S Corp Debt Basis: Everything You Need to Know
An S corp debt basis depends on the stock value and when it generates income, the business does not have to pay taxes at the business level.3 min read
2. Stock Basis Records
3. Debt Basis Goal
An S corp debt basis depends on the stock value. As an S corp generates income, the business does not have to pay taxes at the business level. Instead, such income gets divided and allocated to shareholders, who will then report the income and pay any taxes owed on their individual tax returns.
If an S corp distributes income, or retains it and increases the stock value, neither the sale nor distribution of a shareholder’s stock would result in S corp income being taxed again. This is where adjust basis comes into play, acting as a vehicle that preserves single-level taxation.
C corps, on the other hand, deal with double taxation, where the business and shareholders are taxed separately. At the business taxed, the shareholder pays taxes the second time upon receiving distribution shares filing their personal tax returns.
If, for example, the business retains the value and income of a shareholder stock increase, that shareholder would pay taxes on income the second time in the form of capitals gains when the business distributes the stock.
Stock Basis Example
To understand the basic principle behind stock basis, note the following example:
- You create an S corp by investing $500 in direct cash. You will then use an initial basis in the S corp stock amounting to $500. In year one, an S corp earns $100 in income. The income itself is not taxed at the business level, but sent to you on a Schedule K-1, and you would pay taxes on the $100 from Form 1040.
Additionally, if the business retains the $100 in income, the stock value will increase from $500 to $600. If someone gives you $600 to buy the stock, but you have not adjusted the original $500 stock basis, the sale will increase to $100 of gains, according to Section 1001. However, if you acknowledge the gain on a disposition of an S corp stock, you will pay taxes on the very same $100 earned by the business twice, when you earned it and was allocated to yourself, and another time upon selling the stock.
In addition, you must enhance the stock basis from $500 to $600 when the S corp gives you the $100 in income. If you sell the stock for $600, you get no additional gain.
Stock Basis Records
A shareholder must keep records of the stock basis and not the business. You must keep records because:
- You want to determine losses and gains on the selling of the stock, according to Section 1001
- You wish to assess the loss amount a shareholder may use, including how much should be carried forward and suspended
- You want to determine a distribution’s taxability received from the business to the shareholder
Officials designate two basic types:
- Basis in the stock of an S corp
- Debt that an S corp owes to shareholders
First, the debt basis of the shareholders pertains to assessing the loss amount that a shareholder can utilize. The debt basis does not pertain to determining loss or gain or the selling of the stock, and it does not affect the distribution taxation of an S crop.
- Note: Tax professionals may mistakenly add additional importance to the debt basis of shareholders in cases where it’s unnecessary
Debt Basis Goal
You should know that debt basis has only one purpose – to use losses given to shareholders that surpass that person’s stock basis. To know the shareholder basis of a corporate stock, you should assess the initial basis of the stock of the shareholder, which will not be spearheaded by an S classification. Instead, you must look to the following cases:
- Under Section 358, if the shareholder obtains shares through the creation of the business, that shareholder takes the basis in shares relative to the cash, including the adjusted tax basis of property contributions
- If a shareholder acquires stock through purchase, the initial basis will be the cost, as prescribed under Section 1012
- If the shareholder retains stock in a C corp that turns into an S crop, the initial basis of the shareholder’s S corp stock is the basis in the C corp upon conversion
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