to Provide Additional Support for Basis Adjustment Method

INDERPAL S. KANWAL & HARPREET
K. KANWAL, ET AL.,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent

United States Tax Court

ORDER

These consolidated cases involve the four shareholders of Client Network Services, Inc. (CNSI), a subchapter S corporation. In prior, closed years, the shareholders deducted losses from the corporation in excess of their bases in the corporation's stock. Respondent contends that the deduction of those losses, in violation of section 1366(d)(1),¹ would give rise to double deductions or their equivalent in the years before us (taxable years 2011, 2013, and 2014). To prevent that result, in accordance with what we understand to be an established practice, respondent seeks to employ a method of basis adjustment under the authority of Treasury Regulation § 1.1016-6(a), which requires adjustments to basis “to eliminate double deductions or their equivalent.” Under respondent's method, the losses deducted by each shareholder in excess of his stock basis in prior, closed years are recorded in a “suspense account.” The balance of the suspense account would then be applied to reduce the shareholder's stock basis in the earliest open years, thereby requiring the shareholder to recognize income or gain beyond that reported. Each side has moved for partial summary judgment on the legality of respondent's basis adjustment method.

In a conference call with the parties' counsel on July 14, 2023, we discussed questions we had about each side's arguments. The basis adjustments respondent seeks to make for 2011 would prevent the shareholders from deducting losses carried forward from prior years that do not include the erroneously deducted losses. In our call, we questioned whether the deduction of those losses up to the limit prescribed by section 1366(d)(1) would provide the shareholders with double deductions or their equivalent, thus warranting adjustments to the shareholders' stock bases under Treasury Regulation § 1.1016-6(a). We accepted that the shareholders' deduction of losses in excess of their stock bases in years before 2011 could give rise to double deductions or their equivalent in 2013 and 2014. But we raised the prospect that making basis adjustments to prevent the shareholders' deduction of carryover losses in 2011 would require Treasury Regulation § 1.1016-6(a) to be applied prophylactically. And we questioned whether the regulation authorizes prophylactic basis adjustments.

During our call, respondent's counsel argued, first, that, in the absence of adjustments under Treasury Regulation § 1.1016-6(a), the shareholders' deductions of their carryover losses in 2011 to the extent allowed by section 1366(d)(1) would provide them with the equivalent of double deductions. Respondent's counsel, as we understood them, also argued that, even if the shareholders did not realize double deductions or their equivalent until 2013 or 2014, respondent was nonetheless justified under Treasury Regulation § 1.1016-6(a) in making basis adjustments prophylactically to prevent those double deductions or their equivalent.

Respondent's counsel used a simple, hypothetical example to illustrate their position. In the example, a shareholder of an S corporation has a zero basis in his stock in the corporation at the start of Year 1. During Year 1, the corporation allocates to the shareholder a $100 loss. The shareholder deducts that loss, in violation of section 1366(d)(1). In Year 2, the corporation allocates to the shareholder another $100 loss. In that year, the shareholder properly applies the section 1366(d)(1) limitation: He does not deduct the Year 2 loss in that year but instead carries it forward to Year 3 under section 1366(d)(2). In Year 3, the corporation allocates $100 of income to the shareholder. The shareholder reports the income but also deducts his $100 loss carryover.

If the shareholder's tax situation were assessed when the period of limitation did not bar assessment of additional tax for any of the three years, the appropriate treatment of the shareholder would be to deny the $100 deduction he claimed in Year 1. The example thus rests on the premise that the shareholder's Year 1 is closed. Respondent's counsel reason that the shareholder's deduction of a $100 loss in Year 1 without a concomitant reduction in the shareholder's stock basis (which cannot be reduced below zero) can or will allow the shareholder to realize either a double deduction or its equivalent.

To prevent that result, respondent's basis adjustment method would record the shareholder's erroneously deducted Year 1 loss in a suspense account. Under respondent's method, the suspense account would be applied to reduce the shareholder's stock basis in the earliest open year. In Year 2, the shareholder has no positive basis to reduce. His basis remains zero. But the income allocated to the shareholder in Year 3 would increase his basis by $100 under section 1367(a)(1). Respondent would apply the $100 suspense account to offset that increase in basis, leaving the shareholder, again, with a basis of zero. The shareholder's section 1366(d)(1) limitation for Year 3 would thus be zero, and the shareholder could not deduct in Year 3 the $100 loss carried forward from Year 2. Instead, that loss would be carried forward to future years. (The example posed by respondent's counsel ends with Year 3.)

Whether the deduction of a $100 loss in Year 3 provides the shareholder in the example with a double deduction or its equivalent raises definitional questions. What do the phrases “double deductions” or “their equivalent” mean when used in Treasury Regulation § 1.1016-6(a)? We would have supposed that a double deduction refers to a second deduction grounded in the same economic loss that gave rise to an earlier deduction. Not all tax allowances, however, take the form of deductions. Therefore, Treasury Regulation § 1.1016-6(a) also requires basis adjustments to eliminate allowances that are equivalent to double deductions. An allowance is “equivalent” to a double deduction, as we would interpret that term, if the allowance takes a form other than a deduction but is grounded in the same economic loss as an earlier deduction.

Treasury Regulation § 1.1016-6(a) suggests that a double deduction or its equivalent involves the use of overstated basis. The regulation requires basis adjustments to eliminate double deductions or their equivalent. If a double deduction or its equivalent can be eliminated by means of an adjustment to basis, it follows that a double deduction or its equivalent — at least within the meaning of Treasury Regulation § 1.1016-6(a) — is an allowance that results from overstated basis.

In our call, respondent's counsel seemed to concede that the shareholder's deduction in Year 3 was not a “double deduction,” within the meaning of Treasury Regulation § 1.1016-6(a). We take that concession to mean that respondent's counsel accept that the shareholder's Year 3 deduction is not grounded in the same economic loss as his Year 1 deduction. We are inclined to agree: The shareholder would have been entitled to the Year 3 deduction whether or not he had erroneously claimed a deduction in Year 1. But respondent's counsel contend that the shareholder's Year 3 deduction, though not a double deduction, is equivalent to a double deduction. What concept of equivalence supports that contention? The reason the shareholder's Year 3 loss is not a double deduction is not that it is an allowance in a form other than a deduction. It is a deduction. It is not a double deduction because it is not grounded in the same economic loss as the Year 1 deduction. If the deduction claimed by the shareholder in Year 3 is not grounded in the same economic loss as the deduction he claimed in Year 1, we have difficulty understanding how the Year 3 deduction can appropriately be viewed as the equivalent of a double deduction.

The shareholder would have been entitled to the Year 3 deduction whether or not he had erroneously claimed the Year 1 deduction. The shareholder's claim of a $100 loss in Year 3 does not depend on his erroneous reporting in Year 1. His prior erroneous reporting provides him no benefit in Year 3 that he would not otherwise have enjoyed. Under the taxpayer's reporting, he carries the $100 Year 2 loss into Year 3 and uses it to offset the $100 of income allocated to him in Year 3. If he had reported properly in Year 1, his loss carryover into Year 3 would have been $200 rather than $100. Under section 1366(d)(1), however, he would not have been allowed to use more than $100 of the $200 carryover loss. The shareholder's reporting in Year 3 — $100 of income offset by a $100 loss — is the same as it would have been if the shareholder had reported properly in the prior, closed year. The basis of the shareholder's stock, taking into account his actual reporting, was zero at the start of Year 3 and zero at the end of the year. His reported basis cannot have been overstated because his basis cannot have been less than zero.

During our call, respondent's counsel suggested that the shareholder's basis becomes overstated in Year 3 when it is increased under section 1367(a)(1) for the income allocated by the corporation to the shareholder. (Indeed, it seems that respondent's position must rest on that premise. If the section 1367(a)(1) increase to the shareholder's stock basis for his Year 3 income does not overstate his basis, we do not see how the deduction of his $100 carryover loss could be characterized as either a double deduction or its equivalent. Again, Treasury Regulation § 1.1016-6(a) indicates that double deductions or their equivalent necessarily involve the use of overstated basis.)

We question whether the section 1367(a)(1) adjustment to the shareholder's stock basis in Year 3 overstates his basis. The statutorily required increase to the shareholder's basis reflects income allocated to and reported by him. Not increasing his stock basis by the $100 of income he was allocated would understate that basis. The shareholder's stock basis would have been increased by his $100 of Year 3 income regardless of whether he had erroneously deducted the Year 1 loss when incurred. Not only was the shareholder's stock basis correctly stated (at zero) at the start of Year 3, we would think it was correctly stated throughout the year and at each step of the process of adjusting that basis from zero to $100 and then back to zero.

Counsel's view that increasing the shareholder's stock basis to $100 would overstate that basis would be correct if his basis at the start of Year 3 were negative $100. But the terms of section 1367 (in contrast to those of Treasury Regulation § 1.1502-19(a)(2)(ii)) do not contemplate negative basis.

If the goal of respondent's method of addressing S corporation shareholders' deduction of losses in excess of stock basis is to mimic negative basis, we do not see how the method can achieve its objective. Treasury Regulation § 1.1016-6(a) authorizes basis adjustments only to eliminate double deductions or their equivalent. Double deductions or their equivalent, at least within the meaning of the regulation, result from overstated basis. Because the basis of an S corporation shareholder's stock cannot be reduced below zero, the deduction of losses in excess of that basis does not result in an immediate overstatement of basis. The shareholder's stock basis does not become overstated until the shareholder increases his basis by income that would otherwise have been offset by the losses erroneously deducted too soon. (The overstatement of stock basis results not from the section 1367(a)(1) increase for the income, but instead from the failure to reduce the shareholder's stock basis by the carryover loss that would have been taken into account had it not been prematurely deducted when the shareholder had insufficient basis.)

Returning to the example, we acknowledge that, at the end of Year 3, the shareholder has deducted $200 of losses when he should have deducted only $100. But the $100 disparity between the claimed losses and the losses the shareholder should have claimed arose not in Year 3 but in Year 1. The shareholder's reporting in Year 3 — $100 of income offset by $100 of loss — did not increase that disparity. Yes, the shareholder's taxable income over all three years has been understated. That understatement, however, is not attributable to the shareholder's Year 3 reporting but to his erroneous Year 1 deduction. If Year 1 remained open, that understatement could be remedied by disallowing the Year 1 deduction. Respondent's ability to effect remediation in an open year through an adjustment to the basis of the shareholder's stock under Treasury Regulation § 1.1016-6(a) depends on identifying a double deduction or its equivalent. A disparity between the losses the shareholder reported over the three years and those the shareholder should have reported does not identify a double deduction or its equivalent. That disparity, again, arose from the claim of the initial $100 deduction.

We also acknowledge, however, that the shareholder's claim of a $100 deduction in Year 1 without a concomitant decrease in the shareholder's stock basis is anomalous. Allowance of a loss without a reduction in stock basis under section 1367(a)(2) can result in overstated basis and, thus, the shareholder's realization of a double deduction or its equivalent. In the example posed by respondent's counsel, however, we do not think that has happened yet in Year 3. Seeing how a double deduction or its equivalent could result from the shareholder's $100 Year 1 deduction with no adjustment to stock basis requires extending the example further.

Suppose that, in Year 4, the corporation allocated to the shareholder another $100 of income. And in Year 5, the corporation distributed $100 to the shareholder. The shareholder increases the basis of his stock by $100 under section 1367(a)(1) as a result of the $100 of income allocated to him in Year 4. Then, in Year 5, the shareholder treats the $100 distribution as tax-free return of capital under section 1368(b)(1).

By Year 4, the shareholder has reported the correct amount of net income. Over the four years, he has reported a total of $200 of income and $200 of losses. He simply reported $100 of the losses too early. The shareholder's having reported the right amount of net income over the four years combined, however, does not ensure that he will not realize a double deduction or its equivalent from having deducted $100 of his losses too early. Understanding why requires consideration of the effect of the shareholder's prior, erroneous reporting on his stock basis.

Although the shareholder's zero basis at the end of Year 3 was not (and cannot have been) overstated, his $100 reported basis at the end of Year 4 is overstated. If the shareholder had reported properly in Years 1 through 4, his stock basis at the end of Year 4 would have been zero. Under proper reporting, the shareholder would have carried his $100 Year 1 loss forward to Year 2. His $100 additional Year 2 loss would have increased his carryforward to $200. He would have used $100 of that carryforward in Year 3, leaving him with $100 to carry forward to Year 4. The zero stock basis the shareholder had at the start of Year 4 would have been increased by $100 under section 1367(a)(1) and decreased by $100 under section 1367(a)(2), leaving his basis at zero at the end of the year. By deducting the $100 Year 1 loss in the year it arose, in violation of section 1366(d)(1), the shareholder avoided the $100 reduction in his stock basis under section 1367(a)(2) that would have occurred had he deducted that $100 loss at the proper time, in Year 4.

Whenever the shareholder uses that $100 of overstated basis — whether to deduct a loss, reduce gain, or (as posited) treat a distribution as a return of capital — the shareholder will have realized a double deduction or its equivalent. On the facts assumed in our extension of the example, the shareholder applies his $100 of overstated basis to the $100 Year 5 distribution, treating it as a return of capital rather than capital gain. That exclusion is grounded in the same economic loss that he claimed as a deduction in Year 1. The exclusion depends on basis attributable to income that, under proper reporting, would have been offset by the carryover of the Year 1 loss. The shareholder would not have had sufficient basis to exclude the distribution from income were it not for his erroneous deduction of his Year 1 loss.

If the shareholder in our extended version of the example posed by respondent's counsel does not realize the equivalent of a double deduction until Year 5, might adjustment of his stock basis in Year 3 nonetheless be justified to prevent that double deduction? The answer, to our minds, depends on whether Treasury Regulation § 1.1016-6(a) can be applied prophylactically. Again, respondent seems to think that it can. His position, as we understand it, is that, even if the shareholder's $100 deduction in Year 3 is neither a double deduction nor the equivalent of a double deduction, the shareholder's stock basis can still be reduced in Year 3 by the $100 suspense account to prevent a double deduction or its equivalent in a subsequent year.

That double deduction or equivalent, however, may never arise. Suppose the shareholder sold his stock at the end of Year 3 and reported gain equal to his full amount realized. The shareholder's income from the S corporation over the three years would be understated by $100. Again, however, that does not establish that the shareholder has realized a double deduction or its equivalent. The understatement of the taxpayer's income results from his initial deduction of $100 in Year 1.

Treasury Regulation § 1.1016-6(a) authorizes (indeed, requires) adjustments to basis “to eliminate double deductions or their equivalent.” “Eliminate” is not synonymous with “prevent.” The regulation's text, as we would interpret it, requires the double deduction or equivalent that would arise in the absence of adjustment to be proximate to the adjustment. We are not convinced that the regulation allows adjustments to prevent double deductions or their equivalents that may or may not arise in future years, depending on how circumstances turn out.

Although we have questions about respondent's position, we are not prepared, at this juncture, to grant petitioner's motion for partial summary judgment and deny respondent's motion. Given the importance and complexity of the issues, we will allow respondent to develop his arguments further in response to the points raised above. While we have, for simplicity and convenience, used as a frame of reference the hypothetical example offered by respondent's counsel (and our extension of that example), our disposition of the parties' motions will ultimately turn on our assessment of the legal permissibility of respondent's suspense account method as applied to the (much more complicated) facts of the actual cases. Therefore, while the parties may choose to use the hypothetical example as a frame of reference, they are also free to couch their arguments in terms of the actual facts. And we would expect them to do so should they identify respects in which the example does not adequately represent the issues posed by the actual facts.

On the premises stated, it is

ORDERED that respondent shall, on or before August 17, 2023, submit a supplemental memorandum in support of his motion for partial summary judgment that addresses the matters discussed above and offers any further supplementation to his arguments that he deems appropriate. It is further

ORDERED that petitioners shall, within two weeks after respondent's submission of his supplemental memorandum, provide a response to that memorandum.

James S. Halpern
Judge