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If he ceased to be a shareholder in 2010 and 2010 was his final year of allocation of income/losses then his 2010 Schedule K1 should have been marked as final at the top of the K1 (there is a little box to check). I think the most accurate remedy would be to amend the 2010 Schedule K1 and mark the K1 as final. (Don't forget to mark the box on the K1 as amended as well) You will need to send in the amended K1 with an amended 1120S form. (see page 6 here - http://www.irs.gov/pub/irs-pdf/i1120s.pdf)
If the investor is willing to accept a 2012 Schedule K1 being marked as final that would work as well. It just won't provide the investor with the correct year of disposition of his investment.
The investor needs the K1 marked as final because it provides proof that he disposed of his investment.
Please let me know if you have any further questions.
1. When i use the TaxAct software to provide a Final K1 for the investor, it does not allow me to give a K1 for the investor because he was not a shareholder in 2012. perhaps, One option as you indicate is to amend his 2010 K1 and also call it "final k1"? - If he was no longer a shareholder in 2010 then the 2010 K1 should have been marked as final. You can file an amended 2010 K1 for to rectify this oversight.
2. Even if we try to prepare a final K1 manually for the investor, which line numbers in Federal K1 do we indicate in the investor's K1 his 40k loss against his original investment of 100k? - You do not show his 40K loss. That is his basis tracking responsibility. He put in 100K and you returned 60K and closed out his shares. The company is not required to disclose the 40K loss to the investor, it is the investor's loss, not the company's.
He claims the loss as a short term capital loss on schedule D. He bought stock for 100K and only received 60K back (+/- any allocation of income/losses) thus the 40K is a capital loss for him.