When it comes to taking losses from an S-Corp on an individual return you want to make sure you’re covering your basis (tasteless accounting pun intended). For S-Corp shareholders it’s important to understand that just because you have a loss doesn’t mean the loss will be deductible on your individual return.
Some limitations you’ll face are:
- Stock and debt basis limitations
- At risk limitations
- Passive activity loss limitations
Each limitation must be addressed in the order listed above before a loss can be taken on a shareholder’s return. Each limitation acts as a roadblock that must be cleared before the shareholder reaches their desired destination (which is the deductibility of their S-Corp losses of course).
This article will address the first roadblock – stock and debt basis limitations.
Importance of Stock and Debt Basis
Unlike a C corporation, a shareholder’s stock and debt basis in a S-Corporations will increase or decrease based on the annual operations. For example, income or gain items will increase a shareholder’s stock basis while losses and deductions will decrease a shareholder’s stock basis.
Tracking basis is not as much of an issue with partnerships because a partner’s capital account and debt basis will often be reflected on their K-1. However, an S-Corporation is not obligated to calculate a shareholder’s basis but rather it is the responsibility of the individual shareholders.
So why does a shareholder need to track their stock and debt basis? Great question! If a shareholder receives a K-1 from an S-Corporation with a loss then they must first determine if they have adequate stock and/or debt basis to deduct that loss. If the shareholder does not have adequate stock and/or debt basis then the loss and/or deductions will be suspended and carried forward to next year and may be deductible when basis becomes available.
Additionally, if a shareholder receives a non-divided distribution from an S-Corporation in excess of their stock basis then the shareholder must report any excess as a capital gain.
Lastly, when a shareholder sells or disposes of their interest in the S-Corporation the shareholder must compute a gain or loss on the sale or disposition of the stock. If the sale is high then you want to make sure you’re accounting for all of your basis to offset any gains.
How to Compute Stock Basis
For starters, a shareholder’s stock basis is first calculated by adding their initial capital contribution or the initial cost of the stock they purchased.
The stock basis is then increased and/or decreased by items reported on the shareholder’s K-1. For example, items of income will increase a shareholder’s stock basis while deductions and non-divided distributions will decrease a shareholder’s stock basis.
Firstly, a shareholder’s stock basis is increased by their share of income items reported on their K-1. For 2018 these income items, along with their corresponding line on a shareholder’s K-1, are listed as follows:
- Ordinary income reported in Box 1
- Separately stated income items reported in Boxes 2-10
- Tax exempt income reported in Box 16A & 16B
- Excess depletion reported in Box 15C
A shareholder’s stock basis is then decreased, not below zero, by the following deduction and distribution line items:
- Ordinary loss reported in Box 1
- Separately stated loss items reported in Box 2-12O, 14P and 14Q
- Non-deductible expenses reported in Box 16C
- Non-divided distributions reported in Box 16D
- Depletion for oil and gas reported in Box 17R
Lastly, it’s not only important to know what items increase or decrease a shareholder’s stock basis but it’s also important to know in what order they increase or decrease a shareholder’s stock basis.
Stock basis is adjusted annually on the last day of the S-Corporation’s taxable year in the following order:
- Increased for income items and excess depletion;
- Decreased for distributions;
This ordering is important because it will determine the taxability of non-divided distributions as well as the deductibility of S-Corporation losses.
Stock Basis Examples
To fully understand the importance of this ordering system we’ll look at some examples:
Example 1 – Distribution in Excess of Stock Basis:
Jeff is the sole owner of “Jeff’s Consulting”, an S-Corporation for federal tax purposes. Jeff contributes $10,000 to the business to cover start-up expenses and loans the business another $100,000 to cover daily operations until the business is profitable.
In the first year of operations Jeff has a net loss of $15,000 and distributes $15,000 to himself. Jeff’s stock basis at the end of the year is $0 computed as follows: $10,000 initial contribution – $10,000 distribution.
Notice how the stock basis cannot go below zero and only $10,000 of the $15,000 distribution can be offset against Jeff’s stock basis. The remaining $5,000 distribution is in excess of Jeff’s stock basis and must be reported as a capital gain. Also notice how Jeff’s debt basis isn’t considered when calculating non-divided distributions in excess of stock basis.
Although the $15,000 loss cannot be offset by the stock basis it can be used against Jeff’s $100,000 debt basis.
Example 2 – Losses in Excess of Stock Basis
Assume the same facts as example 1 except Jeff paid off $15,000 of his $100,000 shareholder loan. Jeff’s stock basis at the end of the year will again be $0 however Jeff won’t have any non-divided distributions in excess of his stock basis.
Following the ordering system you’ll add $10,000 for the initial contribution, subtract $10,000 loss (not exceeding the stock basis) and you would take the remaining $5,000 loss against Jeff’s debt basis.
If Jeff had no shareholder loans but instead had other loans which did not increase his debt basis then the $5,000 loss in excess of his stock basis would be non-deductible in the current year and will be suspended to future years when stock and/or debt basis becomes available.
How to Compute Debt Basis
For starters, it’s important to note that S-Corp debt basis is not the same as partnership debt basis. In a partnership you have recourse, non-recourse and qualified non-recourse debt that will give you debt basis. Although not all debt will give you ‘at-risk’ basis (another article in itself) debt in a partnership will generally give you basis to get pass the first loss limitation.
For shareholders in an S-Corp only shareholder loans will give you debt basis. Debt basis will increase when a shareholder loans the S-Corp money and will be decreased when the loan is paid down. However, mortgages, notes payable, line of credits and other forms of debt won’t give the shareholder debt basis.
So why not have the shareholder take a line of credit and put the proceeds in the S-Corp instead of the S-Corp drawing from a line directly? Wouldn’t this get around the debt basis rules? Possibly, however there is still the ‘at-risk’ limitations that looks through to the nature of that loan. This of course would take another article to fully explain so we’ll go on to look at some examples of how to calculate debt basis.
Debt Basis Examples
Example 1 – Taking Losses Against Debt Basis
Susan is the sole owner of “Susan’s Sweaters”, an S-Corporation for federal tax purposes. Susan contributes $10,000 to the business to cover start-up expenses and loans the business another $10,000 to cover daily operations until the business is profitable.
In the first year of business Susan’s Sweater is in a loss position of $15,000 (Apparently selling sweaters in Arizona wasn’t the best idea). Susan will be able to deduct $10,000 of the loss against her stock basis and an additional $5,000 from her debt basis. Her stock basis at the end of the year is 0 and her debt basis is $5,000. Notice how Susan still has $10,000 loaned to the business but her debt basis is only $5,000.
Example 2 – Losses Exceeding Debt Basis
In her second year of business Susan takes out a loan for some equipment so she can make her sweaters herself. She also takes out a line of credit in the business’ name to cover additional operating expenses. Since she is operating under an S-Corp the equipment loan and the line of credit gives her no additional debt basis.
The second year’s results aren’t as bad as the first year’s but Susan loses another $10,000. Remember, Susan’s debt basis was only $5,000 so she can only take a $5,000 loss. The remaining $5,000 will be carried forward and can be taken when basis becomes available.
Example 3 – Debt Basis Recapture
In her third year of business Susan only losses $5,000 – but remember she can’t deduct any of her losses because she has no stock or debt basis. At this point her business is being fueled by credit cards and loans. She needs to pay her own bills so she decides she needs to take some money out of the business.
However, if she distributes any money she will pick up a capital gain because she has no stock basis. Susan remembers that she loaned the business $10,000 so she figures she can pay herself back that way. Technically it’s not a distribution right? Susan decides $5,000 should do the trick and pays herself back half of what she originally loaned. However, her accountant has bad news for her – since she had no debt basis and reduced the loan down she will be subject to recapture. That $5,000 in now taxable as ordinary income.
Susan now has a carryover loss of $10,000 – the $5,000 from the prior year and the $5,000 loss that was clawed back due to the recapture rules.
Example 4 – Restoring Debt Basis
In her fourth year Susan’s Sweaters really takes off! She has a profit of $50,000 and is able to pay off most of her credit card debt. Her accountant has good news for once! Not only will she be able to use up her $10,000 carryforward but she’ll be able to restore her debt basis as well. Her debt basis will increase to the $5,000 she still has owed to herself and the remaining taxable income will increase her stock basis.
To recap, the $50,000 of income will be offset by $10,000 of suspended losses. The remaining $40,000 will be split to restore debt basis and increase stock basis. $5,000 to restore debt basis and $35,000 will increase her stock basis.
Highlights & Added Notes
- Non-dividend distribution in excess of stock basis is taxed as a capital gain on the shareholder’s personal return.
- Not discussed above but relevant: non-deductible expenses reduce stock and or debt basis before deductible expenses. If non-deductible expenses exceed stock and/or debt basis, they are not suspended and carried forward
- Losses in excess of stock and/or debt basis are not allowed. Loss and deduction items not allowable in the current year are suspended due to basis limitations and are carried over to the subsequent year.
- Shareholder’s are only allowed debt basis to the extent they are personally lent money to the S corp. A loan guarantee does not give a shareholder debt basis.
- Part or all of the repayment of a reduced basis debt may be taxable to the shareholder.
- If a shareholder sells their stock the suspended losses due to basis limitations are lost forever! Any gain on the sale of the stock does not increase the shareholder’s stock basis.
The information contained herein is is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined though consultation with your tax adviser. This article represents the views of the author only and does not necessarily represent the views or professional advice of this publication or the author’s employer.