How to calculate stock and loan basis in an S Corp for tax purposes? Or as my hippie friends call it, "The secret of the Golden Flower." Seemingly elusive and yet oh so real.
If you are a shareholder of an S corporation you are responsible for keeping track of your own basis (investment value) in the S corporation of which you own shares. Tracking shareholder basis is usually not the S corporation’s responsibility.
You can have stock basis and loan basis, adjusted each year based on the S corporation’s operations.
It is important to annually calculate your shareholders basis in the S corporation stock for the following reasons:
• You can claim losses and deductions passed through on Schedule K-1 to the extent of their stock and loan basis [§1366(d)(1)].
• If you receive a non-dividend distribution from the S corporation, it’s nontaxable to the extent of you stock basis [§1368(b)(1)].
• When you disposes of the S corporation stock, gain or loss on the disposition is calculated using you stock basis.
Stock basis starts with your initial contribution of capital to the S corporation's capital account or the price paid for the stock. This amount is adjusted annually, as of the last day of the S corporation year, in the following order [Reg. §1.1367-1(f)]:
(1) Increased by all income including tax-exempt income reported on Schedule K-1 and excess depletion.
(2) Decreased by property distributions including cash made by the S corporation that are reported on Schedule K-1 in Box 16 with code D.
(3) Decreased by nondeductible non capital expenses, such as illegal bribes, kickbacks, fines and penalties, expenses and interest related to tax-exempt income, and the nondeductible portion of meals and entertainment.
(4) Decreased by deductible losses and deductions reported on Schedule K-1.
Stock basis can never go below zero.
If non dividend distributions exceed stock basis, the excess is taxed as capital gain on your personal return [§1368(b)(2)].
If deductible losses and deductions exceed stock basis, they can be deducted to the extent you have loan basis and any amount in excess of loan basis is suspended and carried over to the succeeding tax year.
You can elect to reduce your stock basis by deductible losses and deductions before decreasing their basis by non deductible expenses [Reg. §1.1367-1(g)]. If this election is made and nondeductible expenses exceed your stock and loan basis, the excess retains its character and is carried over to the succeeding tax year. If the election is not made, any excess nondeductible expenses are lost, not suspended and not carried over.
Loan basis starts with a loan substantiated with loan documentation from you the shareholder of the S corporation to the S corporation. In other words, it includes a traditional, written note with a reasonable stated rate of interest. It does not include third party loans to the S corporation that you guarantee or co-signs.
Loan basis is adjusted as follows:
• Losses and deductions (deductible and nondeductible) passed through on Schedule K-1 reduce stock basis before they reduce loan basis.
• Loan basis can never go below zero. If deductible losses and deductions exceed your stock and loan basis, the excess is suspended and carried over.
• If there are different types of losses and deductions, the allowable loss and deduction items must be prorated.
• If loan basis has been reduced by pass-through losses and deductions, any net increase in a subsequent year restores the reduced loan basis before it increases your stock basis [Reg. §1.1367-2(c)].
A net increase is the amount by which the increases to stock basis exceed the decreases to stock basis including non dividend distributions.
• Non dividend distributions are not taxable if there is a “net increase” for the year, even if you have no stock basis.
• Reduced loan basis is restored by any “net increase” for the year before any loan repayments during the year are taken into account [Reg. §1.1367-2(d)(1)].
These loan repayments must be allocated in part to a return of your basis and in part to the receipt of income. If the loan is a written note, the note is a capital asset and the income will be capital gain.
As an S corporation shareholder you must establish that you have enough basis in the S corporation before you can claim any pass-through losses or deductions. Basically S corporation shareholders usually tend to get into trouble when they assume that non dividend distributions from an S corporation are entirely nontaxable. Be sure to verify that the distribution does not exceed your stock basis. Also be sure to be aware of the various ordering rules for adjusting stock and loan basis in an S corporation.
For more on this contact me anytime.