SEE-2 - Business Entities and Considerations (35% of the exam) - Section 1.4

Apply S corporation eligibility, election, basis, and pass-through rules, including the shareholder basis ordering rules and the reasonable-compensation requirement.

Identify the S corporation eligibility requirements - 100 or fewer shareholders, only eligible US shareholders, and a single class of stock - and the timing of a valid Form 2553 election. Track shareholder stock and debt basis to determine the deductibility of pass-through losses on Schedule K-1, and recognise that a more-than-2% shareholder-employee must take reasonable W-2 compensation before taking distributions.

Form 1120-SS corporation eligibilityShareholder basisReasonable compensationSingle class of stock

Practice question for this objective

Free sampleBusiness Entities and Considerationshard

An S corporation shareholder has positive stock basis at the start of the year and also holds a direct loan made by the shareholder to the corporation. During the year the corporation passes through a net operating loss that exceeds the shareholder's stock basis but not the combined total of stock and debt basis. Under the basis ordering rules, against which basis must the shareholder absorb the excess loss?

AAgainst debt basis and stock basis at the same time on a pro-rata basis until both reach zero together.
BAgainst the corporation's own basis in its assets, since the loss originates at the entity level.
CAgainst the shareholder's share of corporate-level liabilities owed to outside lenders, which create basis as in a partnership.
DAgainst the shareholder's debt basis in the direct loan, but only after stock basis has been reduced to zero. Correct

S corporation losses reduce stock basis to zero first, then reduce the shareholder's basis in direct loans to the corporation. Section 1366(d) limits a shareholder's deductible pass-through loss to the sum of adjusted stock basis and the basis of any indebtedness the corporation owes the shareholder. The ordering rule applies the loss to stock basis first, and only the loss that remains after stock basis reaches zero may reduce debt basis. Corporate borrowing from outside lenders gives the shareholder no basis, which distinguishes S corporation outside basis from partnership outside basis.

Why A is wrong: Pro-rata absorption is tempting because both items are forms of basis, but the rules are strictly ordered: stock basis is reduced first and debt basis is used only for the loss that remains after stock basis hits zero.

Why B is wrong: This confuses inside basis with outside basis; loss limitation under Section 1366(d) operates on the shareholder's basis in stock and debt, not on the corporation's basis in its assets.

Why C is wrong: Unlike a partner, an S corporation shareholder gets no debt basis from the corporation's borrowing from third parties; only a bona fide loan made directly by the shareholder creates debt basis to absorb losses.

Why D is correct: Pass-through losses first reduce stock basis to zero and any remaining allowed loss then reduces the basis of debt the shareholder owes to the corporation, so debt basis absorbs the excess only after stock basis is exhausted.

See more SEE-2 practice questions, answers explained.

Exam traps in Business Entities and Considerations

Answers that look right on this material and are not. Each one is a distractor from a different question in the SEE-2 bank for this domain.

8,000 dollars, because an S corporation shareholder may deduct pass-through losses only up to stock basis and a direct loan to the corporation does not create any additional loss-absorbing basis.
Why it is wrong: Limiting the loss to stock basis ignores debt basis; a shareholder's bona fide direct loan to the corporation creates debt basis that also absorbs losses, so 8,000 dollars understates the deductible amount.
He may deduct 12,000 dollars this year, the amount of his stock basis, and the remaining 13,000 dollars is permanently disallowed because debt basis cannot absorb losses.
Why it is wrong: Limiting the deduction to stock basis alone ignores that an S corporation loss may also be taken against debt basis from a direct shareholder loan, so stopping at 12,000 dollars understates the deductible loss and wrongly calls the rest permanently lost.
12,000 dollars of the distribution is a capital gain and the full 7,000 dollar loss is deductible, because losses are applied to basis before distributions.
Why it is wrong: This reverses the ordering by subtracting the loss before the distribution; distributions reduce basis before losses do, so applying the loss first wrongly frees the entire loss and miscomputes the gain at 12,000 dollars.

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