S corporation basis reductions for nondeductible expenses

An S Corporation's losses and deductions are allocated among its shareholders according to their proportionate ownership of the S corporation's stock. These losses and deductions reduce the shareholder's basis in his or her stock or, if there is none, in the shareholder's loans to the S corporation. However, these losses and deductions are currently deductible by each shareholder only to the extent that the shareholder has basis in his or her stock and loans to the corporation. Any excess amounts of such otherwise deductible losses and deductions over basis for stock and loans are not currently deductible and are treated as arising for that shareholder in his or her next tax year (the carryover provision). However, there is confusion as to whether the carryover provision also applies to nondeductible, noncapital losses and expenses (e.g., nondeductible meal expenses and fines). Reg. Sec. 1.1367-1(g) provides an elective ordering rule under which a shareholder may elect to decrease basis under Reg. Sec. 1.1367-1(f)(4) prior to decreasing basis under Reg. Sec. 1.13671-1(f)(3). Thus, the shareholder may elect to allow his or her separately and nonseparately stated items of loss or deduction to reduce basis prior to the nondeductible expenses. S corporation nondeductible, noncapital expenses allocated to a shareholder that exceed the shareholder's basis in the S corporation's stock and loans from the shareholder to the corporation do not carry over to a succeeding shareholder tax year and do not reduce basis in any succeeding shareholder tax year unless an election under Reg. Sec. 1.1367-l(g) is made.