Distributions reduce basis (but not below zero) before losses are taken into consideration. Losses then can be deducted to the extent the shareholder has stock basis or basis in loans made to the S corporation. If the losses allocated to the shareholder exceeds the shareholder’s basis as so determined, this excess amount is suspended at the shareholder level (the Form 1040 level for an individual shareholder) until such time as the shareholder has sufficient basis in the S corporation stock (or in debt due to the shareholder from the S corporation) to free up the suspended losses. S corporation shareholders are responsible for tracking their own basis in the S corporation stock and must file Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, if the shareholder is claiming a deduction for the shareholder’s share of aggregate losses (including aggregated losses suspended in a prior year). (See the instructions to Form 7203 at https://www.irs.gov/pub/irs-pdf/i7203.pdf for other situations when an S corporation shareholder is required to file Form 7203.)
A loss suspended due to lack of basis is personal to the shareholder. This means that if the shareholder disposes of or transfers all the shareholder’s stock (even if by gift) to a person other than a spouse, the suspended loss is gone forever. If the shareholder disposes of or transfers all but one share of the stock, the full suspended loss is preserved (although it may take a long time for the shareholder holding the small amount of stock to fully utilize the suspended loss)). (See Reg. §1.1366-2(a)(6).) Suspended losses are something to think about when transferring S corporation stock.