S Corp
July 28, 2021

Shareholder Basis Issues

S-Corp Tax

In an S corporation, shareholders can only deduct the corporation's losses and deductions to the extent of their basis in the corporation’s stock and any loans made to it. Therefore, it’s crucial for shareholders to keep track of their basis levels. Basis is divided into two parts: stock basis and loan basis.

Example

Alex Taylor starts her own company, Apex Design Corporation, and gets all the company’s shares in exchange for $250,000. Over the next year, the company makes $400,000 in profit. Alex doesn’t add more money to the company or take any money out. When she sells her shares for $750,000, she makes a profit of $500,000. Why? The profit on sale is calculated by subtracting her initial $250,000 investment from the $750,000 sale price.

However, the $400,000 of the $500,000 sale profit came from the company’s earnings, which Alex has already paid taxes on. This means her “basis” in the company’s stock has gone up to $650,000 ($250,000 initial investment plus $400,000 company profit). When she sells the shares for $750,000, she only has to report a $100,000 gain ($750,000 sale price minus her $650,000 stock basis).

If a shareholder gets a distribution from an S corporation that is more than their stock basis, the extra amount is considered a profit and must be reported as a capital gain on their taxes. If a shareholder has enough basis in their stock and loans to the corporation to cover a loss, they can carry this loss forward to future years. This means they can use the loss to reduce taxes in the future. However, this loss can only be used by that specific shareholder and can’t be transferred to someone else. A shareholder’s basis in an S corporation’s stock or loans can never be negative. This means you can’t have less than zero basis.

When a C corporation changes to an S corporation, the value that shareholders have in their C corporation stock (their "basis") stays the same even after the switch.

Over time, the basis in S corporation stock can change due to various factors:

  • Increases in Basis:

    • Ordinary Income: Any income that the S corporation earns and passes on to shareholders.
    • Separate Income Items: Special types of income like capital gains or tax-free interest can also increase the basis.
  • Decreases in Basis:

    • Taxable Losses: Any losses that the S corporation experiences and passes on to shareholders.
    • Separate Loss Items: Specific losses or deductions, such as capital losses or tax-exempt expenses, reduce the basis.
    • Non-Deductible Expenses: Costs like fines or penalties that can't be deducted from taxable income also decrease the basis.
    • Distributions: Money or property given to shareholders lowers their stock basis.

Loan Basis in S Corporations

When the basis in an S corporation shareholder’s stock is reduced to zero, losses from the corporation's activities can be deducted against any basis in loans made by the shareholder to the corporation. This allows shareholders to lend money to the corporation to create a basis for claiming losses. However, this strategy is not permitted if the shareholder is considered a related party.

Please note: Issuing loans to an S corporation may make the IRS assume that these loans represent a second class of stock, potentially jeopardizing the S corporation's status. To prevent this, the loan arrangement must include all of the following features:

  1. Documentation: The loan arrangement must be documented in writing.
  2. Repayment Terms: It must include an unconditional promise to repay a specific amount by a certain date or upon request.
  3. Interest: It should require non-contingent interest payments.
  4. Convertible Loans: The loan cannot be convertible into the corporation’s stock.
  5. Eligible Lenders: The lender must not be a nonresident alien, estate, qualified trust, or someone engaged in lending activities.

Example:

A possible concern for a shareholder when issuing a loan to an S corporation is lending more than their proportion of the shares outstanding. This issue is illustrated by the following example:

Alex and Mike each own 50% of Apex Design Corporation and initially contribute $1,000 each. The company faces significant financial difficulties in its first year. Mike is unable to contribute more due to personal medical expenses, so Alex loans the business $120,000 to keep it afloat. The company ends the year with a $150,000 loss, with $75,000 attributed to each shareholder.

In this scenario, Alex's loan basis of $120,000 exceeds her $75,000 share of the loss, resulting in a disadvantage since she can only use $75,000 of her loan basis to deduct loss on her personal tax return. Mike can deduct on his personal return only $1,000 of the loss, as this is is basis. The remaining $74,000 of his loss is carried over to future years in hopes that she will have sufficient basis to deduct these expenses.

Restoring Debt Basis:

A shareholder’s debt basis can be restored by applying the shareholder’s pro rata share of any profits generated by the S corporation in subsequent years. Once the debt basis has been restored, any additional profits.

Please note: When a shareholder receives a distribution from the S corporation that exceeds their stock basis (meaning they receive more than their investment in the stock), this excess distribution must be applied against the stock basis, not the loan basis. In other words, excess distributions cannot be used to offset losses covered by loans; they only affect the stock basis.