Cactus Company is a calendar year S corporation with the following current year information:

Operating loss $ (120,000)
Liabilities:
Notes payable, City Bank 20,000
Notes payable, Jake Crow 20,000

On January 1, John James bought 50% of Cactus Company stock for $30,000. How much of the operating loss may John deduct on his Form 1040? Assume the excess business loss limitation does not apply.

Question

Cactus Company is a calendar year S corporation with the following current year information:

Operating loss	$ (120,000)
Liabilities:	
Notes payable, City Bank	      20,000
Notes payable, Jake Crow	      20,000

On January 1, John James bought 50% of Cactus Company stock for $30,000. How much of the operating loss may John deduct on his Form 1040? Assume the excess business loss limitation does not apply.

BlackTom AI · Accepted Answer

Restated question and options:
- Cactus Company is a calendar year S corporation with: Operating loss = (120,000). Liabilities: Notes payable, City Bank = 20,000; Notes payable, Jake Crow = 20,000. On January 1, John James bought 50% of Cactus Company stock for 30,000. How much of the operating loss may John deduct on his Form 1040? Assume the excess business loss limitation does not apply.
- Answer options: "$60,000", "$30,000", "$40,000", "$50,000".

Evaluation of each option:
Option 1: $60,000
- Why this might seem plausible: John owns 50% of the S corp, so his share of the loss could be 50% of the 120,000 loss, i.e., 60,000. 
- Why it is incorrect: In an S corporation, a shareholder’s deduction from pass-through losses is limited by the shareholder’s basis in the stock (and any at-risk amount). At the time of purchase, John’s stock basis is determined by his cash investment plus his share of any liabilities that are allocated to him. In this scenario, John acquired 50% for 30,000 and there is no indication that he has personal liability for the company’s debt beyond the stock basis. If his basis remains 30,000 (or otherwise limited to his actual increase in basis from the investment), he cannot deduct 60,000 because he lacks sufficient basis. Therefore, 60,000 would overstate his deductible amount unless his basis were at least 60,000.

Option 2: $30,000
- Why this is plausible: John’s initial basis in the S corporation stock is 30,000 (the amount he paid for the 50% stake). In the absence of excess business loss limitations, a shareholder may deduct losses up to their stock basis (and at-risk amount). Since John’s basis appears to be 30,000, his deductible share of the 120,000 loss would be limited to 30,000, assuming no additional basis is created from the company’s liabilities.
- Why it is correct: Given the information, John’s basis governs the deductible loss. He has 50% of the loss, i.e., 60,000, but his basis in the stock is only 30,000, so the deductible amount is limited to 30,000. The liabilities listed (20,000 to City Bank and 20,000 to Jake Crow) do not appear to increase his basis in this problem (they are not described as personally guaranteed by John or allocated to him as increased basis). Therefore, the deductible amount aligns with his stock basis: 30,000.

Option 3: $40,000
- Why this is incorrect: If John’s basis were 40,000, he could potentially deduct up to 40,000. However, the given data indicate an initial investment of 30,000 for 50% ownership and no explicit basis increase from liabilities. Without additional basis information, 40,000 would misstate the limit imposed by his actual basis. The problem as stated does not support a 40,000 basis increase for John.

Option 4: $50,000
- Why this is incorrect: A 50,000 deduction would require a basis of at least 50,000 or some other mechanism increasing deductible loss beyond 30,000. The information provided shows John paid 30,000 for 50% and there is no clear basis increase described that would raise his basis to 50,000. Therefore, allocating 50,000 would exceed his available basis under the standard pass-through loss rule described in the problem.

Summary reasoning (without stating the final answer outright): The key constraint is John’s stock basis, which limits the deductible pass-through loss from the S corporation to the amount of basis he has in the stock (and any at-risk amount). Given his 50% ownership purchased for 30,000 and no explicit basis augmentation from liabilities, his deductible loss is capped by his basis, which is 30,000. The other choices fail because they either assume a higher basis than provided, or ignore the basis limitation entirely, leading to overstatement of deductible loss.

SP25-BL-BUS-A327-1377 Quiz 12

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