The Tax Court recently issued an order declining to grant either the IRS’s or taxpayers’ motions for partial summary judgement. The taxpayers in question are the shareholders of a subchapter S corporation that in prior, now closed years, deducted losses from the corporation in excess of their adjusted bases in the corporation’s stock. The IRS is seeking to establish a suspense account for each taxpayer, which would offset future increases in basis in the stock of the corporation that the taxpayers would otherwise be entitled to receive. The Tax Court, skeptical of the IRS’s long-standing practice of using prophetic suspense accounts, but unwilling to immediately rule against the practice, ordered the IRS to further develop its arguments. The order in question, while clearly an ongoing case, provides an excellent discussion of the IRS’s suspense account practice, as well as Judge Halpern’s criticisms of the same. The facts in this case were not the focus of the order, rather the Court examined the example proposed by the IRS (discussed below).
Suspense Account Method
S corporations are pass-through entities for tax purposes, meaning that items of income, loss, deduction, or credit flow through to the shareholders of the entity. The shareholders are then responsible for reporting such items on their individual tax returns. Items of income that flow to the shareholders increase their adjusted basis, while items such as losses and deductions decrease a shareholder’s adjusted basis. There are several other items that affect a shareholder’s basis in his or her S corporation stock, but a discussion of such is beyond the scope of this article.
Since Congress seems to dislike the idea of a negative adjusted basis, the losses that flow to a shareholder from an S corporation in a given tax year can only be deducted by the shareholder to the extent the shareholder has sufficient adjusted basis in the S corporation stock. Losses in excess of the shareholder’s basis are suspended and carried forward until the shareholder obtains additional adjusted basis. If a shareholder were to improperly claim a deduction in excess of their adjusted basis, the IRS should theoretically deny the deduction on the shareholders individual tax return. However, what happens if the IRS does not catch the improper deduction that was taken until after the statute of limitations for the return has passed? Enter the suspense account method.
Relying upon Treasury Regulation §1.1016-6(a), which provides that adjustments to basis must be made “to eliminate double deductions or their equivalents,” the IRS creates a suspense account in an amount equal to the improper deduction from the prior closed years. Any income reported in subsequent years would first offset the balance of the suspense account, rather than creating additional adjusted basis for the shareholder. The shareholder would be unable to report losses from the corporation or receive tax-free distributions from the corporation until the balance in the suspense account is reduced to zero.
IRS Example and Discussion
In addition to the pleadings filed, each side discussed their arguments with Judge Halpern via conference call on July 14, 2023. The IRS argued that establishing a suspense account was necessary to prevent the taxpayers from obtaining double deductions or their equivalent. To illustrate their point, the IRS presented the following hypothetical 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. Assume the statute of limitations for the year 1 return passed without the IRS detecting the improper deduction. See the handy chart I created below summarizing the result.
|Year||Gain/Loss Passthrough||AB in Stock (after passthrough)||Loss Deducted||Total Suspended Loss|
Under the suspense account method, the suspense account would be applied to reduce the shareholder’s stock basis in the earliest open year. In Year 2, the shareholder had no positive basis to reduce since his basis was still zero. But the income allocated to the shareholder in Year 3 would increase his basis by $100, were there no suspense account. The IRS would apply the $100 suspense account to offset that increase in basis, leaving the shareholder, again, with a basis of zero. Thus, the loss from Year 2 could not be deducted by the taxpayer in year 3 and would be further suspended.
However, the Court questioned what the phrases “double deductions” or “their equivalent” actually meant. The order stated the following:
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.
The Court stated that the shareholder’s Year 3 loss was not a double deduction because it was not grounded in the same economic loss as the Year 1 deduction, since he would have been entitled to the Year 3 loss regardless of taking the improper Year 1 deduction. The below chart summarizes the result if the shareholder did not take the improper Year 1 deduction.
|Year||Gain/Loss Passthrough||AB in Stock (after passthrough)||Loss Deducted||Total Suspended Loss|
As you can tell, the only difference in Year 3 compared to the prior chart is that the shareholder has an additional $100 of suspended loss. Importantly, the shareholder’s adjusted basis is zero at the beginning and end of Year 3 in both scenarios. Since Treasury Regulation § 1.1016-6(a) indicates that double deductions or their equivalent necessarily involve the use of overstated basis, the Court found the IRS’s argument that the Year 3 deduction was equivalent to a double deduction could not be accurate. Instead, the IRS was really arguing that the shareholder could potentially receive a double deduction or its equivalent in a future year. The Court extended the IRS’s example as follows:
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).
As depicted by the above charts, if the shareholder did not improperly deduct the $100 loss in Year 1, he would have an additional $100 suspended loss at the end of Year 3. Had the shareholder not improperly taken the Year 1 deduction, the allocation of $100 of income to the Shareholder in Year 4 would have increased his basis by the same amount and the suspended $100 loss should have been deducted at that time. Thus, he would have ended Year 4 with zero adjusted basis again. In Year 5, since the shareholder had no adjusted basis, the $100 distribution would have been a taxable distribution.
However, since the shareholder improperly took the Year 1 deduction, he did not have any suspended loss at the end of Year 3. So, there was no decrease to his basis in Year 4 because there was no loss to deduct, resulting in an adjusted basis of $100 at the end of Year 4. Then when the shareholder receives the $100 distribution in Year 5, he would be able to use his $100 of adjusted basis to treat the distribution as a tax-free return of capital. This change in what would otherwise be a taxable distribution to a tax-free return of capital due to the overstated basis is where the shareholder realizes a double deduction or its equivalent since the shareholder would not have been able to exclude the income had he not improperly taken the deduction in Year 1.
The IRS was not proposing to create the suspense account in Year 5, after the double deduction or its equivalent had occurred, rather it wanted to create the suspense account in Year 3 to essentially prevent a possible future double deduction or its equivalent. The Court noted that Treasury Regulation § 1.1016-6(a) authorizes adjustments to basis “to eliminate double deductions or their equivalent” and that “Eliminate” is not synonymous with “prevent.” The Court noted that the double deduction or its equivalent could never arise, such as if the shareholder sold his stock at the end of Year 3 and reported gain equal to his full amount realized. Over the course of the three years, the shareholder’s income would have been understated by $100, however no double deduction or its equivalent would have occurred because there was no overstatement of basis resulting in a further benefit to the shareholder. Rather the $100 understatement was taken in Year 1 and just carried through the entire time the shareholder owned the stock.
Nonetheless, the Court was not prepared to rule for the taxpayers quite yet. Given that the facts in the actual case are much more complex than the example given by the IRS (and expanded upon by the Court), the Court ordered that the IRS should submit a supplemental memorandum in support of its motion for partial summary judgment that further developed its arguments in response to the points addressed by the Court. The taxpayers were also given two weeks to respond to the IRS’s supplemental memorandum with their own arguments.
One might think that once the statute of limitations for a tax return has run, that the IRS’s means of recourse are similarly exhausted. However, that is not the case. Treasury Regulation § 1.1016-6(a) clearly allows adjustments to be made to eliminate double deductions or their equivalents. The IRS seems to have made a practice of employing the regulation in a prophetic application of the suspense account method. Judge Halpern at least seems to take issue with this approach.
It will be interesting to see how much the facts differ from the example presented by the IRS. Given that the IRS presented the example, I would not be surprised if they are fairly similar, still requiring the IRS to apply the suspense account method in an attempt to prevent double deductions or their equivalents rather than waiting for them to actually occur. Were the facts of the case such that the IRS was attempting to eliminate double deductions or their equivalents, I expect the example presented by the IRS would have been crafted more carefully to reflect such. But who knows, maybe the attorney for the IRS thought of the example on the spot during that call, or perhaps the IRS did not expect Judge Halpern to distinguish between eliminating as opposed to preventing double deductions or their equivalents.
 Kanwal v. Commissioner, Order, Docket Nos. 23766-18, 23769-1, 23776-18, and 23842-18, US Tax Court, July 18, 2023.
 IRC § 1366(a).
 IRC § 1367.
 See IRC § 1367.
 IRC § 1366(d)(1).
 IRC § 1366(d)(2) & (3).