[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1366-2]

[Page 740-743]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.1366-2  Limitations on deduction of passthrough items of an S 
corporation to its shareholders.

    (a) In general--(1) Limitation on losses and deductions. The 
aggregate amount of losses and deductions taken into account by a 
shareholder under Sec. 1.1366-1(a) (2), (3), and (4) for any taxable 
year of an S corporation cannot exceed the sum of--
    (i) The adjusted basis of the shareholder's stock in the corporation 
(as determined under paragraph (a)(3)(i) of this section); and
    (ii) The adjusted basis of any indebtedness of the corporation to 
the shareholder (as determined under paragraph (a)(3)(ii) of this 
section).
    (2) Carryover of disallowance. A shareholder's aggregate amount of 
losses

[[Page 741]]

and deductions for a taxable year in excess of the sum of the adjusted 
basis of the shareholder's stock in an S corporation and of any 
indebtedness of the S corporation to the shareholder is not allowed for 
the taxable year. However, any disallowed loss or deduction retains its 
character and is treated as incurred by the corporation in the 
corporation's first succeeding taxable year, and subsequent taxable 
years, with respect to the shareholder. For rules on determining the 
adjusted bases of stock of an S corporation and indebtedness of the 
corporation to the shareholder, see paragraphs (a)(3) (i) and (ii) of 
this section.
    (3) Basis limitation amount--(i) Stock portion. A shareholder 
generally determines the adjusted basis of stock for purposes of 
paragraphs (a)(1)(i) and (2) of this section (limiting losses and 
deductions) by taking into account only increases in basis under section 
1367(a)(1) for the taxable year and decreases in basis under section 
1367(a)(2) (A), (D) and (E) (relating to distributions, noncapital, 
nondeductible expenses, and certain oil and gas depletion deductions) 
for the taxable year. In so determining this loss limitation amount, the 
shareholder disregards decreases in basis under section 1367(a)(2) (B) 
and (C) (for losses and deductions, including losses and deductions 
previously disallowed) for the taxable year. However, if the shareholder 
has in effect for the taxable year an election under Sec. 1.1367-1(g) 
to decrease basis by items of loss and deduction prior to decreasing 
basis by noncapital, nondeductible expenses and certain oil and gas 
depletion deductions, the shareholder also disregards decreases in basis 
under section 1367(a)(2) (D) and (E). This basis limitation amount for 
stock is determined at the time prescribed under Sec. 1.1367-1(d)(1) 
for adjustments to the basis of stock.
    (ii) Indebtedness portion. A shareholder determines the 
shareholder's adjusted basis in indebtedness of the corporation for 
purposes of paragraphs (a)(1)(ii) and (2) of this section (limiting 
losses and deductions) without regard to any adjustment under section 
1367(b)(2)(A) for the taxable year. This basis limitation amount for 
indebtedness is determined at the time prescribed under Sec. 1.1367-
2(d)(1) for adjustments to the basis of indebtedness.
    (4) Limitation on losses and deductions allocated to each item. If a 
shareholder's pro rata share of the aggregate amount of losses and 
deductions specified in Sec. 1.1366-1(a)(2), (3), and (4) exceeds the 
sum of the adjusted basis of the shareholder's stock in the corporation 
(determined in accordance with paragraph (a)(3)(i) of this section) and 
the adjusted basis of any indebtedness of the corporation to the 
shareholder (determined in accordance with paragraph (a)(3)(ii) of this 
section), then the limitation on losses and deductions under section 
1366(d)(1) must be allocated among the shareholder's pro rata share of 
each loss or deduction. The amount of the limitation allocated to any 
loss or deduction is an amount that bears the same ratio to the amount 
of the limitation as the loss or deduction bears to the total of the 
losses and deductions. For this purpose, the total of losses and 
deductions for the taxable year is the sum of the shareholder's pro rata 
share of losses and deductions for the taxable year, and the losses and 
deductions disallowed and carried forward from prior years pursuant to 
section 1366(d)(2).
    (5) Nontransferability of losses and deductions. Any loss or 
deduction disallowed under paragraph (a)(1) of this section is personal 
to the shareholder and cannot in any manner be transferred to another 
person. If a shareholder transfers some but not all of the shareholder's 
stock in the corporation, the amount of any disallowed loss or deduction 
under this section is not reduced and the transferee does not acquire 
any portion of the disallowed loss or deduction. If a shareholder 
transfers all of the shareholder's stock in the corporation, any 
disallowed loss or deduction is permanently disallowed.
    (6) Basis of stock acquired by gift. For purposes of section 
1366(d)(1)(A) and paragraphs (a)(1)(i) and (2) of this section, the 
basis of stock in a corporation acquired by gift is the basis of the 
stock that is used for purposes of determining loss under section 
1015(a).
    (b) Special rules for carryover of disallowed losses and deductions 
to post-termination transition period described in section 1377(b)--(1) 
In general. If, for the

[[Page 742]]

last taxable year of a corporation for which it was an S corporation, a 
loss or deduction was disallowed to a shareholder by reason of the 
limitation in paragraph (a) of this section, the loss or deduction is 
treated under section 1366(d)(3) as incurred by that shareholder on the 
last day of any post-termination transition period (within the meaning 
of section 1377(b)).
    (2) Limitation on losses and deductions. The aggregate amount of 
losses and deductions taken into account by a shareholder under 
paragraph (b)(1) of this section cannot exceed the adjusted basis of the 
shareholder's stock in the corporation determined at the close of the 
last day of the post-termination transition period. For this purpose, 
the adjusted basis of a shareholder's stock in the corporation is 
determined at the close of the last day of the post-termination 
transition period without regard to any reduction required under 
paragraph (b)(4) of this section. If a shareholder disposes of a share 
of stock prior to the close of the last day of the post-termination 
transition period, the adjusted basis of that share is its basis as of 
the close of the day of disposition. Any losses and deductions in excess 
of a shareholder's adjusted stock basis are permanently disallowed. For 
purposes of section 1366(d)(3)(B) and this paragraph (b)(2), the basis 
of stock in a corporation acquired by gift is the basis of the stock 
that is used for purposes of determining loss under section 1015(a).
    (3) Limitation on losses and deductions allocated to each item. If 
the aggregate amount of losses and deductions treated as incurred by the 
shareholder under paragraph (b)(1) of this section exceeds the adjusted 
basis of the shareholder's stock determined under paragraph (b)(2) of 
this section, the limitation on losses and deductions under section 
1366(d)(3)(B) must be allocated among each loss or deduction. The amount 
of the limitation allocated to each loss or deduction is an amount that 
bears the same ratio to the amount of the limitation as the amount of 
each loss or deduction bears to the total of all the losses and 
deductions.
    (4) Adjustment to the basis of stock. The shareholder's basis in the 
stock of the corporation is reduced by the amount allowed as a deduction 
by reason of this paragraph (b). For rules regarding adjustments to the 
basis of a shareholder's stock in an S corporation, see Sec. 1.1367-1.
    (c) Carryover of disallowed losses and deductions in the case of 
liquidations, reorganizations, and divisions--(1) Liquidations and 
reorganizations. If a corporation acquires the assets of an S 
corporation in a transaction to which section 381(a) applies, any loss 
or deduction disallowed under paragraph (a) of this section with respect 
to a shareholder of the distributor or transferor S corporation is 
available to that shareholder as a shareholder of the acquiring 
corporation. Thus, where the acquiring corporation is an S corporation, 
a loss or deduction of a shareholder of the distributor or transferor S 
corporation disallowed prior to or during the taxable year of the 
transaction is treated as incurred by the acquiring S corporation with 
respect to that shareholder if the shareholder is a shareholder of the 
acquiring S corporation after the transaction. Where the acquiring 
corporation is a C corporation, a post-termination transition period 
arises the day after the last day that an S corporation was in existence 
and the rules provided in paragraph (b) of this section apply with 
respect to any shareholder of the acquired S corporation that is also a 
shareholder of the acquiring C corporation after the transaction. See 
the special rules under section 1377 for the availability of the post-
termination transition period if the acquiring corporation is a C 
corporation.
    (2) Corporate separations to which section 368(a)(1)(D) applies. If 
an S corporation transfers a portion of its assets constituting an 
active trade or business to another corporation in a transaction to 
which section 368(a)(1)(D) applies, and immediately thereafter the stock 
and securities of the controlled corporation are distributed in a 
distribution or exchange to which section 355 (or so much of section 356 
as relates to section 355) applies, any loss or deduction disallowed 
under paragraph (a) of this section with respect to a shareholder of the 
distributing S corporation immediately before the transaction is 
allocated between the distributing corporation and the controlled

[[Page 743]]

corporation with respect to the shareholder. Such allocation shall be 
made according to any reasonable method, including a method based on the 
relative fair market value of the shareholder's stock in the 
distributing and controlled corporations immediately after the 
distribution, a method based on the relative adjusted basis of the 
assets in the distributing and controlled corporations immediately after 
the distribution, or, in the case of losses and deductions clearly 
attributable to either the distributing or controlled corporation, any 
method that allocates such losses and deductions accordingly.

[T.D. 8852, 64 FR 71646, Dec. 22, 1999]