Question

A new client is starting a business, and would like to form an S corporation so that any losses can pass through to his personal tax return. After viewing the video, explain to your client how a shareholder’s stock basis enters into loss limitation rules for S corporations.  

Answer 1

Basis measures the amount that the property’s owner is treated as having invested in the property. At the start of the investment, this is the property’s cost. But in the S corporation context, basis can become a moving target as a shareholder’s investment in the company changes. Unlike with C corporation stock basis, which stays the same each year, annual income, distributions and loans can all affect an S corporation shareholder’s basis, in sometimes surprising ways.

Calculating the S corporation shareholder’s basis correctly is important because it measures the amount the shareholder can withdraw or receive from the S corporation without realizing income or gain. The shareholder’s basis should reflect the shareholder’s economic investment in the corporation. Basis adjustments should be made at the end of each taxable year, taking into account income, distributions and deductions and losses—in the right order.

Often, the task of tracking basis is neglected because, when a profitable company makes only minimal distributions, the number simply doesn’t matter—until a major change happens, such as a change in the shareholder’s ownership or the end of the company’s life. When individuals embark on an investment or business venture, they often don’t think about what happens when the venture is over. Unless the tax accountant preparing the shareholder or company tax returns has the foresight to begin and maintain the basis calculations, piecing stock basis back together is like reconstructing a mosaic without all the pieces—it’s tedious, often difficult and sometimes nearly impossible. CPAs can help their shareholder clients avoid this mess by tracking basis from day one or as soon as they realize that their clients’ basis records are lax.

ITEMS OF ADJUSTMENT

A good way to explain stock basis to clients is to compare it to a checking account. Basis is deposits and earnings less withdrawals. Like a bank account, more cannot come out than goes in—basis can never go negative. Since basis begins when the company stock is acquired, basis should be tracked from day one. Updating basis each year is a straightforward process, and it can be calculated manually or by using tax preparation software. The extra few minutes it takes to update basis annually are well worth the headaches they will save down the road.

Initial basis is generally the cash paid for the S corporation shares, property contributed to the corporation, carryover basis if gifted stock, stepped-up basis if inherited stock, or basis of C corporation stock at the time of S conversion. Common basis increases include capital contributions, ordinary income, investment income and gains; common decreases include Sec. 179 deductions, charitable contributions, nondeductible expenses and distributions.

Basis adjustments are normally calculated at the end of the corporation’s taxable year. First, they are increased by income items; then decreased by distributions; and, finally, decreased by deduction and loss items. The order is important because, if basis is positive before distributions but would be negative if all deduction items were subtracted (however, again, basis cannot be negative), then the excess loss is suspended rather than the excess distributions being taxable.

It should be pointed out that an S corporationshareholder’s basis in stock is reduced by current-year losses, regardless of whether the loss or deduction is disallowed under another rule, such as the passive loss rules.

RECONSTRUCTING BASIS

Reconstructing basis is not difficult procedurally. The difficult part is tracking down all company Schedules K-1 and capital contribution records since the stock was acquired (often the day the company opened its doors). Re-creating basis for a company that opened last year is easy. Taking on the task for a company that opened in 1965 is not easy, but it may be necessary. Once all records are gathered, the process requires accumulating annual increases and decreases from inception to the present year. Retaining supporting documentation is necessary in case of an IRS inquiry.

If a company has been tracking basis, that doesn’t necessarily mean the numbers are correct. I recently ran into a basis schedule for a company that had the wrong capital contribution entered for the initial year, even though the schedule had been updated annually. The calculation had been reviewed annually for changes and continuity, but when the company decided to make a large distribution, the basis schedule indicated the distribution was taxable, and in this situation a taxable distribution didn’t make sense. The age-old adage of “garbage in, garbage out” holds true for basis schedules.

WHEN BASIS MUST BE APPLIED

Generally speaking, basis enters tax calculations when:

The company has losses;

The company makes distributions; or

The company changes owners.

If the company has losses, they are allowed as a deduction on the shareholder or partner’s tax returns to the extent the individual has basis. Without basis, those losses are suspended/carried over to offset future income or basis. If basis is unknown or incorrect, a shareholder might incorrectly deduct losses he or she is not entitled to deduct. Note that in general, credits are not limited to basis, so in a given year, a taxpayer would not be able to enjoy the tax benefit of a loss without basis but would be able to enjoy the benefit of a credit regardless of basis. However, in some instances credits can affect basis, directly or indirectly, so be sure to review the rules regarding specific credits carefully.

A constant struggle between accountants and their clients lies in distributions—or over-distributions, to be more accurate. When a shareholder or partner takes all the basis out and then some, the excess is a taxable capital gain—often an unwelcome surprise to shareholders accustomed to receiving distributions tax-free. Distributions are an important and common reason for good basis calculations and good basis discussions with clients ahead of time.

The third common need for accurate basis calculations comes with an ownership change. The proceeds over stock basis will be the taxable gain when an S corporation shareholder disposes of the stock. If there are no stock basis records, the shareholder runs the risk that the entire proceeds are taxable.

OTHER BASIS CONSIDERATIONS

One of the more complex issues in S corporation basis is debt basis. The S corporation rules are different from partnership rules, and debt basis needs to be reviewed carefully. S corporation shareholders do not receive basis for debts owed by the company to third parties. For a shareholder to receive debt basis, the shareholder must make a direct loan to the corporation—one owed by the corporation to the shareholder. Personal guarantees or co-borrowing situations do not create basis. Basis is often created when a shareholder borrows from a bank and turns around and lends the money to the corporation. This situation bears some risk, and shareholders should follow the debt basis rules carefully. The S corporation should make loan repayments to the shareholder, who then pays the bank, rather than skipping over the shareholder and paying the bank directly. (For a more detailed review of debt basis, see “The Story of Basis,” The Tax Adviser , June 2010, page 398.)

If a shareholder’s stock basis has been reduced to zero and the shareholder has debt basis, then losses and deductions are allowed to the extent of the debt basis. This basis is then called “reduced debt basis” and is restored by net increases over decreases in any given year. If the debt basis is repaid before the basis is restored, all or part of the repayment is taxable. Partial repayments adjust basis by a ratio of the note amount less basis as the numerator and the loan amount as the denominator, with any remaining amount recognized as gain, as illustrated in Example 2. Income is ordinary in cases where the debt is an open receivable and capital gain if evidenced by a formal note.

Example 1: Full repayment. Andrew is the sole shareholder of XYZ Inc., a calendar-year S corporation. Andrew loans XYZ $100,000 on Jan. 1, 2008. The loan was documented with a formal note requiring regular interest payments, which were paid on schedule. The company passed through losses over several years to Andrew, reducing his stock and debt basis to zero.

On Dec. 31, 2010, XYZ pays off the $100,000 note in full. The corporation also passes through another loss for the year. Since Andrew’s debt basis is zero and he held the note more than 12 months, he recognizes long-term capital gain of $100,000 on the repayment.

Example 2: Partial repayment. The facts are the same as in the prior example, except debt basis has been reduced only to $50,000 and XYZ pays off only $75,000 of the note. Since Andrew’s debt basis is $50,000 and he held the note more than 12 months, he recognizes long-term capital gain of $37,500 and a nontaxable return of basis of $37,500 on the repayment, calculated in Exhibit 1.

THE END IN MIND

The best advice to a practitioner regarding S corporation basis is to “begin with the end in mind.” Start tracking stock basis from day one and keep tracking it. If a complex situation comes up, tackle it right away, not 10 years down the road when information and memories are incomplete. Consider saving all Schedules K-1 to the company’s permanent file in case basis needs to be re-created or reviewed. Finally, consider adding language to engagement letters addressing the basis tracking responsibilities so clients are aware of recordkeeping obligations. While basis is the responsibility of the shareholder, the accountant preparing the corporate return will most likely be asked for assistance when basis records are missing or unprepared. Don’t be caught in a situation where you need to get caught up.

EXECUTIVE SUMMARY

  
Tracking owners’ basis in S corporation stock is a necessary but sometimes neglected task that can require extensive and difficult reconstruction if not updated and adjusted regularly.

Items that increase basis include capital contributions, ordinary income, investment income and gains. Items that decrease it include Sec. 179 deductions, charitable contributions, nondeductible expenses, and distributions. It is important to first increase basis by income items before decreasing them by deduction and loss items.

Reconstructing basis over the course of past yearsrequires thorough collection of records and checking them for correctness.

An owner’s share of losses that exceed basis are carried over to offset future income or basis. Tax credits are generally limited to basis but may in some cases affect basis directly or indirectly.

S corporation shareholders generally do not increase their basis for debts owed by the company to third parties, but create debt basis only for a direct loan they make to the corporation. In this respect, they differ from partners and partnerships.