Key Takeaways

  • An S corporation shareholder’s stock basis measures their investment in the company and determines loss deductibility and distribution taxation.
  • Unlike C corps, S corp stock basis changes annually based on income, losses, distributions, and contributions.
  • The initial basis is usually what was paid for shares or the value of contributed property, with later adjustments for earnings, contributions, and certain expenses.
  • Proper tracking avoids tax problems; losses in excess of basis are suspended until more basis is created.
  • Debt basis (from direct shareholder loans) is separate from stock basis and affects how losses are applied.

The Basics of S Corporation Stock Basis

S corp basis calculation refers to the amount the owner has invested in the business or property. When the investor first makes an investment in the business, this is the initial cost of the property. However, as an S corporation grows or scales back, the basis calculation can change as the investment of the shareholder shifts.

This is something that sets S corporations apart from C corporations, as the stock basis of a C corp remains the same each year. The basis calculation of an S corporation can change, based on factors such as:

  • Loans
  • Distributions
  • Annual income

These shifts can be surprising to shareholders and managers in an S corp. When calculating the basis for each shareholder, it's important to make sure that it is handled accurately. This figure measures how much a shareholder can receive or withdraw from the S corporation without tracking the gain or income. Each shareholder's basis represents their economic investment in the business.

The calculations and adjustments for stock basis should happen at the end of the taxable year. These figures should include any losses, deductions, distributions, and account income. It's also important to calculate each amount in the correct order to get the right number.

Many companies overlook or neglect the task of tracking the basis calculation. This may happen because the company is becoming more profitable but making minimal distributions, so the number isn't as important to the shareholders. However, the need to keep accurate calculations will become more critical when a change occurs, such as the company reaches the end of its life or a shareholder alters their ownership interest. When people start a new business venture or invest in a company, they typically don't consider what will happen when it comes to an end.

When the shareholders of a corporation don't keep track of the basis calculation on an ongoing basis, trying to do it after the fact is challenging and tedious. In fact, the process can feel a bit like trying to put a puzzle together without having all the necessary pieces. In some cases, the accountant for the business will keep track of the basis calculation when preparing company or shareholder tax returns. 

A CPA assigned to handle the financials for a corporation can help clients by tracking the basis calculation from the day the business starts. In some cases, a CPA may come in after the fact, which means they could come into a poorly managed system for basis calculations. The basis is a number that will go up and down as the company engages in different business activities.

The ultimate purpose of this number is to determine whether losses are deductible or distributions are subject to tax. Each shareholder's basis should be tracked from the start of the formation of the corporation and continue to be calculated every year. The two main basis numbers that should be tracked are debt basis and stock basis.

Understanding Initial Basis and Annual Adjustments

Your initial S corporation stock basis is generally the cash you invest or the fair market value of any property you contribute when acquiring shares. This amount may also stem from a converted C corporation’s stock basis, a carryover basis from a gift, or a stepped-up basis for inherited shares.

Once established, the stock basis is adjusted each year in a set order:

  1. Increases for items such as:
    • Your share of ordinary business income
    • Tax-exempt income
    • Additional capital contributions
  2. Decreases for:
    • Non-deductible expenses
    • Distributions not reported as wages
    • Your share of deductible losses and deductions (including charitable contributions and Section 179 deductions)

It’s crucial to follow the IRS-prescribed order because applying adjustments incorrectly can overstate or understate your ability to deduct losses or take tax-free distributions.

Items of Adjustment

Understanding stock basis and explaining it to any clients can be challenging. Comparing it to a checking account can make it clearer. The stock basis includes the earnings and deposits, minus any withdrawals. Similar to a bank account, shareholders and managers can't take out more money than what is coming in. The stock basis can't dip below a positive level. The stock basis starts as soon as a corporation is formed and starts doing business, so it's critical to track it at the start of the business.

When the basis is tracked and updated every year, it becomes a less complex and more straightforward process. In fact, it's simple enough to use standard tax preparation software or calculate it manually. In the beginning, the initial basis is typically the amount of cash that was paid for shares in the S corporation. It can also refer to the basis of stock in a C corporation when it converts to an S corporation, the stepped-up basis if the stock was inherited, the carryover basis if the stock was gifted, or how much property was contributed to the business.

Some of the increases commonly used to calculate stock basis include:

  • Non-deductible distributions and expenses
  • Capital contributions
  • Charitable contributions
  • Ordinary income
  • Section 179 deductions
  • Investment gains and income
  • Common decreases

Step-by-Step: How to Calculate Stock Basis

To determine your S corp stock basis at year-end:

  1. Start with the prior year’s ending basis (or the initial basis if it’s your first year).
  2. Add:
    • Your share of the S corporation’s income (including separately stated items like capital gains, interest, or rental income)
    • Any tax-exempt income
    • Additional cash or property contributions you made during the year
  3. Subtract:
    • Distributions received that are not wages or loan repayments
    • Non-deductible expenses allocated to you
    • Your share of deductible losses and deductions, applied in the correct order

Example:If your beginning basis is $20,000, you add $15,000 for your share of income and $5,000 in capital contributions, raising your basis to $40,000. If you then take a $10,000 distribution and have $8,000 in losses, your ending basis is $22,000.

Common Mistakes in Basis Calculation

Many shareholders miscalculate basis by:

  • Failing to track basis annually, making it difficult to reconstruct later.
  • Confusing stock basis with debt basis (loans you personally make to the corporation).
  • Applying losses before subtracting distributions, which can incorrectly suspend losses.
  • Not recognizing that loan guarantees do not create debt basis unless you actually lend personal funds.

Maintaining accurate, year-by-year basis records helps prevent IRS disputes, avoids loss disallowance, and ensures you take full advantage of tax-free distributions when eligible.

Debt Basis Considerations

Debt basis applies only when you personally lend money to the S corporation. Third-party loans—such as bank loans—do not increase your debt basis unless you directly borrow the funds and re-lend them to the corporation. Losses can be deducted against debt basis once stock basis is reduced to zero. However, debt basis is restored before stock basis when income is earned in future years.

Frequently Asked Questions

  1. What is the purpose of tracking S corp stock basis?
    It determines if losses are deductible and whether distributions are taxable, ensuring compliance with IRS rules.
  2. Does stock basis include loans from a bank to the S corp?
    No, unless you personally borrow the funds and lend them to the corporation, bank loans do not increase your basis.
  3. What happens if my losses exceed my stock basis?
    Excess losses are suspended and carried forward until you add more stock or debt basis.
  4. How often should I calculate my stock basis?
    At least annually, ideally when preparing your tax return, to apply adjustments in the correct order.
  5. Can I have a negative stock basis?
    No. If your calculations show a negative basis, it means part of your distribution may be taxable as a capital gain.

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