S Corporation Basis 101: What Every Shareholder Needs to Track
A company organized as an S corporation (S corp) has some unique advantages compared to C corporations (C corps) and partnerships and is a great organizational structure for many businesses. However, one of the often overlooked issues, albeit important, is S corp basis.
What Is S Corp Basis?
S corp basis is the running total of a shareholder’s investment in the company.
Why Does It Matter?
Business losses are limited by basis, and distributions are only tax-free to the extent of basis. Basis can quickly cause issues at tax time for shareholders if one is unaware of these tax consequences.
How Does Basis Increase or Decrease?
Under IRC Section 1367, the following increase S corp basis:
- Capital contributions
- Income (i.e., ordinary income, interest income, etc.)
- Tax-exempt income
The following decrease S corp basis:
- Distributions
- Loss and deduction items (i.e., ordinary loss, charitable contributions, Section 179 expenses, etc.)
- Non-deductible expenses
When calculating basis, there are rules for the order in which basis is calculated. Income items are added first, then decreased for distributions, followed by non-deductible expenses, and finally losses and deductions.
What Happens When Basis Goes to Zero?
The two big tax consequences when basis is low or goes down to zero are the inability to deduct business losses and distributions are no longer tax-free. If a shareholder has no basis and the S corp passes through a loss on Schedule K-1, that loss will not be deductible on the shareholder’s personal return. That loss is not gone forever; it’s just “trapped” until the shareholder has enough basis to take the loss. If the S corp has a large amount of income the following year, that loss could be used to offset that income. This is something to be aware of because it can certainly cause a surprise at tax time if a business owner was hoping to offset other sources of income with a large business loss.
Distributions are another tax consideration when basis is at zero. Taking distributions in excess of basis would cause those otherwise tax-free distributions to become taxable as capital gain. This can mitigate the huge advantage of single taxation as an S corp. Goodbye single level of taxation!
Stock Basis vs. Debt Basis
Debt basis only exists if the S corp owes the shareholder a direct, bona fide debt. Debt basis only comes into play after stock basis has been reduced to zero. So, a situation could arise where a shareholder has zero stock basis but positive debt basis and, therefore, may still deduct losses but cannot take a distribution tax-free.
What Should Business Owners Do?
Business owners should ensure they (or their tax advisors) are keeping accurate basis schedules. As a business owner, S corp shareholders are entitled to take whatever distributions they’d like, granted they are pro-rata. However, keeping basis in mind, it’s a best practice to be cognizant of the distributions being taken to ensure basis isn’t getting too low. Lastly, just being aware of basis can ensure there aren’t surprises and can allow for tax planning opportunities if basis is getting low.
For more information, or if you have thoughts and/or questions about the information outlined above, please do not hesitate to contact us; our seasoned and experienced tax professionals are always here to help. You can also learn more by visiting our Tax service page.
