1. S-Corporation Shareholder Basis
2. What Are S-Corporations?
3. S-Corporations and Taxes
4. Stock Basis, Debt Basis, and Losses

S-Corporation Shareholder Basis

S-corp basis refers to a number that rises and falls depending on the activity of the company. According to the IRS, "basis" is defined as the amount of investment that an individual makes in the business for the purpose of taxes. Basis measures how much the owner has invested in the property.

What Are S-Corporations?

S-corporations refer to businesses that have a maximum of 100 shareholders and also have the ability to choose to be subject to taxes in the context of a partnership. These corporations are pass-through entities that pass to the shareholders both the losses and income incurred from the business. The shareholders are taxed based on the losses and income of their business on their income tax returns.

S-Corporations and Taxes

S-corporations usually aren't subject to taxes on the income that they generate at the entity level. The only exceptions to this rule are detailed in Sections 1374 and 1375. Rather, the income from S-corporations is divided among the shareholders. The shareholders are responsible for reporting the income and paying taxes on the income on their individual tax returns.

The purpose of the statute is to make sure that the income of the S-corporation is only taxed once rather than twice. This is true whether the corporation retains the income, which would boost the value of the stock of the shareholders, or distributes the income. 

Section 1366 consists of basis adjustment rules, which act as a method by which the single level of taxation unique to S-corporations can be preserved. These rules make sure that the sale of stocks or the distribution of income does not lead to second-level taxation.

In the beginning of the investment, the basis is the cost of the property. However, in the context of S-corporations, basis can transform into a moving target as the investment of the shareholder in the company changes.

On the other hand, the stock basis of C-corporations remains the same every year. The following all have the ability to impact the shareholder's basis of an S-corporation:

  • Distributions
  • Annual income
  • Loans

All shareholders of an S-corporation will receive a K-1 form when the S-corporation files the 1120S form, which is the tax return. The purpose of the K-1 form is to show deductions, profits, and losses distributed to the shareholder. The K-1 does not indicate the amount of the distribution that is taxable. This amount depends on the stock basis. 

Stock Basis, Debt Basis, and Losses

The main purpose of stock basis is to decide whether losses are deductible and whether distributions are taxable. A shareholder's basis is calculated annually and needs to be tracked from the first day of ownership.

A shareholder can obtain S-corporation basis via cumulative net income, the purchase of stock, additional equity contributions, and having fewer distributions allocated to the shareholder during the period when the stock is under ownership. Shareholders obtain debt basis from any loans that they made to the S-corporation.

You should keep in mind that non-dividend distributions are not able to reduce debt basis even though they can reduce stock basis. Non-dividend distributions refer to any distributions that don't come from accumulated profits and earnings.

Sec. 1366(d)(1) makes it so that deductible pass-through losses for a shareholder cannot be greater than the adjusted basis of stock of the shareholder in the S-corporation in combination with the adjusted basis of the shareholder pertaining to the indebtedness of the corporation to said shareholder.

Basis is of the utmost importance because it serves as the first test to decide whether a shareholder possesses a deductible loss from the S-corporation. Shareholders also need to pass the passive activity and at-risk loss tests before they report a loss on their personal tax returns.

On the other hand, Sec. 1366(d)(2) makes it so that pass-through loss can be rolled over indefinitely if the shareholder doesn't have sufficient basis for the current tax year to deduct a loss.

However, you should keep in mind that taxpayers can lose their ability to deduct losses in the future if enough basis is not restored or created before the corporation shuts down or is sold.

If you need help with S-corp basis, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.