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The Role of Basis in S Corp Tax Planning
Posted by Sylvia Lagerquist, CPA
The entity format you choose for your business is a complex and important decision, but one thing is for sure: The entity format you ultimately select will have a direct and powerful impact on your taxes. For the owners of S corporations, one key factor that is essential to understand is the concept of basis, which is used by the IRS to evaluate and assess key aspects of your taxes as a shareholder in the business.
What Is an S Corporation?
An S corporation is a business that is treated as a pass-through entity by the Internal Revenue Service (IRS) for federal tax purposes. You can establish an S corporation by filing articles of incorporation with the state in which you want to establish the entity.
S corporations issue stock and are governed as a corporation, and the owners of an S corp. are shareholders who enjoy the same liability protections as their counterparts in C corporations. In addition, LLC members in most states can elect to have their entities treated as S corporations by the IRS.
However, like a sole proprietorship or partnership (and unlike a C corp.), the S corporation passes through most of its income and loss to the shareholders directly. Therefore, there is no problem with double taxation as is commonly experienced with C corporations.
Advantages and Disadvantages of the S Corporation
The advantages of the S corporation model are strong, which is why they are such a popular entity format for new companies. These advantages include a high level of protection for shareholders’ assets; pass-through taxation at the federal level and, in most cases, at the state level; the ability of shareholders to draw salaries and receive dividends or distributions.
The disadvantages of an S corporation include the costs associated with forming and maintaining them compared to, say, sole proprietorships; restrictions on the class of stock available in an S corp.; and less flexibility in allocating income and loss compared to a partnership or LLC treated as a partnership.
One other factor impacting S corporations is increased complexity in some cases when it comes to proper compliance with IRS regulations. For example, the IRS may look closely at payments made to shareholders to ensure that proper classification of dividends vs. salaries are applied (in part to ensure that employment taxes are being paid). In addition, the IRS will examine a shareholder’s basis in the company, which is why understanding basis is so essential.
Understanding Basis in an S Corporation
Basis is defined generally as the amount of one’s investment in a given business or property, as viewed for tax purposes. There are two forms of basis: stock basis and loan (debt) basis. In an S corporation, the stock and loan (debt) basis of the business can change every year, depending upon the company’s operations and financing situation.
This is one reason why an S corporation files a Schedule K-1 each year, which establishes the income, loss deductions and distributions allocated to a given shareholder. What the K-1 does not show is the tax treatment of the distribution…and it is this figure that is contingent upon the shareholder’s stock basis.
Stock Basis and Loan (Debt) Basis
Let’s begin by calculating stock basis. Your stock basis would be determined, and adjusted annually, as follows:
- Begin with the amount you contributed for the purchase of stock.
- Add income reported in your Schedule K-1 (including any tax-exempt income) or subtract losses reported in your Schedule K-1.
- Add in any capital contributions, including purchases of stock.
- Subtract any cash or property distributions made by the corporation.
- Subtract any nondeductible expenses.
- This final figure is your adjusted basis in the S corporation’s stock at the end of the year.
What about loan (debt) basis? What’s important to note is that, as a shareholder, if you loan to the company this may enable you to take a tax deduction in the current year for losses in excess of your stock basis – but only to the extent that you have loan (debt) basis.
In our example, let’s now calculate your loan (debt) basis. The loan basis would be determined as follows:
- Take the initial dollar amount that you loaned to the company.
- Add any additional amounts loaned to the company.
- Subtract the amount of loan principal repaid.
- Now, also subtract your share of any net loss in excess of your adjusted stock basis.
- This final figure is your adjusted basis in the S corporation’s debt at the end of the year.
One important point to understand about loan basis is that you do not gain basis for bank loans made directly to the company. You only gain basis when you make a personal loan to the business. In addition, if you lend the company funds in a given year, you may gain basis to deduct losses. However, the basis may reduce to zero and then, in a subsequent year you may have the company repay the loan back to you and assume that it is not taxable. Yet with basis at zero, you must pay taxes on that amount. Put another way, you need income to restore loan basis before you can start paying it back tax-free.
In a similar manner, distributions made by the company to a shareholder are only tax free if the shareholder has sufficient basis. In fact, it is not unusual for a business owner to discover an unexpected tax liability due to having assumed that distributions would be tax free, when due to lack of basis they are not.
Basis can never be reduced below zero, and losses unused because of insufficient basis are carried forward to future years. Where no debt exists, the basis of the stock at the beginning of the year is zero, which is then adjusted by any losses or deductions from prior years. You may also restore your stock or loan (debt) basis in a number of ways, including making additional cash investments in the business to restore stock basis, or providing additional cash loans to restore loan basis.
NOTE: Both of these calculation examples assume a great number of variables and are further simplified for general information purposes only. They do not constitute an official or comprehensive set of instructions and should not be used for any actual basis calculations in tax planning. Such steps should only be performed your certified public accountant.
When and Why Basis Should be Calculated
Remember that as a shareholder, it is your responsibility to calculate your stock and loan (or debt) basis. It is not the company’s responsibility. This is because the company may not have all of the information necessary to compute basis properly, which is why it is not specifically noted on the Schedule K-1.
Your CPA should calculate basis each year in the process of preparing your tax returns. In fact, doing so is critical because if you have allocated a loss or deduction flow-through from your S corporation, you must first have adequate stock and loan basis in order to claim that loss or deduction. Specifically, you and your CPA should use tax planning throughout the year as well as prior to year-end to review your current basis and ensure that your basis is adequate to align with your intended uses thereof.
It is essential to calculate your adjusted stock basis and loan basis just before year-end, so that you will have sufficient time to make additional investments in, or loans to, the business in order to ensure that any losses are full tax-deductible.
Failing to plan and track your basis can have disastrous consequences. For example, you might plan some major equipment investments at year-end to take advantage of the Section 179 deduction and reduce your tax liabilities. However, if you have insufficient stock or loan basis, you could later find when you file your tax returns that the deductions are not available, creating an unexpected tax liability.
Next Steps to S Corp. Success
There is a lot more we could discuss when it comes to establishing and tracking basis in your S corporation. To dig in deeper, we encourage you to review the resources shared below. And of course, feel free to contact Haines & Lagerquist CPAs to discuss how a proactive basis planning strategy can enhance your tax planning process.
S Corporation Advantages and Disadvantages
S Corporation Accounting: Basis, At Risk Rules, and Passive Activity Losses
Calculation of Shareholder’s Stock and Debt Basis in an S Corporation
Impact of S Corporation Debt on Shareholder’s Basis
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