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S Corporation Stock and Debt Basis

Shareholder Loss Limitations

An S corporation is a corporation with an "S" election in effect. The impact of the election is that the S corporation's items of income, loss, deductions and credits flow to the shareholder and are taxed on the shareholder's personal return.

The two main reasons for electing S corporation status are:

  1. Avoid double taxation on distributions.
  2. Allow corporate losses to flow through to its owners.

There are three shareholder loss limitations:

  1. Stock and Debt Basis Limitations
  2. At Risk Limitations
  3. Passive Activity Loss Limitations

Each limitation must be met, and in the order presented, before a shareholder is allowed to claim a flow-through loss.

The fact that a shareholder receives a K-1 reflecting a loss does not mean that the shareholder is automatically entitled to claim the loss.

S Corporation Shareholders are Required to Compute Both Stock and Debt Basis

The amount of a shareholder's stock and debt basis in the S corporation is very important. Unlike a C corporation, each year a shareholder's stock and/or debt basis of an S corporation increases or decreases based upon the S corporation's operations. The S corporation will issue a shareholder a Schedule K-1.

It is important to understand that the K-1 reflects the S corporation's items of income, loss and deduction that are allocated to the shareholder for the year. The K-1 shows the amount of non-dividend distribution the shareholder receives; it does not state the taxable amount of a distribution. The taxable amount of a distribution is contingent on the shareholder's stock basis. It is not the corporation's responsibility to track a shareholder's stock and debt basis but rather it is the shareholder's responsibility.

If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder's stock basis. Debt basis is not considered when determining the taxability of a distribution.

Loss or Deduction Flow-Through Items

If a shareholder is allocated an item of S corporation loss or deduction, the shareholder must first have adequate stock and/or debt basis to claim that loss and/or deduction item. In addition, it is important to remember that, even when the shareholder has adequate stock and/or debt basis to claim the S corporation loss or deduction item, the shareholder must also consider the at-risk and passive activity loss limitations and therefore may not be able to claim the loss and/or deduction item.

S Corporation Stock and Debt Basis

Importance of Stock Basis

It is important that a shareholder know his/her stock basis when:

  • The S corporation allocates a loss and/or deduction item to the shareholder.
    In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and/or debt basis.
  • The S corporation makes a non-dividend distribution to the shareholder.
    In order for the shareholder to determine whether or not the distribution is non-taxable they need to demonstrate they have adequate stock basis.
  • The shareholder disposes of their stock.
    As with any asset, including C corporation stock, when the asset is sold or disposed of, basis needs to be established in order to reflect the proper gain or loss on the disposition.

Since shareholder stock basis in an S Corporation changes every year, it must be computed every year.

Computing Stock Basis

In computing stock basis, the shareholder starts with their initial capital contribution to the S corporation or the initial cost of the stock they purchased (the same as a C corporation). That amount is then increased and/or decreased based on the flow-through amounts from the S corporation. An income item will increase stock basis while a loss, deduction, or distribution will decrease stock basis.

A shareholder's stock is increased by (using 2012 Form 1120S Schedule K-1 box items):

  Schedule K-1
1. Ordinary income Box 1
2. Separately stated income items Boxes 2 - 10
3. Tax exempt income Boxes 16A & 16B
4. Excess depletion Box 15C

A shareholder's stock basis is decreased, but not below zero, by.

 

  Schedule K-1
1. Ordinary loss Box 1
2. Separately stated loss items Boxes 2 - 12O
and 14L, 14M
3. Nondeductible expenses Box 16C
4. Non-dividend distributions Box 16D
5. Depletion for oil and gas Box 17R

NOTE: Only non-dividend distributions reduces stock basis, dividend distributions do not. The corporation is responsible for telling the shareholder the amount of non-dividend and dividend distributions. Box 16D of Schedule K-1 reflects non-dividend distributions. Form 1099-DIV is used to report dividend distributions; dividends are not reported on the shareholder's Schedule K-1.

Most distributions from an S corporation are non-dividend distributions. Dividend distributions can occur in a company that was previously a C corporation or acquired C corporation attributes in a non-taxable transaction (i.e., merger, reorganization, QSub election, etc.).

The order in which stock basis is increased or decreased is important. Because both the taxability of a distribution and the deductibility of a loss are dependent on stock basis, there is an ordering rule in computing stock basis. Stock basis is adjusted annually, as of the last day of the S corporation year, in the following order:

  1. Increased for income items and excess depletion;
  2. Decreased for distributions;
  3. Decreased for non-deductible, non-capital expenses and depletion; and
  4. Decreased for items of loss and deduction.

When determining the taxability of a non-dividend distribution, the shareholder looks solely to his/her stock basis (debt basis is not considered).

For loss and deduction items, which exceed a shareholder's stock basis, the shareholder is allowed to deduct the excess up to the shareholder's basis in loans personally made to the S corporation. Debt basis is computed similarly to stock basis but there are some differences.

If a shareholder has S corporation loss and deduction items in excess of stock basis and those losses and deductions are claimed based on debt basis, the debt basis of the shareholder will be reduced by the claimed losses and deductions.

If an S corporation repays reduced basis debt to the shareholder, part or all of the repayment is taxable to the shareholder.

Stock Basis Example

Mark, the sole shareholder of an S corporation, has $15,000 of stock basis on January 1, 2012. Mark received a 2012 K-1 reflecting the following:

Box 1 (20,000) Ordinary business income (loss)
Box 9 4,000 Net section 1231 gain
Box 12 A 5,000 Cash contributions (50%)
Box 16 C 1,000 Non-deductible expenses
Box 16 D 12,000 Distributions

For this example, assume Mark does not have any debt basis.

Using the ordering rule, stock basis is first increased by items of income - so our initial stock basis of $15,000 is increased by the $4,000 net section 1231 gain. Our stock basis before distributions is $19,000.

Then we reduce stock basis by distributions of $12,000. Since the shareholder has adequate stock basis before distributions, the distribution will reduce stock basis to $7,000 and the $12,000 distribution is non-taxable.

Next, stock basis is reduced by the $1,000 of non-deductible expenses. Stock basis before loss and deduction items is $6,000.

Mark has ($25,000) of loss and deduction items:

  • ($20,000) ordinary loss
  • $5,000 charitable contribution

Since loss and deduction items exceed stock basis, we would look to see if the shareholder had valid debt basis. Since there is no debt basis in our example, the loss and deduction items are pro-rated to determine the amount currently allowable:

  • 20,000/25,000 * 6,000 = ($4,800) ordinary loss
  • 5,000/25,000 * 6,000 = $1,200 charitable contribution

 

January 1, 2012 Stock Basis 15,000
Plus: Net section 1231 gain 4,000
Equals: Stock Basis before Distributions 19,000
Less: Non-dividend distributions (12,000)
Equals: Stock Basis before nondeductible expenses 7,000
Less: Nondeductible expenses (1,000)
Equals: Stock Basis before Loss & Deductions 6,000
Less: Ordinary business loss {20/25 * 6} (4,800)
Less: Cash contributions {5/25 * 6) (1,200)
Equals: December 31, 2012 Stock Basis 0

Therefore, although the corporation allocated Mark a ($20,000) ordinary loss, he should reflect on his 2012 Schedule E only ($4,800) due to the stock and debt basis limitations.

2012 Ordinary business loss (20,000)
Allowable 2012 Ordinary business loss (4,800)
Suspended Ordinary business loss (15,200)

In addition, although Mark was allocated a cash contribution of $5,000, he would only be allowed to take $1,200 on his 2012 Schedule A, subject to the 1040 contribution deduction limitations.

2012 Cash contribution 5,000
Allowable 2012 Cash contribution 1,200
Suspended Cash contribution 3,800

 

IRC §1366(d)(2) holds that any loss suspended because of lack of stock and debt basis shall be treated as incurred by the corporation in the succeeding taxable year with respect to that shareholder.

For 2013 Mark’s K-1 reflected the following:

Box 1 35,000 Ordinary business income (loss)
Box 9 (10,000) Net section 1231 loss
Box 12 A 1,000 Cash contributions (50%)
Box 16 C 5,000 Non-deductible expenses

 

Mark’s basis in his stock at the beginning of the year is $0.  Losses suspended in a previous year are treated as being incurred in the next tax year and can only be deducted when basis is increased.

Stock basis is computed as follows:

January 1, 2013 Stock Basis 0
Plus: Ordinary Income 35,000
Equals: Stock Basis before Distributions 35,000
Less: Non-dividend distributions 0
Equals: Stock Basis before nondeductible expenses 35,000
Less: Nondeductible expenses (5,000)
Equals: Stock Basis before Loss & Deductions 30,000
Less: Ordinary business loss – 2012 carryover (15,200)
Less: Cash contributions – current year (1,000)
Less: Cash contributions - 2012 Carryover (3,800)
Equals: December 31, 2013 Stock Basis 10,000

Although the K-1 will only show the current year income items, the shareholder will be allowed to take the losses previously suspended due to the stock basis limitations. Suspended losses should not be combined with current income amounts, but listed on a separate line on the Form 1040, Sch. E, Supplemental Income and Loss, or the appropriate schedule when possible.

Also, Treas. Reg. §1.1366-2(a)(3)(i) holds that the suspended ordinary loss carryover is not netted with the current year ordinary income when applying the stock basis ordering rules.

If the Stock basis before losses and deductions had only been $17,500 instead of $30,000, the following losses and deductions would have been allowed in 2013.

Equals: Stock Basis before Loss & Deductions 17,500
Less: Ordinary business loss - 2012 carryover {15,200/20,000 * 17,500} (13,300)
Less: Cash contributions  
Current year (1,000)
2012 carryover (3,800)
Total {4,800/20,000 * 17,500) (4,200)
Equals: December 31, 2013 Stock Basis 0

The carryover to 2014 would be:

2013 Ordinary business loss (based on 2012 carryover) (15,200)
Allowable 2013 Ordinary business loss (13,300)
Suspended Ordinary business loss (1,900)

 

2013 Cash contribution (based on current year and 2012 carryover) 4,800
Allowable 2013 Cash contribution 4,200
Suspended Cash business loss 600

The loss and deduction items in excess of stock and debt basis:

  • retain their character
  • are treated as loss and deduction items incurred in the subsequent tax year and will be allowed if stock or debt basis is increased or restored
  • carryover indefinitely or until all the shareholder's stock is disposed of

Once a shareholder disposes of all of their stock, any suspended loss and deduction items are lost and cannot be deducted.

Important Things You Should Know:

  • A non-dividend distribution in excess of stock basis is taxed as a capital gain on the shareholder's personal return. It is a long-term capital gain (LTCG) if the S corporation stock has been held for longer than one year.
  • Non-deductible expenses reduce a shareholder's stock and/or debt basis before loss and deduction items. If non-deductible expenses exceed stock and/or debt basis, they are not suspended and carried forward.
  • If the current year has different types of loss and deduction items, which exceed stock and/or debt basis, the allowable loss and deduction items must be allocated pro rata based on the size of the particular loss and deduction items.
  • A shareholder is not allowed to claim loss and deduction items in excess of stock and/or debt basis. Loss and deduction items not allowable in the current year are suspended due to basis limitations and are carried over to the subsequent year.
  • Suspended losses and deductions due to basis limitations retain their character in subsequent years. Any suspended loss or deduction items in excess of stock and/or debt basis are carried forward indefinitely.
  • In determining current year allowable losses, current year loss and deduction items are combined with the suspended loss and deduction items carried over from the prior year, though the current year and suspended items should be separately stated on the Form 1040 Schedule E or other appropriate schedule on the return.
  • A shareholder is only allowed debt basis to the extent he or she has personally lent money to the S corporation. A loan guarantee is not sufficient to allow the shareholder debt basis.
  • If a shareholder contends he or she has contributed or loaned substantial funds to the S corporation, consideration should be given to whether the shareholder had the financial means to make the contribution or loan.
  • Part or all of the repayment of a reduced basis debt is taxable to the shareholder.
  • If a shareholder sells their stock, suspended losses due to basis limitations are lost. Any gain on the sale of the stock does not increase the shareholder's stock basis.

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Page Last Reviewed or Updated: 26-Mar-2014