Basics of shareholder basis in an S Corporation

Generally, when a taxpayer becomes a shareholder in an S Corporation, their focus is on the business’ prosperity and daily operations. However, it is just as important to understand the concept and value of the basis of their investment.

When a shareholder receives a K-1 reflecting a loss, receives a distribution, or the S Corporation has a change in ownership, the shareholder must know their adjusted basis amount to determine if they are entitled to claim the loss on their personal income tax return or if the distribution is a taxable event. The burden of basis tracking falls on the shareholder, not the S Corporation.

Basis

Basis refers to the amount of investment the taxpayer has in the business. It is important to keep track of basis year over year because this can hinder the ability of the shareholder to use losses that pass through from an S Corporation. Also, if the shareholder disposes of their S Corporation stock, it is imperative to know the adjusted basis to compute the gain or loss on that disposition properly. As of 2021, shareholders are required, under certain circumstances, to file Form 7203, S Corporation Shareholder and Debt Basis Limitations, and report their stock and debt basis.

Initial basis

This is where it all begins! The initial basis is the amount of capital contribution the shareholder makes in exchange for stock ownership in the S Corporation. Capital contributions can come as cash or property transferred to the S Corporation.

Adjusted basis

Adjusted basis is the result of the shareholder’s initial basis after increasing and decreasing it by their share of the S Corporation’s income, loss, and other certain items. Adjusted basis is generally calculated at the end of the S Corporation’s taxable year. It is the amount the shareholder will use to determine whether they can deduct their pro rata share of an S Corporation’s pass-through loss. 

IRC Section 1367 dictates the order of items that affect basis:

Election under Treas. Reg. 1.1367-1(g)

A shareholder may elect to have the S Corporation’s pass-through losses reduce basis before basis is reduced by nondeductible, noncapital expenses. Making this election may allow the shareholder to deduct more pass-through losses. The election must be made with the tax return and can only be reversed by IRS approval.

No such thing as “negative basis”

When decreases exceed the adjusted basis amount, the basis can never go negative. Instead, the excess loss is suspended and carried over to the succeeding taxable year. The suspended prior year losses and deductions are treated as incurred in the current year, and added to the shareholder’s current year loss and deduction items.

For example,  a shareholder made an initial contribution of $100 to an S Corporation. At the end of the tax year, the S Corporation issued the shareholder a K-1 where it reflects an ordinary loss of ($500) and a distribution to the shareholder of $20:

The following year, the S Corporation issues a K-1 reflecting income of $1,000:

*The income on the K-1, as well as the allowed suspended loss will be reflected separately on the Shareholder’s personal income tax return.

Distributions (non-dividend) to the shareholder

A non-dividend distribution from an S Corporation is a payment made to a shareholder that is not classified as a dividend. Non-dividend distributions to the shareholder are generally a tax-free event as long as the distribution is not over the stock basis of the shareholder. If the distribution exceeds the amount of stock basis, the excess distribution will be taxed as a capital gain. If the stock was held for more than a year, the capital gain is a long-term gain. Otherwise, it will be taxed as a short-term capital gain.

Debt basis

When a shareholder makes a direct loan to the S Corporation, the shareholder will have debt basis. It is important to note that only when the S Corporation owes the shareholder directly, it creates debt basis. If the shareholder personally guarantees an S Corporation’s loan to third parties, this does not constitute debt basis. Once the stock basis of the shareholder has been reduced to zero, pass-through losses and deductions can still be deducted to the extent the shareholder has debt basis.

Form 7203

There has been an increased focus on the compliance to basis tracking. Starting tax year 2021, shareholders are required to file Form 7203, and attach it to their Form 1040 to track and report their stock and debt basis.

Form 7203 is required to be filed if the shareholder:

• Is claiming a deduction for their share of a loss from the S Corporation,
• Received a non-dividend distribution from an S Corporation,
• Disposed of stock in an S Corporation, or
• Received a loan repayment from an S Corporation.

Even if the shareholder does not meet these requirements to file Form 7203, it is advisable to complete Form 7203 in order to properly maintain basis year after year.

Reconstructing basis

If the shareholder’s basis has not been tracked in years, it is imperative to collect prior year K-1s and capital contribution records from the day the investment in the S Corporation began. Once all prior year records are available, start with year 1 and prepare basis schedules for each year until present day. Recordkeeping and supporting documentation are a must to support the adjusted basis amount today.

If a shareholder has not kept track of their stock and debt basis, it is important to start today. Even if the S Corporation has shown profits year after year and no distributions have been made to the shareholder, verify that the basis has been kept up to date and properly accounted for. This could save everyone time and proper tax treatment in the future!

Resources: IRS Guide on S Corporation Stock and Debt Basis

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