Key Takeaways

  • S corp basis represents a shareholder’s investment and affects taxation of distributions and losses.
  • Basis includes stock and debt basis, both of which determine the ability to deduct losses.
  • Stock basis changes yearly based on income, deductions, distributions, and contributions.
  • Debt basis comes from direct loans a shareholder makes to the corporation.
  • Tracking basis is essential to avoid disallowed losses and future tax issues, especially upon sale or liquidation.
  • Distributions exceeding basis may be taxable as capital gains, even if not reported on a K-1.
  • Losses that exceed basis can be suspended and carried forward, but may be permanently lost if basis isn’t restored before dissolution.

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.

How to Calculate and Track S Corp Basis

Shareholders must maintain accurate records of their basis, as the IRS does not track this for them. Calculating basis begins with the amount paid for the stock, plus any direct capital contributions. Each year, the shareholder’s basis is adjusted as follows:

Increase Basis by:

  • Additional capital contributions
  • Share of the S corp’s income (including tax-exempt income)
  • Excess of deductions over losses if restored from prior year suspensions

Decrease Basis by:

  • Distributions received (not including taxable dividends)
  • Share of S corp losses and deductions
  • Non-deductible expenses not capitalized

The IRS Form 7203 (starting in tax year 2021) is now required to report stock and debt basis and calculate allowable losses.

Shareholders who fail to maintain basis records may be denied deductions for losses or may inadvertently report taxable distributions incorrectly.

Debt Basis Limitations and Repayments

A debt basis is only created when a shareholder directly lends money to the S corp. Guarantees of third-party loans do not create basis unless the shareholder actually repays the loan.

If the S corp repays part or all of the loan, the shareholder's debt basis is reduced. Future losses can only be deducted to the extent of the remaining basis. Once debt basis is used to deduct losses, it must be restored by additional loans before further loss deductions are allowed.

Debt repayments that restore basis must also be tracked, especially in years when there are accumulated suspended losses.

Distributions and Tax Implications

Distributions from an S corporation are generally not taxable if they do not exceed the shareholder’s stock basis. However, if distributions exceed the available stock basis:

  • The excess is treated as a capital gain.
  • It is reported on the shareholder’s personal tax return and taxed accordingly.

Importantly, the K-1 form does not indicate whether a distribution is taxable—that determination depends entirely on the shareholder’s individual basis calculation.

Distributions do not affect debt basis unless the distribution is a loan repayment. This distinction is crucial when determining whether a distribution should be taxed.

Suspended Losses and Loss Carryovers

When an S corp shareholder’s losses exceed their stock and debt basis, the excess is disallowed under IRC §1366(d). These losses are suspended and carried forward indefinitely until the shareholder restores basis.

To deduct previously suspended losses, shareholders must:

  • Increase stock basis (via income or contributions), or
  • Increase debt basis (by making additional direct loans).

However, if a shareholder sells or abandons their stock or the corporation liquidates before basis is restored, those suspended losses are permanently lost. Therefore, proactive basis tracking and restoration is essential to preserve tax benefits.

Frequently Asked Questions

1. What is S corp basis used for?S corp basis is used to determine if a shareholder can deduct losses or must pay tax on distributions.

2. What happens if I don't track my S corp basis?You risk losing deductions or misreporting taxable income, which can lead to IRS penalties.

3. Can I create debt basis by co-signing a loan for the S corp?No. Debt basis only arises from direct shareholder loans that are personally funded.

4. Do all distributions from an S corp reduce basis?Distributions reduce stock basis, but not debt basis, unless they are loan repayments.

5. How do I restore basis to deduct suspended losses?You can restore basis through additional capital contributions, increased income allocation, or new direct shareholder loans.

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