S-Corporations Shareholder basis

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.

Importance of Stock Basis

It is important that a shareholder know his/her stock basis when:

• The S corporation makes a non-dividend distribution to the shareholder.

In order for the shareholder to determine whether the distribution is non-taxable they need to demonstrate they have adequate stock basis.

• The S corporation allocates a loss and/or deduction item to the shareholder.

In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and/or debt basis.

• The shareholder disposes of their stock.

As with any asset, including S corporation stock, when the asset is sold or disposed of, basis needs to be established in order to reflect the proper gain or loss on the disposition.

Since shareholder stock basis in an S corporation changes every year, it must be computed every year.

Computing Stock Basis

In computing stock basis, the shareholder starts with their initial capital contribution to the S corporation or the initial cost of the stock they purchased (the same as a C corporation). That amount is then increased and/or decreased based on the pass-through amounts from the S corporation. An income item will increase stock basis while a loss, deduction, or distribution will decrease stock basis.

Debt must meet two requirements to qualify as S corporation basis. First, the debt must run directly from the shareholder to the S corporation. Second, under Regs. Sec. 1.1366-2(a)(2), the indebtedness must be bona fide. Whether indebtedness to a shareholder is bona fide is determined under general federal tax principles and depends upon all the facts and circumstances.

The IRS adopted these “bona fide debt” provisions on July 23, 2014, when it issued final regulations providing guidance regarding basis for S corporation loans (T.D. 9682). Rather than adopt a judicial doctrine of an “actual economic outlay” that leaves the shareholder “poorer in a material sense,” the regulations adopted provisions for determining whether a shareholder is entitled to debt basis under Sec. 1366(d)(1)(B).

Regs. Sec. 1.166-1(c) defines a bona fide debt as arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money. Courts have looked to the intent of the parties at the time the loan is made to verify a debtor-creditor relationship. The shareholder must have a real expectation of repayment and intent to enforce collection efforts against the S corporation in the event of a default on the loan.

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, non-deductible 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.

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. 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.