An S corporation is an entity that has elected to pass income, losses, deductions, and credits through to its shareholders for federal tax purposes. Shareholders report the flow-through of income and losses on their personal tax returns. Tracking your shareholder basis may likely enable you to determine how your gains and losses from a K-1 are reported on your 1040 return.
What is the shareholder basis of an S corporation and how does it affect my personal taxes?
Regardless of how tedious the tracking could be for certain shareholders; the basis should be updated annually and tracked by the shareholder. It is not the corporation's responsibility to track a shareholder's stock and debt basis but rather it is the shareholder's responsibility. The stockholder basis is referred to as an outside basis which is different than the company equity or retained earnings. Shareholders should therefore track it for gain and loss recognition purposes.
The following are simple basic formulas for calculating basis:
Tax basis = amount you paid + contributions + tax earnings - distributions (this is not wages or bonus). You can think of the stock basis as your own personal retained earnings account.
At the beginning of an S Corporation, you must calculate your original basis. Initial stock basis = the amount you paid for your shares plus tax basis for any property contributed to the S corporation.
After the first year, you must keep your basis up to date every year with positive and negative adjustments.
Adjusted stock basis = initial basis plus contributions plus your share of the income minus your share of nondeductible expenses and distributions. If you still have a positive basis remaining, then reduce it further with the other expenses and losses, but not below zero. The ordering rule is very important unless you want to permanently elect to change the order under Reg 1.1367-1(g).
This article in Forbes from Tony Nitti provides great examples of Determining A Shareholder's Basis In S Corporation Stock and Debt. It also discusses debt basis that we didn’t cover here (purposely).
Your basis generally determines how much gain/loss you should recognize on your tax returns and you should carry forward, if applicable.
Can you take a disproportionate distribution in an S corp?
No. In an S Corp, profit and loss distributions must be completed according to the ownership percentage. That is, you have to pay out distributions to all shareholders in proportion to their ownership. Anything additional should be treated as compensation and run through payroll. So, an S Corp should make payroll before generally paying out huge distributions to shareholders. If you’re paying bonuses (payroll) in lieu of distributions to one shareholder but not to the others, that’s OK because only actual distributions need to be distributed pro rata. However, wages and bonuses are paid out to employees only. Contractors, if any, receive 1099-Misc.
Disproportionate distribution may result in a revocation of an S election.
Example: Assuming S Corp is formed by shareholder A with 30% interest and shareholder B with 70% interest. If you distribute 70K to B, A must receive exactly 30k. If you want to provide shareholder A more than 30K, then it must be run through payroll if shareholder A is an employee. If Shareholder A is not an employee, then S Corp may decide to issue a loan to A and A should give S Corp a promissory note with loan repayment terms, including interest. Can't give out loans for free, just be aware.
How is an excess distribution treated?
What is excess distribution? Excess distribution occurs when a shareholder receives a distribution that is over their adjusted basis, which reduces the adjusted basis to zero.
Generally, if you receive a distribution in excess of your basis, you must report that excess on your individual tax return subject to capital gains tax.
Specifically,
1. Any losses over your basis are disallowed and carried forward to future years.
2. Any distributions in excess of basis are capital gains. The holding period of the stock determines if the gain is long or short-term.
3. When you sell your shares of the S corporation, you recognize a capital gain or loss on the sale similar to any capital assets sale. However, suspended losses due to basis limitations are lost. Any gain on the sale of the stock does not increase the shareholder's stock basis.
4. If you terminate or liquidate your interest in an S Corporation, you must recognize capital gains or losses on your individual tax return.
Usually, in a profitable business and in a perfect world, your basis should increase more than what you are receiving as distribution. Also, most companies leave money in the bank for, for example, working capital, investments, and maybe future distributions. Oh wait, there may be so many other reasons for keeping cash in the corporation, such as rainy fund days!
Debt Basis: Shareholder loan basis
A shareholder is generally only allowed debt basis to the extent he or she has personally lent money to the S corporation. A loan guarantee is not sufficient to allow the shareholder debt basis.
So, I lent money to the corporation, I should ask the S corp to promise to pay me back my money with interest on mutually agreed terms on a signed promissory note. In this case, I should pick up the interest income and the S corp should pick up the interest expenses on the annual tax returns.
You lent money to S corp as a shareholder. How repayment of the loan by the S corporation affects the shareholder debt basis?
Corporate repayment of loans reduces shareholders' debt basis. However, part or all of the repayment of a reduced basis debt is taxable to the shareholder. In other words, if the debt basis was previously reduced by any S corporation losses, then gain is recognized to the extent the repayment exceeds the debt basis.
So, when a shareholder debt basis has been reduced by the S corp losses, in the current or previous years, repayment of the loan is a taxable event to the extent:
- full repayment exceeds the shareholder's basis in the debt,
- or partial repayments exceed a pro-rata portion of the basis in the debt. Here is an article of the Tax Adviser discussing a few tips about avoiding gains at shareholder level when the loan is repaid. Summary:
It is important for shareholders to track their basis in order to accurately report their distributive shares of profit and loss on their US individual income tax returns. Substantiation rests on the shareholder, should there be an audit. Also, taxpayers are expected to report complete and accurate information on their tax returns.
For more information, see the IRS website page discussing S corporation stock and debt basis
Get in touch with Whin Global if you have any questions or would like a consultation on S Corporations.
Published date: 08/13/2019