Problem
Joe Stephens formed Sigma Corporation on January 4 of Year 1, and the corporation immediately made an S election effective for that year. In forming the corporation, Joe contributed $50,000 cash in exchange for 100% of Sigma's stock. Shortly thereafter, the corporation obtained a $75,000 bank loan to assist with operations. Sigma's first two years did not go as well as expected, with Sigma incurring a $60,000 ordinary loss in Year 1 and a $12,000 ordinary loss in Year 2. Moreover, in Year 2, Joe and his wife Marsha divorced. As part of the divorce settlement, on March 31 of Year 2, Joe gave Marsha 50% of the Sigma stock. In Year 3, Sigma's performance improved, with the corporation earning $40,000 of ordinary income. Joe asks your help in determining the tax consequences of these events, particularly the usage of the S corporation losses. At a minimum, you should consider the following resources: IRC Sec. 1366 Reg. Sec. 1.1366-2.