Business Tax Preparation · Analysis of financial records

Pass-through activity (e.g., K-1, separately stated items, non-deductible expenses)

A Schedule K-1 is not a summary. It is a set of instructions telling the owner to redo, at owner level, work the entity was forbidden to finish. Two questions decide almost every issue here: why is this item on its own line, and what has it done to basis.

The rule

The entity computes, then unbundles. each partner takes into account separately its distributive share of short-term and long-term capital gains and losses, IRC § 1231 gains and losses, charitable contributions, qualified dividends, foreign taxes, and any other item the regulations require to be stated separately^TY2026 (IRC § 702(a)), and the partnership is barred from taking certain deductions itself — the partnership itself may not deduct personal exemptions, foreign taxes, charitable contributions, a net operating loss, the additional itemized deductions for individuals, or oil and gas depletion — those items travel to the partners instead^TY2026 (IRC § 703(a)(2)). Subchapter S states the same idea as a test rather than a list: a shareholder takes into account its pro rata share of items of income, including tax-exempt income, loss, deduction or credit the separate treatment of which could affect any shareholder’s tax liability, together with nonseparately computed income or loss^TY2026 (IRC § 1366(a)(1)). Everything not separately stated is the single ordinary business income or loss figure.

Why an item is stated separately. an item is stated separately when its character or a limitation attached to it could produce a different result at owner level than it would inside the entity — which is why the test in subchapter S is expressly whether separate treatment could affect any shareholder’s liability^TY2026 (IRC § 702(a)(7); IRC § 1366(a)(1)(A)).

Basis moves with everything, including what is not deductible. Up: a partner’s basis is increased by its distributive share of partnership taxable income, of income exempt from tax, and of the excess of depletion deductions over the basis of the property subject to depletion^TY2026 (IRC § 705(a)(1)). Down: a partner’s basis is decreased, but not below zero, by distributions and by its distributive share of partnership losses and of expenditures not deductible in computing taxable income and not properly chargeable to capital account^TY2026 (IRC § 705(a)(2)), and on the S side a shareholder’s stock basis is decreased, but not below zero, by distributions not includible in income under IRC § 1368, by separately stated and nonseparately computed losses and deductions, and by any expense of the corporation not deductible in computing taxable income and not properly chargeable to capital account^TY2026 (IRC § 1367(a)(2)). Note the phrase common to both — expenditures not deductible and not properly chargeable to capital account. Tax-exempt income raises basis and a nondeductible fine lowers it, because basis tracks economics rather than taxable income.

Losses stop at basis, and the two regimes stop at different places. a partner’s distributive share of partnership loss is allowed only to the extent of the adjusted basis of the partnership interest at the end of the partnership year in which the loss occurred, the excess being allowed when the basis is restored^TY2026 (IRC § 704(d)), against a shareholder’s losses and deductions may not exceed the sum of the adjusted basis of the stock and the adjusted basis of any indebtedness of the corporation to that shareholder — a second tier partnerships do not have — with disallowed amounts carried forward indefinitely^TY2026 (IRC § 1366(d)).

The owner is not free to disagree. a partner must treat any partnership-related item on its own return consistently with the treatment on the partnership return, and an underpayment caused by inconsistent treatment is assessed as if it were a mathematical or clerical error — without the ordinary deficiency procedures^TY2026 (IRC § 6222).

Current figures

How it works in practice

Ask why the item is on its own line, and the answer follows. A charitable contribution is stated separately because the owner’s own percentage limitation applies to it, not the entity’s. A capital loss is stated separately because it nets against the owner’s other capital transactions. Foreign taxes are stated separately because the owner may take a credit or a deduction. In each case the entity could not reach the right answer, because the right answer depends on facts the entity does not have.

Nondeductible expenses are the reliable trap. A fine, the disallowed half of a business meal, club dues, the premium on a corporate-owned life insurance policy — none reduces taxable income, and every one reduces basis. The logic is that basis measures the owner’s investment, and money that left the entity is gone whether or not the Code allowed a deduction for it. The mirror image is tax-exempt interest, which increases basis without increasing income.

Order the adjustments before computing the loss limit. Increase basis for income items first, then decrease for distributions, then for losses and deductions. Running distributions after losses overstates the loss allowed and can produce a negative basis, which neither § 705 nor § 1367 permits.

Remember the second tier exists only in subchapter S. A shareholder may deduct losses against basis in direct shareholder debt as well as stock basis; a partner has no equivalent because partnership liabilities are already in outside basis under § 752. That single structural difference explains why an S corporation shareholder who lends the company money creates deductible capacity and one who guarantees a bank loan usually does not.

Consistency is enforced by an unusual mechanism. An underpayment caused by treating a partnership-related item differently from the partnership return is assessed as though it were a mathematical or clerical error, and IRC § 6222(b) disapplies IRC § 6213(b)(2) — so the taxpayer does not get the ordinary right to request abatement and force a deficiency notice. A partner who disagrees must notify the Service under § 6222(c), not simply file differently.

Scenarios

Traps

How this has changed

The architecture of §§ 702, 703, 705, 1366 and 1367 has been stable for decades. What has moved is the population of separately stated items, and it has grown considerably. IRC § 199A required partnerships and S corporations to report qualified business income, W-2 wages and unadjusted basis immediately after acquisition, none of which existed before 2018; the section did not expire, since Pub. L. 119-21 § 70105(b)(1) replaced the terminating subsection outright. IRC § 163(j) requires excess business interest expense, excess taxable income and excess business interest income to be reported separately, and § 70303(a) put that limitation back on an EBITDA base for taxable years beginning after 31 December 2024, changing the amounts without changing the reporting.

The consistency rule in IRC § 6222 took its present form with the centralised partnership audit regime, which replaced TEFRA for partnership taxable years beginning after 31 December 2017. The math error assessment mechanism it carries is the most aggressive collection route in the subtitle, and it applies to any partnership-related item.

Nothing in the post-2024 legislation alters the basis adjustment provisions or the loss limitations in IRC § 704(d) and § 1366(d). What did change around them is IRC § 461(l), made permanent by Pub. L. 119-21 § 70601(a): the excess business loss limitation now applies indefinitely and sits after the basis and at-risk and passive activity limitations in the sequence, so a loss that clears basis may still be deferred.

Exam focus

Learn the § 702(a) list, then learn the test behind it. Questions often supply an item not on the list and ask whether it is separately stated; the answer comes from whether its character or a limitation would change the owner’s result.

The § 703(a)(2) list of deductions the partnership may not take is worth memorising outright, because it is short and because each item is a plausible distractor as an entity-level deduction.

Be able to run a basis computation in order and to state both directions of the nondeductible and tax-exempt adjustments. Expect at least one question in which a nondeductible item is offered as having no effect on basis.

Keep the two loss limitations apart. Partnership: basis in the interest, full stop, with liabilities already inside it. S corporation: stock basis plus basis in direct shareholder debt, with a guarantee giving nothing.

Finally, know that IRC § 6222 enforces consistency by math error assessment and that IRC § 6213(b)(2) is disapplied, so the usual abatement request is unavailable.

Check yourself

1. An S corporation has ordinary income of $200,000, tax-exempt interest of $8,000, a $12,000 nondeductible penalty, and makes a $30,000 distribution to its sole shareholder, whose opening stock basis is $40,000. What is closing basis?

Answer: $206,000. Increase for the items of income described in IRC § 1366(a)(1)(A), which expressly include tax-exempt income, and for the nonseparately computed income: $40,000 plus $200,000 plus $8,000 is $248,000. Then decrease under IRC § 1367(a)(2) — the $30,000 distribution not includible in income under § 1368, and the $12,000 expense not deductible in computing taxable income and not properly chargeable to capital account — giving $206,000. The penalty reduces basis though it never reduced income, and the exempt interest raises it though it never was income.

2. A partnership pays $18,000 of foreign taxes and deducts them in computing ordinary business income. Is that right?

Answer: No. IRC § 703(a)(2)(B) denies the partnership the IRC § 164(a) deduction for taxes described in IRC § 901 paid or accrued to foreign countries and possessions, and IRC § 702(a)(6) makes those taxes a separately stated item. The reason is that each partner may elect either a credit or a deduction, and the entity cannot make that election for them — the choice depends on facts, including other foreign income and limitation carryovers, that exist only at partner level.

3. A shareholder guarantees the S corporation’s $150,000 bank loan. The corporation has a $120,000 loss and the shareholder’s stock basis is $30,000. How much loss is allowed?

Answer: $30,000. IRC § 1366(d)(1) limits losses to stock basis plus the shareholder’s adjusted basis in indebtedness of the corporation to the shareholder. A guarantee creates no such indebtedness — the corporation owes the bank, not the shareholder — so there is no second tier. The remaining $90,000 is suspended under § 1366(d)(2) and carried forward indefinitely, available if the shareholder later contributes capital or makes an actual loan. A partner in the same position would be treated very differently, because IRC § 752 can put a share of the liability into outside basis.

4. A partner believes the partnership mis-characterised an item and reports it correctly on their own return without notifying the Service. What follows?

Answer: IRC § 6222(a) requires the partner to treat any partnership-related item consistently with the partnership return, and § 6222(b) provides that an underpayment resulting from inconsistency is assessed and collected as if it were a mathematical or clerical error — with IRC § 6213(b)(2) expressly disapplied, so the partner cannot request abatement and force a statutory notice of deficiency. The route the partner should have taken is the notification of inconsistent treatment under § 6222(c). Being right on the merits does not help until that notice is filed.

5. Why does a nondeductible expense reduce basis at all?

Answer: Because basis measures the owner’s economic investment, not the accumulation of taxable income. Money the entity spent on a fine is gone, and the owner’s interest is worth less by their share of it, whether or not the Code allowed a deduction. If basis were left unreduced, the owner would recover the same dollars a second time as a smaller gain on disposing of the interest. The symmetry runs the other way with tax-exempt income, which increases basis under IRC § 705(a)(1)(B) and IRC § 1367(a)(1)(A) so that the exemption is not clawed back on sale.