The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 12, July 2002, Panel Publishers, New York, NY.


By Robert W. Wood

One of the hallmark rules of S corporations is that corporate losses are limited to S corporation shareholders by that shareholder's aggregate adjusted basis in his S corporation stock, and by his adjusted basis in the indebtedness of the S corporation. I.R.C. §1366(d)(1). S corporation shareholders have long had an incentive to manipulate this rule, making additional capital contributions or loans to the S corporation to try to boost that basis. Often, though, the basis is insufficient to claim all of the losses flowing from the S corporation. Although suspended losses carry forward indefinitely to succeeding taxable years in which the corporation is an S corporation, that carry forward is sometimes of little solace. See I.R.C. §1366(d)(2).

If a corporation's S election is terminated, there is a special rule for the carryover of suspended losses. If losses have been disallowed in the last taxable year for which the corporation is an S corporation, these losses are treated as incurred by the shareholder on the last day of the post-termination transition period. I.R.C. §1366(d)(3)(A). The result is that these losses can be claimed.

Significantly, though even these losses are limited to the adjusted basis of the shareholder's stock determined on the last day of the post-termination transition period. Any losses in excess of this stock basis are permanently disallowed. Reg. §1.1366-2(b)(2).

Merger of C and S Corporation

How do these rules apply in a merger? Do these suspended losses survive? Field Service Advice 200223052 (May 7, 2002) addresses the question whether a shareholder of a target S corporation who is also a shareholder of an acquiring C corporation may apply losses that are suspended against the shareholder's historic basis in the C corporation when the C and S merge. The FSA does not address the question just how large a shareholder the person is in either the C or the S corporation.

Indeed, this issue, since it is not discussed, does not seem to matter. What is important is that he is a shareholder in both, and he has suspended losses in the S corporation which would be obliterated on the statutory merger of the C and S corporations. Interestingly, after noting that the general disallowance rule contemplates that a shareholder may acquire additional basis in his S corporation stock during the post-termination transition period, the question is how that rule should interact in the case of a statutory merger of the S corporation with a C corporation in a transaction qualifying as an A reorganization.

The Service first confirms that both the statute and its legislative history contemplate a situation in which a shareholder acquires additional basis during the post-termination transition period. Then, the Service says that a shareholder with suspended losses at the time of the S corporation to C corporation merger could only acquire additional basis during that post-termination transition period if the shareholder makes additional capital contributions to the survivor company (here, the C corporation). Finding that there is no compelling reason for reaching a different conclusion if the shareholder has historic basis in the acquiring C corporation (rather than newly-acquired basis), the Service concludes that the shareholder's historic basis in the C corporation stock can be used to offset suspended S corporation losses on the merger.

The purpose of the loss suspension rule, after all, is to prevent shareholders from using losses that are not related to any corresponding economic outlay. Here, reasoned the Service, the shareholder has made real economic outlays in the form of investing in the acquiring C corporation. In other words, it is "real" basis in the C corporation, and hence can be used to offset the S corporation losses.

The corollary is that on using the shareholder's basis in his C corporation stock, he would be required to reduce his basis in that stock up to the amount of the losses taken.


Field Service Advice 200223052 represents an eminently sensible rule. Since S corporation shareholders (both large and small) often struggle with loss deductibility/basis issues, this rule facilitates the efficient use of losses post-acquisition. Perhaps more importantly, not all of this has to be addressed in advance of the merger. Given the number of issues that do need to be planned in advance, it is nice that existing C corporation stock basis can be used to offset suspended S corporation losses post-acquisition.

Merger of S and C Corporations Yields Suspended Loss Benefit, Vol. 10, No. 12, The M&A Tax Report (July 2002), p. 4.