Schedule K-1s used to report various matters related to S Corporation shareholders (e.g. income or loss) do not contain all of the information required to calculate basis, and S Corporations are not required to report basis calculations to shareholders, or the IRS. In fact, the only information on how to calculate stock basis is in the Schedule K-1 instructions, but for most of us the thought of reading such instructions is tantamount to hitting the dreaded “Help Key” in Windows.
Many S Corporations prepare their tax returns on a cash basis and their financial statements on the accrual basis of accounting, and this can cause confusion in computing basis (e.g. the financials may report accrual based earnings which would generally increase basis, but if such earnings are deferred through a cash basis tax return, then the increase in basis would also be deferred).
The IRS has not promulgated any specific publications for S corporations. This may surprise many of you who might reasonably believe the IRS would have addressed this issue somewhere in the Internal Revenue Code given that it is about seven times the length of the Bible.
Unfortunately, and despite the above, the IRS is not very compassionate when losses and deductions are incorrectly claimed. So, for this and other reasons, S Corporation shareholders should have a general understanding of how they create and maintain “basis” in these investments. In a nutshell, basis in an S Corporation is the amount a shareholder has “at risk,” which amount is increased or decreased by the entity’s results of operations, and distributions. There are two types of basis as follows:
“Stock” basis which is the amount of money and other property contributed by the shareholder; and
“Debt” basis which results from loans made to the corporation. Please note that unlike certain other pass-through entities, the act of guaranteeing S Corporation debt does not create basis.
Shareholder stock basis is important because it measures the amount shareholders can withdraw from an S Corporation without realizing income or gain (assuming that the shareholder has no debt basis). If, on the other hand, the shareholder has also loaned money to the corporation, then additional losses and deductions are allowed to be deducted to the extent of such debt basis.
In computing stock basis, a shareholder starts with the initial capital contribution or the initial cost of the stock he purchased and adjusts such amount annually in the following order: It is increased by ordinary income, investment income and gains (including tax-exempt income); and then capital contributions and stock purchases; and
It is decreased by cash and property distributions made by the corporation; non-deductible expenses; and any other deductible losses and deductions.
Calculation of basis becomes extremely important in the following situations: When the S-corporation recognizes a taxable loss – In these cases, the losses may be taken as a deduction on the shareholder’s tax return to the extent they have basis. Without basis, the loss is “suspended” and carried forward to offset any future income.
When the shareholder takes a distribution – Proper use of distributions can result in tax savings, but distributions in excess of basis generally result in the “excess” distributions being recognized as a taxable capital gain.
When there is an ownership change – Profits on sales of S Corporation stock in excess of the stock basis create a taxable gain. Again, if the shareholder doesn’t know his basis or has miscalculated it, the shareholder may over- or underreport his gain from the sale of such shares.
In a similar manner, S Corporation shareholders also need to be aware of their debt basis because losses and deductions may also be taken to the extent of such basis even when stock basis has been reduced to zero. In the event such losses are taken, any “reduced debt basis” can be restored by net increases in loan balances; however, if the debt is repaid before the basis is restored, all or part of the repayment will be taxable. Like stock basis, debt basis is adjusted annually and tracked in the following manner: It is increased by loans made to the company, including interest capitalized (i.e., not paid); and
Decreased by payments on loans and any losses or deductions taken in excess of the shareholder’s stock basis. While it is important that S Corporation shareholders have a general understanding of how their basis is tracked, it is equally important to understand that despite the apparent simplicity of the above verbiage, the calculations can be complex. Accordingly, you should be satisfied your tax advisor is tracking your basis appropriately on an annual basis. Doing so may provide you with a sound “basis” for peace of mind, and many happy (income tax) returns.
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