In the matter of Surk LLC v. Commissioner,[1] the Tax Court was presented with the question of basis computations related to an interest in a partnership. In a tax year that is now closed for assessment, the taxpayer mistakenly deducted losses that exceeded the limitation set forth in Internal Revenue Code Section 704(d). The central issue is whether the taxpayer should reduce its basis in subsequent years by the amount of those disallowed losses or should compute the basis by treating those losses as if they were never deducted.

The general facts of the case are summarized by the Court at the beginning of the opinion:

Surk, LLC (Surk), a partnership for federal tax purposes under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, §§401-407, 96 Stat. 324, 648-71, improperly deducted passthrough losses from a lower tier TEFRA partnership, Outerknown, LLC (Outerknown), for 2014 and 2015 that were in excess of its outside basis in Outerknown (excess losses) in violation of the loss limitation rule of section 704(d). Both years are closed to assessment. See §6229. Respondent did not disallow the excess loss deductions, and he does not seek to do so now. Rather, he issued a Notice of Final Partnership Administrative Adjustment (FPAA) for 2017 that determined that Surk must decrease its outside basis in Outerknown for 2017 to account for the excess losses. In the FPAA, after accounting for the excess losses, respondent disallowed part of Surk's passthrough loss deduction from Outerknown for 2017 on the basis of the section 704(d) loss limitation rule.

During the course of this proceeding, the parties agreed that Surk was entitled to increase its outside basis in Outerknown in 2017 to account for a cash distribution that Surk made in 2016 but previously failed to account for. As a result, Surk had sufficient outside basis to deduct the entire 2017 Outerknown loss.2 Accordingly, respondent concedes that Surk is entitled to the loss deduction that he disallowed in the FPAA. However, respondent continues to assert that Surk must decrease its 2017 yearend outside basis by the excess losses as he determined in the FPAA.[2]

The opinion goes on to provide the detailed amounts involved in the matter:

From 2014 to 2017 Surk owned a majority interest in Outerknown. Surk deducted the excess losses on its 2014 and 2015 returns. For 2014 it deducted an Outerknown loss of $1,123,680, but its outside basis was $544,042. Thus, it improperly deducted an excess loss of $579,638. See §704(d). For 2015 it deducted an Outerknown loss of $2,729,129, but its outside basis was zero. Accordingly, the entire deduction was an excess loss. Respondent did not disallow any part of the 2014 or 2015 excess loss deduction or issue an FPAA for either year. The total excess losses were $3,308,767.

For 2016 Surk’s Outerknown loss was $3,001,009. During 2016 Surk made a cash distribution that increased its basis in its capital assets including a $3,812,500 increase in its outside basis in Outerknown. See §743. When it prepared its 2016 return, Surk did not increase its outside basis to account for the cash distribution. It calculated that its outside basis was $1,730, deducted only $1,730 of its Outerknown loss, and carried forward $2,999,279 of the loss pursuant to section 704(d) (2016 carryforward loss). According to Surk’s reporting, the $1,730 loss deduction decreased its outside basis to zero for yearend 2016.

For 2017 Surk’s Outerknown loss was $4,963,892. For purposes of preparing its 2017 return, Surk calculated that its outside basis in Outerknown was $5,304,992. It deducted the entire 2017 loss plus $341,100 of the 2016 carryforward loss for a total loss of $5,304,992. Its remaining 2016 carryforward loss at yearend 2017 was $2,658,179. The record does not reflect whether Surk has deducted any part of the carryforward loss for any year after 2017.[3]

The case is a bit unusual because, due to the failure of Surk to properly adjust its outside basis under IRC §743, the IRS conceded that the entire loss Surk claimed on its 2017 return was now allowed to be deducted. But the agency insisted that Surk must reduce its basis in Outerknown by those previously deducted losses that should never have been deducted since the outside basis had been reduced to zero but the loss deductions had not been limited.

In the FPAA respondent determined that Surk must decrease its 2017 outside basis by the excess losses and disallowed part of Surk’s loss deduction for 2017 on the basis that Surk had insufficient outside basis in Outerknown pursuant to the section 704(d) loss limitation rule. After accounting for the basis adjustment from the 2016 cash distribution, respondent concedes that Surk is entitled to the entire loss deduction that it claimed for 2017. However, he maintains that Surk must decrease its yearend 2017 outside basis in Outerknown by the excess losses. He calculates that Surk’s outside basis at yearend 2017 was $535,048.[4]

Ultimately the issue is whether or not the IRS, having failed to disallow those excess losses in prior years, is able to force the taxpayer to take those into account in later year basis computations or if they have.

The Court analyzed the problem, beginning with a discussion of the rules regarding a partner’s basis computation as well as the impact of basis on loss deductions allowed:

Turning to the issue presented for decision, a partner may deduct its distributive share of partnership loss. §702(a). However, section 704(d) limits a partner’s deduction to its outside basis in its partnership interest at the end of the partnership year in which the loss occurred. See Sennett v. Commissioner, 80 T.C. 825 (1983), aff’d per curiam, 752 F.2d 428 (9th Cir. 1985). Any loss in excess of the partner's outside basis is carried forward and allowed as a deduction for the partnership year in which such excess is repaid to the partnership. §704(d); see Treas. Reg. §1.704-1(d)(1). In other words, the partner may carry forward the loss until it has sufficient outside basis to deduct it.[5]

The Court turns to IRC §705 to look at how a partner is instructed to compute his/her basis:

Initially, a partner’s outside basis equals its monetary contributions to the partnership plus its adjusted basis in any other property that it contributes. §722. Section 705(a) provides the general rules for calculating outside basis thereafter. It requires that partners calculate their outside bases on an annual basis to account for the partnership’s activities during the year, such as additional contributions to the partnership, distributions from the partnership, liabilities incurred, income, loss, and expenses. See §§705(a), 752(a). When calculating their bases each year, section 705(a) provides that partners account for their annual distributive shares of partnership income and/or loss since the partnership began. See Robertson v. Commissioner, T.C. Memo. 2009-91; Chong v. Commissioner, T.C. Memo. 2007-12. Specifically, section 705(a) provides that a partner’s outside basis increases by the sum of its distributive share of taxable income “for the taxable year and prior taxable years” and decreases by the sum of its distributive share of partnership loss “for the taxable year and prior taxable years.” §705(a)(1) and (2). Thus, the plain wording of the statute requires that a partner decrease its outside basis by the sum of all current and prior losses. However, in their annual calculation partners cannot reduce their outside bases below zero. §705(a)(2).[6]

The Court is going to base its decision on very specific wording found in IRC §705(a)(2), so it may be useful to look at §705(a) with what will be the key provisions specifically highlighted, as they are below:

(a) General rule. The adjusted basis of a partner’s interest in a partnership shall, except as provided in subsection (b), be the basis of such interest determined under section 722 (relating to contributions to a partnership) or section 742 (relating to transfers of partnership interests)--

(1) increased by the sum of his distributive share for the taxable year and prior taxable years of--

(A) taxable income of the partnership as determined under section 703(a),

(B) income of the partnership exempt from tax under this title, and

(C) the excess of the deductions for depletion over the basis of the property subject to depletion;

(2) 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; and

(3) decreased (but not below zero) by the amount of the partner’s deduction for depletion for any partnership oil and gas property to the extent such deduction does not exceed the proportionate share of the adjusted basis of such property allocated to such partner under section 613A(c)(7)(D).

The taxpayer is emphasizing the “note below zero” clauses, but the Court is going to focus on the fact that the language for losses includes not just the current year but also “prior taxable years” in the computation.

The Tax Court notes that the year in question in 2017, which becomes key to its argument that the year when the deduction was claimed is not relevant if the basis is not forced below zero looking at instant the basis issue becomes relevant.

The plain wording of section 705(a) requires Surk to decrease its outside basis by the excess losses. Respondent’s calculation is consistent with section 705(a). The one caveat is that outside basis cannot be reduced below zero. However, respondent is not recalculating Surk's outside basis for 2014 or 2015 and improperly reducing it below zero. Rather, he is calculating Surk’s 2017 yearend basis to account for current-year and prior-year losses. Surk reduced its outside basis below zero when it claimed the excess loss deductions for 2014 and 2015.[7]

The Court also points out that while IRC §704(d) distinguishes between allowed and disallowed losses, IRC §705(a) does not make such a distinction:

A partner is required to calculate its outside basis only when necessary to determine its tax liability. Treas. Reg. §1.705-1(a)(1). The calculation of outside basis is ordinarily made at the end of a partnership year. Id. The section 704(d) loss limitation rule is one example of when it is necessary to calculate outside basis. The regulations under section 704(d) rely on the basis calculation rules of section 705. However, they provide specific rules for computing outside basis for purposes of section 704(d). The section 704(d) rules differ from section 705(a) as they distinguish between allowed or disallowed losses. Section 705(a) does not make such a distinction. Under section 705, all prior-year and current-year losses (both allowed and disallowed) decrease outside basis but not below zero. For purposes of section 704(d), outside basis is decreased only for prior-year losses that were allowed. Treas. Reg. §1.704-1(d).[8]

The Court then discusses the §704 regulations as they determine which losses are disallowed under IRC §704(d).

Treasury Regulation §1.704-1(d)(2) provides an ordering rule, first to make positive basis adjustments under section 705(a)(1) and then negative adjustments under section 705(a)(2) “except for losses of the taxable year and losses previously disallowed.” From this first step of the calculation, a partner determines the amount of its outside basis that is available to deduct current-year loss. If the partner’s outside basis is less than its distributive share of current-year loss, the partner may deduct the current-year loss equal to its outside basis and must carry forward the excess loss to future years when it has sufficient outside basis to deduct it. Treas. Reg. §1.704-1(d)(2). Conversely, if the partner’s outside basis exceeds its distributive share of current-year loss, the partner may deduct the current-year loss plus prior-year disallowed losses, i.e., carryforward losses, to the extent of its remaining outside basis. Id.[9]

The opinion emphasizes that this regulation allows excluding only “losses previously disallowed” from the computation of basis for a year’s computation of the IRC §704(d) deduction limit, and the court determines a loss previously claimed by the taxpayer was excluded from any “losses previously disallowed” even in that computation.

We interpret the regulation’s exclusion of “losses previously disallowed” to mean that a partner must decrease its outside basis by all previously allowed losses in the first step of the calculation. We have defined an “allowed deduction” as a deduction actually claimed on a return and allowed by the Internal Revenue Service (IRS), which we have distinguished from an “allowable deduction,” i.e., a deduction which qualifies under a specific provision of the Code. See Lenz v. Commissioner, 101 T.C. 260, 265 (1993); Reinhardt v. Commissioner, 85 T.C. 511, 515-16 n.6 (1985); see also Flood v. United States, 33 F.3d 1174, 1177 (9th Cir. 1994). On its 2014 and 2015 returns Surk deducted over $3.3 million of excess losses. The IRS did not disallow the deductions, and those years are closed. In such an instance, the returns provide the final tax treatment, and Surk is bound by the reporting on the returns. See Meruelo v. Commissioner, 132 T.C. 355, 365 n.7 (2009), aff’d, 691 F.3d 1108 (9th Cir. 2012); Roberts v. Commissioner, 94 T.C. 853, 857 (1990); see also Harris v. Commissioner, 99 T.C. 121, 124-25 (1992), supplementing T.C. Memo. 1990-80. Accordingly, the 2014 and 2015 excess losses are previously allowed losses, and Surk must decrease its outside basis by the excess losses for its annual calculation of outside basis for purposes of section 704(d). This is the proper outside basis calculation for 2017 and for future years.[10]

The Court rejects the taxpayers’ argument that the IRS cannot adjust their outside basis unless the IRS issues an FPAA for 2014 and 2015 (something it would be time barred from doing), but rather can use an FPAA for 2017 to make this adjustment:

Notwithstanding the computation rules above, petitioner argues that respondent cannot use an FPAA for 2017 to adjust Surk's outside basis to account for the 2014 and 2015 excess losses. It argues that respondent’s only recourse was to issue an FPAA for 2014 and 2015 to disallow the excess loss deductions. We disagree. As stated above, under section 705(a) a partner must calculate outside basis annually and must decrease its outside basis for the current-year loss as well as all prior-year losses since the partnership began. Treasury Regulation §1.704-1(d)(2) adopts the section 705 basis adjustment rules although it limits the negative basis adjustment to allowed losses. Thus, it is immaterial that respondent did not issue an FPAA for 2014 and 2015 or that those years are closed. Respondent is calculating Surk's outside basis for yearend 2017. For this same reason, we also reject petitioner’s argument that respondent's position decreases Surk’s outside basis below zero. Respondent’s calculation of Surk's 2017 yearend outside basis does not result in an outside basis below zero.[11]

A significant consideration that the Court implicitly deems crucial is that the Internal Revenue Code Section 705 (IRC §705) itself does not explicitly mention an annual calculation that commences with the basis of the preceding year, incorporates or deducts various elements, and subsequently determines an ending basis that must be utilized to determine the basis for the ensuing year. While most accountants may object to disregarding the annual computations, the Court’s perspective is that IRC §705 itself mandates a “from scratch” calculation of the basis from the date the partner first acquired the interest each time it is required.

The Court goes on to point out that as the IRS is not attempting to make an assessment against 2014 and 2015, there is no prohibition against the agency looking at information from those years to impact the 2017 basis amount.

Moreover, respondent is not seeking to make an assessment for a closed year or to disallow the excess loss deductions for 2014 and 2015. The question before the Court is how the excess loss deductions factor into the annual outside basis calculation. Events from nondocketed, prior, closed years may be considered to calculate outside basis for the docketed year. See G-5 Inv. P’ship v. Commissioner, 128 T.C. 186, 191-92 (2007); see also §6214(b) (for deficiency cases).

Petitioner concedes that Surk improperly deducted the excess losses for 2014 and 2015. Surk now seeks to disregard its own reporting to claim future tax benefits. If Surk were not required to decrease its outside basis by the previously allowed excess losses, its outside basis would be overstated and would permit loss deductions in excess of Surk’s investment in its Outerknown partnership interest. We hold that for purposes of section 704(d) Surk must decrease its outside basis in Outerknown by all previously allowed losses including the $3,308,767 of excess losses that it deducted for 2014 and 2015.[12]

In the November 14, 2024 edition of Tax Notes Today, an article appears[13] that discusses this opinion, specifically looking at how the case was impacted by a ruling in an S corporation matter that I wrote about in July of 2023.[14] In that matter in the case of Kanwal v. Commissioner,[15] the court declined to grant the IRS’s motion for summary judgment based on the “Suspense Account Method” the agency had been using when taxpayers had claimed losses in excess of basis in now closed years.

As I wrote in that article:

The suspense account method pertains to the IRS’s perspective on handling situations where it identifies that a shareholder of an S corporation has claimed losses exceeding their basis in a year that is no longer open for assessment. Relying upon Treasury Regulation §1.1016-6(a), the IRS would allocate the improperly deducted losses from closed years to a suspense account. The regulation provides that adjustments to basis must be made to eliminate double deductions or their equivalents.

Once there is the creation of the suspense account, any income reported in subsequent years would need to be offset against that suspense account, starting from the first year that remains open for assessment when the IRS discovers the issue. 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.

In an article published in Tax Notes Today Federal,[16] Kristen Parillo highlights that the IRS initially introduced the suspense account method in a 2002 Field Service Advice (FSA) document with the reference number 200230030. The IRS further endorsed the use of this method in a Technical Advice Memorandum (TAM) with the reference number 200619021. Eventually, the IRS incorporated the method into a Practice Unit titled “Losses Claimed in Excess of Basis” in April 2018, under the SCO/P/53_05_01_03-06 reference.[17]

As that article notes, the judge hearing the Kanwal case asked the IRS to provide more information to support the method, raising specific questions about whether, in fact, their reliance on Reg. §1.1016-6(a)’s methods to deal with double deductions allowed such adjustments to be made in specific cases where the judge suggested there did not appear to be a double deduction. The 2024 Tax Notes Today Federal article notes that while the IRS did file a memo in August 2024 modifying the position somewhat in the Kanwal case, the case was eventually settled the case before any additional court orders or opinions were issued.

In the Surk case the IRS had initially also attempted to apply the suspense account method to justify making the adjustment to basis, but following the development in the Kanwal case the IRS modified its argument before the Surk court on the basis issue to the one the judge in this case ultimately agreed with.[18]

So a key question arises: what impact does this case have on S corporation matters? I am of a similar opinion to that expressed by Robert Keller of KPMG LLP who is quoted in the more recent Tax Notes Today Federal article that the language of IRC §1367(a) does not support the same “from day one” analysis of basis noting:

S corporations don’t have the same unified basis regime as partnerships, Keller said, noting that basis in stock is tracked separately from basis in debt for S corporation shareholders, with specific ordering rules between the timing of the use of losses against stock and debt basis.

Another difference is in section 1367(a), Keller said. That provision states that the basis of each shareholder’s stock in an S corporation shall be decreased (but not below zero) by the sum of its pro rata share of the corporation’s non-separately stated and separately stated deductible and nondeductible items for “such period.”

“Section 1367(a) does not contain the same broad language that the Surk court found to be persuasive in finding in favor of an approach to tracking basis that would include cumulative ‘gross’ losses — whether appropriately allowed or not — in the partner’s basis,” Keller said.

That is, while section 705(a) explicitly states that basis shall account for current- and prior-year losses allocated to the partner in tracking basis for the year, section 1367(a) simply references the tracking of relevant losses for “such period” in a rolling-forward basis, Keller said.[19]

Looking at IRC §705(a) and 1367(a) side by side makes it very clear that IRC §1367(a) specifically requires an annual calculation that would seem to make it very difficult to argue that the test is made each year on a cumulative basis, rather than each year’s analysis beginning with the properly computed §1367(a) stock basis for the prior year. Only because IRC §705(a) makes no such reference to the “current period” does that open the door to looking at a cumulative calculation each time the basis number is needed.

Readers should note that the Surk case is not a reported Tax Court case and, as well, the taxpayer may elect to take this matter up with the appropriate Court of Appeal. The article referenced contains quotes from tax professionals who question the court’s analysis in Surk as applied to partnerships, so for now this case is just one point of information for advisers facing this issue.

[1] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/partnership-must-adjust-outside-basis-include-excess-losses/7msc2 (retrieved November 15, 2024)

[2] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[3] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[4] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[5] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[6] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[7] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[8] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[9] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[10] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[11] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[12] Surk, LLC v. Commissioner, TC Memo 2024-99, October 29, 2024

[13] Kristen A. Parillo, “Tax Pros Weigh Impact of Ruling on IRS Basis Calculation Method,” Tax Notes Today Federal, November 14, 2024, https://www.taxnotes.com/tax-notes-today-federal/basis/tax-pros-weigh-impact-ruling-irs-basis-calculation-method/2024/11/14/7n5bg (retrieved November 15, 2024, subscription required)

[14] Edward K. Zollars, “IRS Required to Justify Its Suspense Method for Dealing With S Corporation Losses Claimed in Closed Year With Insufficient Basis,” Current Federal Tax Developments website, July 20, 2023, https://www.currentfederaltaxdevelopments.com/blog/2023/7/20/irs-required-to-justify-its-suspense-method-for-dealing-with-s-corporation-losses-claimed-in-closed-year-with-insufficent-basis (retrieved November 15, 2024)

[15] Kanwal v. Commissioner, Order, Docket Nos. 23766-18, 23769-1, 23776-18, and 23842-18, US Tax Court, July 18, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/irs-to-provide-additional-support-for-basis-adjustment-method/7gzqc (retrieved November 15, 2024)

[16] Kristen A. Parillo, “Tax Court Weighing Validity of IRS’s ‘Suspense Account’ Method,” Tax Notes Today Federal, July 20, 2023, https://www.taxnotes.com/tax-notes-today-federal/basis/tax-court-weighing-validity-irss-suspense-account-method/2023/07/20/7gzs5 (retrieved November 15, 2024, subscription required)

[17] Edward K. Zollars, “IRS Required to Justify Its Suspense Method for Dealing With S Corporation Losses Claimed in Closed Year With Insufficient Basis,” Current Federal Tax Developments website, July 20, 2023

[18] Kristen A. Parillo, “Tax Pros Weigh Impact of Ruling on IRS Basis Calculation Method,” Tax Notes Today Federal, November 14, 2024

[19] Kristen A. Parillo, “Tax Pros Weigh Impact of Ruling on IRS Basis Calculation Method,” Tax Notes Today Federal, November 14, 2024