1. Understanding the Intent of S Corp Distribution Rules
2. Items of Adjustment

S corp stock basis is the amount each shareholder has invested in the property, which starts off as the cost of the property and evolves with changes in the shareholder's investment in the S corporation. S corporation stock basis differs from that of a C corporation, which is static from year to year. With an S corp, the stock basis varies depending on the shareholder's annual income, loans, and distributions.

If you own an S corporation, it's critical to correctly calculate each shareholder's stock basis since it indicates the amount he or she can receive from the corporation without realized gain. The basis should reflect his or her financial investment in the S corporation.

At the end of each tax year, you must adjust each shareholder's stock basis by accounting for income, distributions, deductions, and losses in a specified order. Each shareholder is subject to both basis in the corporation's stock as well as in debt he or she is owed by the company.

Each shareholder is required to track his or her stock basis to:

  • Determine gain or loss on sale of stock in the S corporation
  • Determine how much of an allocated loss may be currently utilized by the shareholder and how much must be carried forward
  • Determine whether and how distributions to the shareholder are taxed

Many shareholders fail to track their stock basis because it doesn't make a big difference, but this number suddenly becomes important in the event of an ownership change or the end of the company. When this occurs, determining stock basis is nearly impossible if it hasn't been done on an ongoing basis. For this reason, shareholders should hire a CPA to track basis as soon as they purchase stock in an S corporation.

Understanding the Intent of S Corp Distribution Rules

Shareholders should understand why S corporation distributions are taxed differently from C corporation distributions. C corporations are subject to double taxation, which means that income is taxed at the corporate level when received and at the individual level when it is distributed to shareholders.

S corporations are generally subject to pass-through taxation, in which income is not taxed at the corporate level. Instead, it is "passed through" to shareholders who report it on their individual tax returns.

Section 1368 and its associated regulations preserve this distinction between S and C corporations. Although these regulations are complex and confusing, shareholders should focus on the intent of Section 1368. Taxes on S corporation distributions depend on stock basis, previously taxed shareholder income, and the corporation's earnings and profits and accumulated adjustment accounts.

Items of Adjustment

Think of the concept of stock basis as a checking account. The basis is made up of the deposits and earnings of an account minus the withdrawals that are made. As with a checking account, a stock basis cannot be negative.

Stock basis starts as soon as shares in a company are acquired and should be tracked right away. It's easy to update each year if you do so manually or use tax preparation software. Taking this step annually can help you avoid complications down the road.

The initial basis is comprised of the amount paid for shares in an S corporation, property given to the corporation, carryover basis if the person was gifted the stock, stepped-up basis if the stock was inherited, or C corporation basis if the corporation recently elected S taxation.

Stock basis must be increased by the shareholder for:

  • Capital contributions
  • Separately reported income, such as tax-exempt income, and computed income
  • Depleted deductions that exceed the basis subject to depletion

Stock basis must be decreased for:

  • Distributions that are not taxed as dividends
  • Separately reported loss and deduction items, and computed losses
  • Expenses that are not deductible and cannot be charged to a capital account
  • Depletion deduction for oil and gas property if applicable

When loss is allocated to an S corporation shareholder, these losses must be limited to the extent of his or her stock basis and corporate debt. Stock basis must first be adjusted for required increases, then reduced by non-dividend distributions, oil and gas depletion deductions, stated items of loss and deduction, and losses that are not stated separately (in that order).

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