Tax Court Requires Partner to Reduce Basis for Excess Losses Claimed in Closed Years

The Tax Court recently issued its opinion in Surk, LLC v. Commissioner, holding that a partner was required to reduce the current tax basis in a partnership interest because it had inappropriately claimed losses due to insufficient basis during previous tax years that were now closed under the statute of limitations. Partners affected by this ruling are now confronted with peculiar challenges in determining when these basis adjustments should be made.

Facts

In Surk, the Taxpayer (an Upper Tier Partnership) treated losses allocated to it by a Lower Tier Partnership in the following manner:

• For the 2014 and 2015 tax years, it improperly deducted losses in excess of its outside basis in the Lower Tier Partnership by a total of $3,308,767.
• For the 2016 tax year, the Taxpayer was allocated an additional loss of approximately $3 million. It disregarded a transaction that would have created additional basis and deducted only $1,730 of losses (the amount it calculated as its outside basis) and carried forward $2,999,279 to 2017. The Taxpayer treated its outside basis as zero at the end of 2016.
• For the 2017 tax year, the Taxpayer was allocated a loss of $4,963,892, and it determined that its basis in the Lower Tier Partnership was $5,873,827. It deducted the entire 2017 loss plus $341,100 of the 2016 carryforward loss.

The IRS was prohibited from making adjustments to the 2014 and 2015 years because of the statute of limitations and, therefore, could not propose deficiencies with respect to the inappropriate loss deductions taken in those years. Instead, the IRS argued that the Taxpayer must reduce its 2017 outside basis in the Lower Tier Partnership by the improper excess losses taken in 2014 and 2015 and used this reduced basis to determine its eligibility for 2017 loss deductions.

Tax Court’s Analysis

The Taxpayer noted that while IRC Section 704(d) limits a partner’s deduction of its distributive share of partnership losses, IRC Section 705(a)(2) provides the method for calculating adjusted basis of a partner’s interest in a partnership. This latter section provides that in calculating basis, certain decreases apply for allocated losses and nondeductible expenditures, but not below zero. The Taxpayer claimed that this language provides for an annual computation of partnership basis, which cannot be negative.

The Tax Court, however, accepted the IRS’s analysis, which focused on other language contained in IRC Section 705(a)(2). It requires that basis be “Decreased (but not below zero) by distributions by the partnership as provided in Section 733 and by the sum of his distributive share for the taxable year and prior taxable years of (A) Losses of the partnership; and (B) Expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to capital account” (emphasis added). The Tax Court states that the plain wording of the statute requires Surk to decrease its outside basis by the excess losses since these are losses allocated in prior taxable years.

In this case, the Tax Court noted that the Service was not attempting to recalculate the Taxpayer’s outside basis for the 2014 or 2015 tax years and to reduce it below zero. Additionally, the IRS was not looking to adjust the improper deductions taken in the closed 2014 or 2015 tax years. Instead, the Taxpayer’s 2017 outside basis in the Lower Tier Partnership is being determined, as required by the statutory language, by considering current year and prior year losses.

The Tax Court notes that IRC Section 704(d) makes a distinction between “allowed” and “disallowed” losses. Regulation Section 1.704-1(d)(2) further provides that basis must be reduced for IRC Section 705(a)(1) negative adjustments “except for losses of the taxable year and losses previously disallowed.” The Tax Court concludes that a loss inappropriately deducted on a tax return during a year that is closed under the statute of limitations and that was unchallenged by the IRS would not be included within the meaning of the phrase “losses previously disallowed.”

Observations

This case involved a scenario where both sides were aware of the excess losses deducted inappropriately in prior years. However, the Tax Court treated those excess losses as a reduction to basis because they were never challenged by the IRS and they pertained to prior years. It is not clear whether this basis reduction is required prior to the time when the prior years are closed under the statute of limitations. If not, then this requirement would not exist during the intervening years, potentially leading to peculiar results.

Also, with the Tax Court’s decision that outside basis must be reduced by allocated losses for all prior years, the Service could begin requiring more extensive basis schedules that reflect decreases for all prior years. Further, an examiner may now be less accepting of a current-year basis computation that merely carries forward prior-year amounts.

Also, the impact of this case on S corporation stock and debt basis calculations remains unclear. The Service previously asserted a requirement to use a “suspense account” method under Regulation Section 1.1016-6(a) to avoid a double deduction by S corporation shareholders. Under this approach, the IRS required improperly deducted losses from closed years to be maintained in a “suspense account,” which is used during later tax years to offset subsequent items that increase basis.

This approach was called into question in Kanwal v. Commissioner, where the Tax Court did not grant summary judgment in favor of the government. The judge raised additional questions to the IRS concerning the use of the suspense account method. The judge noted that the items involved in that case were not with respect to a double deduction of the same item and, consequently, may not fall within the purview of Regulation Section 1.1016-6(a). While responses were submitted by the IRS after the judge made those observations, the parties ultimately settled, so there was no opinion that addressed the validity of this approach.

Since IRC Section 1367, which deals with decreases to the basis for S corporation stock, does not contain language comparable with IRC Section 705, which looks at losses and deductions for prior years in the computation, the Surk case may have limited applicability to S corporations.

Partners confronted with similar situations to those involved in Surk should monitor the status of that case in the event it is appealed. In the meantime, partners must consider these lingering questions in developing an approach to respond to the court’s recent decision. For assistance with these evaluations, please connect with us.