There are certain rules that may prevent you from deducting losses from your business. The concern of the IRS is that business owners are taking loss deductions when they are not suffering an actual economic loss. One way to limit taxpayers’ losses to the amount of economic loss they actually incur is through basis limitations. This post will focus on the basis rules applicable to S corporations.
What is Basis?
While basis is a critical concept in tax law, it is not defined in the Internal Revenue Code or in Treasury regulations. Basis is basically your investment in a business (i.e., the amount you “put into” the business). To generate basis, you have to incur some type of actual economic outlay. You cannot deduct losses in excess of your basis in the business. Any distributions that exceed your basis in the S corporation are taxed as capital gains. Basis is therefore advantageous and should generally be maximized.
Determining the Initial Basis in an S Corporation.
A shareholder’s initial basis in an S corporation depends on how the shares are acquired.
|If Shares are Acquired by:||Then Basis is:|
|outright purchase from an existing shareholder||the initial cost of those shares|
|forming and capitalizing the S corporation||equal to cash plus the original cost (not current market value) of assets contributed plus gain recognized on the transfer (if any)|
|gift||equal to the basis in the hands of the donor (generally)|
|inheritance||equal to the fair market value of the shares on the date of death (if the estate tax is in effect)|
|holding stock on the date the corporation makes an S corporation election||the shareholder’s original basis in the stock|
|providing services to the corporation||equal to the fair market value of the stock (the shareholder has compensation income for the services provided in exchange for the stock)|
Shareholders generate basis in an S corporation by loans they make DIRECTLY to the S corporation. It is VERY important to note that only direct loans to the business create basis—bank loans and other third party loans to the business do NOT generate basis.
Example: Joan invests $5,000 from her savings accounts in her newly formed S corporation. The S corporation borrows $20,000 from a bank to pay business expenses. Joan has a basis in her S corporation of $5,000 for her cash contribution. She can deduct losses up to her $5,000 basis. The $20,000 bank loan to the S corporation does not increase Joan’s basis.
Example 2: Same facts as in the above example. The S corporation has lost all of the $25,000 invested in it. How much can Joan deduct as a loss on her tax return? Only $5,000—her basis in the S corporation. The $20,000 bank loan does not create basis.
Even if the shareholders personally guarantee bank loans and other third party loans to S corporations, they still do not receive basis for such loans.
A solution is to have the bank make the loan directly to the shareholder and then the shareholder will make a loan to the S corporation.
Example: Now assume that Joan personally borrows $20,000 from a bank then loans it to the S corporation. Joan now has a basis of $25,000 in the S corporation ($5,000 cash contributed plus $20,000 in direct shareholder loans). Now that Joan’s basis is $25,000, she can deduct the full loss of $25,000.
If a business is going to have significant bank or third party debt, the business may be better off being organized as an LLC. LLC members can receive basis for their shares of the LLC’s third party debt.
Any losses disallowed under the basis limitation are carried forward into future years and can be deducted if the shareholder’s basis in the S corporation increases.
How Shareholder Basis is Increased and Decreased
In addition to increasing basis by contributing cash, property, and making direct loans to the S corporation; each shareholder’s basis is adjusted each year by pass-through items of income, loss, and deduction, and by distributions to the shareholder. Adjustments are generally made to stock basis in the following order.
- increased by pass-through income and gain items;
- decreased by distributions; and
- decreased for pass-through items of loss or deduction.
Example: Tina has a $5,000 basis in her S corp stock. The S corp has current year revenues of $100,000, deductions of $50,000, and Tina received distributions during the year of $60,000.
Her basis and allowed losses are:
Initial Basis $5,000
Income Items $100,000 (revenues)
Remaining Basis $35,000
Allowed Losses ($35,000) (limited to remaining basis)
Disallowed Losses $ 15,000 (which are carried forward)
Example 2: Same as above except that S corp only has $50,000 of revenues for the year:
Initial Basis $5,000
Income Items $50,000 (revenues)
Excess Distributions $15,000 (since distribution exceed basis,
the shareholder has a capital
gain in the amount of the excess
distribution – $15,000)
Basis $0 (reduced to $0 by distributions)
Disallowed Losses $50,000 (which are carried forward)
Wasn’t this fun. The basis rules tend to trip up taxpayers when there’s a significant amount of third party debt for which the taxpayer does not receive basis.
If you have any questions on how these rules apply to you, please feel free to contact me with questions.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.