Updated August 10, 2022
Since the sweeping changes in the Tax Cuts and Jobs Act of 2017 went into effect, many businesses have rethought how they are structured. S corporations have a certain appeal and may be a good fit for some. Today, we’ll help you understand the importance of tracking your basis in an S corporation.
When investing in an S corporation, it is important to know your basis. According to the Internal Revenue Service, basis is defined as your capital investment in a property for tax purposes. It is used to figure out your depreciation, amortization, depletion, as well as gain or loss on the sale, exchange and disposition of the property. As a shareholder in an S corporation, you receive a K-1 that reflects current-year income or loss, and deductions. The K-1 that you receive does not reflect your current-year taxable distributions. This is because the taxable amount of your distribution depends on your basis. Unfortunately, it is the responsibility of the individual shareholder, not the corporation, to keep track of basis. S corporations are subject to single-level taxation. An S corporation generally does not pay taxes on the income it generates; rather the income is allocated to the shareholders and taxed at the individual level. Shareholders must have adequate stock and debt basis in order to take losses or deductions that flow-through from the S corporation.
Computing your basis in an investment can be boring and tedious or it can be as easy as looking at your checking account — but it's important to know because it reflects a shareholder's post-tax investment in an S corporation.
On February 6, 2019, the IRS released clarification on line 28, column (e), of Schedule E (Form 1040), which highlights a new box that was added to Schedule E related to shareholder basis, that says:
“As stated in Part II of the Schedule E (Form 1040), a taxpayer who owns an interest in an S corporation and reports a loss, receives a distribution, disposes of stock, or receives a loan repayment from the S corporation must check a corresponding box under line 28, column (e), and attach a computation detailing their S corporation basis. The discussion about basis rules for S corporations in the Instructions for Schedule E (Form 1040) for Parts II and III does not limit or modify this requirement.”
As we are half-way through the year, it is recommended that shareholders review their basis as part of tax planning to know whether losses can be deducted, suspended and/or carried forward, as well as to determine the taxability of distributions.
As tax advisors, we are here to help you break down the complicated rules of calculating shareholder basis. Let’s take a look!
The S corporation stock basis of your investment starts with your initial capital contribution and your initial cost of the stock purchased. Stock basis is increased by the income you receive and decreased, but not below zero, by any loss, deductions or distributions on the Form K-1 you receive.
For example, stock basis at the beginning of the year is $100,000 and you receive Form K-1 with the following amounts:
| Box 1 |
Ordinary Business Income (loss) |
($8,000) |
|
Box 2 |
Rental Income | $4,000 |
|
Box 4 |
Interest Income |
$2,000 |
| Box 9 |
Net Section 1231 Gain (Loss) |
$1,900 |
| Box 16A | Tax Exempt Interest * | $500 |
| Box 16D | Distribution** | $16,000 |
*Tax Exempt Interest increases shareholder basis. Basis is increased by this amount to preserve the nature of the Tax Exempt income. If the shareholder fails to include Tax Exempt Interest in the calculation, then the Tax Exempt Interest will be taxed when the stock is sold (even though it shouldn’t be taxed).
** Non-dividend distributions reduce stock basis, while dividend distributions do not. Box 16D on schedule K-1 reflects non-dividend distributions. Dividend distributions will be reported on Form 1099-DIV.
Assuming no debt basis and using the ordering rules, stock basis is increased by income and reduced by distributions, losses and deductions:
| Beginning of Year Stock Basis | $100,000 |
| Add: | |
| Rental Income | $4,000 |
| Interest Income | $2,000 |
| Net Section 1231 Gain (Loss) | $1,900 |
| Tax Exempt Interest | $500 |
| Stock Basis Before Distribution | $108,400 |
| Less: | |
| Shareholder Distribution** | $16,000 |
| Stock Basis Before Loss and Deductions | $92,400 |
| Ordinary Income (Loss) | ($8,000) |
| End of Year Stock Basis | $84,400 |
***Since there is adequate stock basis before distribution, the distribution of $16,000 is non-taxable.
Shareholders get basis in debt that they personally loan to the S corporation. Any debt loaned from third parties to the corporation does not increase the debt basis of the shareholder.
Debt basis is computed and updated similarly to stock basis, but there are a few differences. Shareholders are able to deduct losses and deductions that exceed their stock basis in the current year against their existing debt basis. Debt basis is decreased by repayments made by the S corporation to the shareholder and increased by additional loans made to the company by the shareholder.
Here’s an example of how to track debt basis: Debt basis at the beginning of the year is $20,000. During the year, the shareholder deducts $3,000 for S corporation losses that were in excess of stock basis, and repayments made of debt to the shareholder during the year were $2,000:
| Beginning of Year Stock Basis | $20,000 |
| Less: | |
| Principal paid to shareholder | ($2,000) |
| Losses/Deductions in excess of Stock basis | ($3,000) |
| End of Year Debt Basis | $15,000 |
In this article, we tried to make these examples as simple as possible. If you have questions or need assistance, contact our experts.
