16 May Calculating Adjusted Basis in an S-Corporation
It seems to me that a relatively significant problem for most Sub chapter S Corporations is accounting for the capital accounts of each and every single shareholder. The company must maintain reasonably detailed records of each shareholder’s equity investments of cash and property, loans that each shareholder advances to the company as well as distributions made to shareholders to arrive at shareholder’s equity.
Shareholder’s Equity is reflected in the shareholder’s capital account. This account should show the dollar amount of cash investments, and value of property donated to the company. A shareholder who contributed cash of $100,000, a computer worth $20,000, and software worth $4,000 would have a capital account showing a total investment of $124,000. The capital account is adjusted from time to time to reflect additional equity investments. Additionally, the capital account is adjusted at the end of the year to reflect each shareholder’s pro-rata share of income and expenses.
Unlike limited partnerships and limited liability companies, shareholders of S-corporations must divide the corporation’s net income in strict proportion to their share of ownership. If a shareholder has contributed exactly one-third of the company’s capital, then exactly one-third of the company’s net profit or loss must be allocated to that shareholder. A shareholder’s capital account needs to reflect the shareholder’s investments and current basis in the S-Corporation’s equity or liabilities. A shareholder is invested in the S-Corporation to the extent that a shareholder has made an equity investment or advanced a loan to the company.
The capital accounts come into play in two crucial parts of an S-Corporation’s financial and tax reporting. First, the capital accounts are reported on the company’s balance sheets as shareholder equity and loans from shareholders. Second, each shareholder’s capital account can be summarized on Form 1120S Schedule K-1. Insufficient capital investments can cause shareholders to fail to meet the At-Risk rules for losses and can cause business losses to be suspended or even become non-deductible. Generally speaking the adjusted basis of a shareholder’s stock is calculated as follows:
- Adjusted basis at the beginning of the year
- + Share of all income items that are separately stated, including tax-exempt income
- + Share of all non-separately stated income items
- + Share of deduction for excess depletion of oil & gas properties
- – Distribution of cash or property to the shareholder that was not included in the shareholder’s wages
- – Share of all loss and deduction items that are separately stated, including Section 179 deductions and capital losses
- – Share of all non-separately stated losses
- – Share of non-deductible expenses, such as the non-deductible portion of meals & entertainment expense or non-deductible fines and penalties
- – Share of depletion for oil & gas properties not in excess of the property’s basis.
- = Adjusted basis in S-Corporation stock at the end of the year
Overall, the S-Corporation reports total income and expenses at the company level, and passes-through a share of net profit or loss to individual shareholders. The S-Corporation needs to maintain excellent records regarding each shareholder’s investment of cash or property. These records are crucial for establishing each shareholder’s percentage of ownership in the company.
Generally, S-Corporation accounting is the same as C-Corporation accounting. Income and expenses are reported at the corporate level, and the nature of various types of income and expense are identified at the corporate level as well. S-Corporations can choose an accounting method best suited to report the income and expenses of the company. S-Corporations are not required to use the accrual method of accounting; they may choose the cash method or a hybrid method of accounting if those methods of accounting.
Income and expense items retain their character when they are passed-through to S-corporation shareholders. Long-term capital gains, for example, earned by the S-corporation are passed through as long-term capital gains to shareholders. S-Corporations therefore need to identify types of income and types of expenses for the benefit of their shareholders.
Donating Property to an S-Corporation. Shareholders can invest cash or property to an S-Corporation. A shareholder might contribute a computer, desk, reference books, and software programs to her newly formed S-Corporation in addition to her cash investment. The value of the shareholder’s property is the lower of (a) the fair market value of the property, or (b) the shareholder’s adjusted basis in the property.