Why it is important for shareholders of S corporations to maintain accurate records of their basis in the corporation.
by Debbie Mitchell, CPA, MST
The S Corporation has been an entity choice for over 25 years. The issue of shareholder basis has been an important factor throughout the years. A few reasons for the importance of maintaining good basis records are:
* Determination of deductible losses
* Taxability of distributions
* Gain or loss on sale of stock
* Determination of basis upon gift of stock
While the responsibility for determining whether there is stock or debt basis in a corporation ultimately lies with the shareholder, these records are often maintained at the corporate level.
When a shareholder receives a Schedule K1 from an S corporation showing a loss, the question should be: Is there sufficient basis to take the loss? While the shareholder cannot deduct a loss without sufficient basis, any losses that are limited because of lack of basis may be carried over to future years.
In instances in which the shareholder is a passive shareholder and therefore subject to the passive-activity loss rules, the basis determination comes before the passive-activity limitations. These passive-activity losses limitations are documented on Form 8582 (PDF).
For a newly formed entity the basis calculation starts with the stock basis. Information reported on the shareholder’s K1 is used to determine increases and decreases in stock basis. Some of the more common items are:
* Non-separately stated items of income
* Separately stated items of income (including tax-exempt income)
* Non-separately stated items of loss and deduction
* Separately state items of loss
* Distributions (to the extent not taxable to shareholder)
* Non-deductible expenses
The ordering for these adjustments to stock basis is as follows:
* Increased for income items
* Decreased by distributions
* Decreased for non-deductible items
* Decreased for loss-and-deduction items
These ordering rules are important. For example, in an instance in which distributions are in excess of stock basis before taking the current year loss into consideration, distribution first decreases the stock basis. At that point, the taxability of the distribution is determined. It should be noted that shareholders may use items of loss and deductions before non-deductible items to make an election to reduce stock basis. It should also be pointed out that shareholder basis cannot go below zero.
While maintaining basis records on a regular basis is not an extremely difficult task, trying to create these records from scratch for an entity that has been in existence for years could be quite cumbersome, especially if old K1s are not readily available.
A shareholder without stock basis may be able to deduct losses if they have debt basis. Debt basis is obtained by loaning money to the corporation. Guaranteeing a loan of the corporation does not provide debt basis; the loan must be owed directly to the shareholder. Once a shareholder uses debt basis to deduct a loss, it becomes a reduced basis debt. Debt-basis worksheets should be maintained in addition to the stock-basis worksheets. Items of income can restore the debt basis in subsequent years.
Repayment of Reduced Basis Loan
Shareholders should be aware that they may have taxable income when the corporation makes payments on a reduced-basis loan. If the shareholder receives a payment on a debt before the debt’s basis has been fully restored, the shareholder recognizes taxable income for a portion of the amount of this debt repayment, based on the ratio of the amount of the basis reduction to the amount of the face value of the debt. As an example, a shareholder loaned $50,000 to the S corporation. In order to deduct a $20,000 loss for which they had no stock basis, they reduced their debt basis by the $20,000 leaving a $30,000 debt basis. Subsequently $10,000 of the $50,000 loan was repaid by the corporation. Four thousand dollars of this repayment is taxable to the shareholder representing $20,000 reduction in basis as a percentage of the $50,000 face value of the loan times the repayment.
Distributions From S Corporations
An S corporation shareholder may receive a nontaxable distribution from the corporation if there is stock basis. Debt basis does not affect the taxability of distributions. In instances in which distributions exceed stock basis the taxpayer needs to report the gain on Schedule D as gain from the sale or exchange of property. It is treated as long or short term depending on how long the stock was held. The amount of the distribution that is taxable does not reduce stock basis.
The current Section 179 deduction limitation provides for a great deal of planning opportunities. For 2011, this limitation is $500,000. Before deciding to take the full $500,000 Section 179 deduction (or an amount up to the $500,000) there are some variables to take into consideration:
* The section 179 deduction is limited to taxable income at both the S corporation and shareholder levels. In determining the amount of the S corporation’s income for this purpose, shareholder-employee salary is added back to taxable income.
* Any distributions made to shareholders reduces shareholder basis. When deciding how much 179 expense to take in a given year, the amount of distributions should be taken into consideration.
* State tax treatment for 179 expenses often differs from the federal treatment. These differences should be taken into consideration when making decisions on how much should be expensed.
It is important for shareholders of S corporations to maintain accurate records of their basis in the corporation. This applies to both stock basis and debt basis. Even in years of income, in which loss limitations may not apply, these worksheets should be updated in order to have an accurate running balance of basis the S corporation.