S Corporation Shareholders are Required to Compute Both Stock and Debt Basis
The amount of a shareholder’s stock and debt basis is very important. Unlike a C corporation, each year the stock and/or debt basis of an S corporation goes up and/or down based upon the S corporation’s operations. The S corporation will issue a shareholder a Schedule K-1.
It is important to understand that the K-1 reflects the S corporation’s income, loss and deductions which are allocated to the shareholder for the year. The K-1 does not state the taxable amount of the distribution. The taxable amount of distribution is contingent on the shareholder’s stock basis. It is not the corporation’s responsibility to track a shareholder’s stock and debt basis rather it is the shareholder’s responsibility.
If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder’s stock basis.
Losses or Deduction Flow-Through
If a shareholder is allocated an S corporation loss or deduction flow-through, the shareholder must first have adequate stock and/or debt basis to claim that loss and/or deduction. In addition, it is important to remember, that even when the shareholder has adequate stock and debt basis to claim the S corporation loss or deduction, the shareholder must also consider at-risk limitations and passive activity limitations and therefore may not be able to claim the loss and/or deduction.
Computing Stock Basis
In computing stock basis, the shareholder starts with the initial capital contribution to the S corporation or the initial cost of the stock purchased (the same as a C corporation). That amount is then increased and/or decreased based on the flow-through amounts from the S corporation. An income item will increase stock basis while a loss, deduction or distribution will decrease stock basis.
The order in which stock basis is increased or decreased is important. Since both the taxability of a distribution and the deductibility of a loss are dependant on stock basis, there is an ordering rule in computing stock basis. Stock basis is adjusted annually, as of the last day of the S corporation year, in the following order:
Increased for income items and excess depletion;
Decreased for distributions;
Decreased for non-deductible, non-capital expenses and depletion; and
Decreased for items of loss and deduction.
When determining the taxability of a non-dividend distribution the shareholder looks solely to his/her stock basis (debt basis is not considered).
For losses and deductions which exceed a shareholder’s stock basis, the shareholder is allowed to deduct the excess up to the shareholder’s basis in loans personally made to the S corporation.
Debt basis is computed similarly to stock basis but there are some differences.
If a shareholder has S corporation losses and deductions in excess of stock basis and those losses and deductions are claimed based on debt basis, the debt basis of the shareholder will be reduced by the claimed losses and deductions.
If an S corporation repays reduced basis debt to the shareholder, part or all of the repayment is taxable to the shareholder.
Important Things You Should Know:
A non-dividend distribution in excess of stock basis is taxed as a capital gain on the shareholder’s personal return, usually a long-term capital gain (LTCG).
Non-deductible expenses reduce a shareholder’s stock and debt basis before loss and deduction items. If non-deductible expenses exceed basis, they do not get carried forward.
If the current year has different types of losses and deductions, which exceed stock and debt basis, the allowable losses and deductions must be allocated pro rata based on the size of the particular loss and deduction items.
A shareholder is not allowed to claim losses and deductions in excess of stock and debt basis. Losses and deductions not allowable in the current year are suspended due to basis limitations.
Suspended losses and deductions due to basis limitations retain their character in subsequent years. Any suspended losses or deductions in excess of stock and debt basis are carried forward indefinitely until basis is increased in subsequent years or the shareholder disposes of the stock
In determining current year allowable losses, current year loss and deduction items are combined with the suspended losses and deductions carried over from the prior year, though the current year and suspended items should be separately stated on the Form 1040 Schedule E or other appropriate schedule on the return.
A shareholder is 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.
If a shareholder contends he or she has contributed or loaned substantial funds to the S corporation, consideration should be given to whether the shareholder had the financial means to make the contribution or loan.
Part or all of the repayment of a reduced basis debt is taxable to the shareholder.
If stock is sold, suspended losses due to basis limitations are lost. The sales price does not have an impact on the stock basis. A stock basis computation should be reviewed in the year stock is sold or disposed of.