Shareholder basis reflects a shareholder’s post-tax economic investment in a corporation. Calculating correctly and in the proper order can be a challenge with a small business corporation (an S corporation), since items of income and loss pass through to the shareholders for tax purposes. S corporation stock basis is important for determining tax treatment when a company has losses, makes distributions, or changes owners. Think of it as a checking account. The account is opened with an initial amount (contributions) and increased by income (earnings) and deposits before being decreased by any expenses (deductions) and withdrawals (distributions). Neither basis nor a bank account should go negative, so withdrawals and distributions are limited to how much is available.
The calculation of shareholder stock basis is made at the end of the taxable year. First, it is increased by income items including tax-exempt income. Then, it is decreased by distributions. Finally, it is decreased by any deduction and loss items including nondeductible expenses and disallowed losses. While scenarios where basis is a factor do not always happen regularly, it is important to annually update these calculations. Additionally, the IRS is now requiring basis to be reported with shareholders’ returns. Falling behind on basis calculations can lead to costly and time-consuming reconstruction, as well as potential misreporting of tax consequences.
A company’s taxable losses are allowed as reductions to shareholder taxable income to the extent the shareholder has basis. In a situation where the shareholder has no basis remaining, the losses are suspended and carried over to offset future income once the shareholder has basis again. Distributions received by the shareholder are normally not taxable; however, distributions exceeding the amount of remaining basis are treated as a taxable capital gain. Additionally, if the S corporation distributes appreciated property to the shareholder, the corporation must recognize the gain as if the property were sold to the shareholder at fair market value. This gain passes through to shareholders and increases their basis in the stock. In the event of a sale of stock by a shareholder, taxable gain is computed based on the amount received in excess of the stock basis. If basis records are not available, the shareholder risks being taxed on an incorrectly computed gain. There are other complexities involved in calculating S corporation basis. For example, shareholders making direct loans to the corporation receive debt basis, adding to overall basis. This basis increase does not apply for third-party debts owed by the company and/or loans guaranteed by the shareholder, a difference from partnership rules. If debt basis is used to take losses, repayments of the loan can lead to taxable gains to the shareholder.
Besides shareholder basis, two other pieces play a key part in determining the tax treatment of S corporation distributions: the accumulated adjustments account (AAA) and earnings and profits (E&P), corporate-level measures, unlike shareholder stock basis.
AAA is a measure of cumulative taxable income earned by an S corporation but not yet distributed to shareholders. When the S election is made, AAA starts at zero and is updated annually for many of the same items as shareholder basis.
For all intents and purposes, AAA only matters when accumulated E&P exists; otherwise, distribution rules all default to the shareholder basis rules described earlier. If an entity is already an S corporation without any E&P, congratulations! E&P cannot be generated at this point in normal circumstances and is now unable to further complicate the taxability of a distribution. However, if an S corporation does have accumulated E&P, either from prior C corporation years and/or inherited from a C corporation through a reorganization, distributions in excess of AAA are treated as dividends to the extent of E&P, subjecting those earnings to the classic double taxation of a C corporation/shareholder scenario. Remaining distributions merely reduce basis (something that actually happens even as AAA and E&P are depleted). A distribution in excess of shareholder basis is treated as a gain from sale of the stock.
To restate: proper computation and continual monitoring of stock basis (and AAA and E&P) is a key part of proper tax management of an S corporation. It is far easier to calculate basis annually than to go back through years of prior information researching and reconstructing the historical record. If you are a shareholder, CFO, or controller of an S corp, you may want to discuss these items with your tax advisor to ensure that basis is being computed consistently and correctly.
Jack A. Kaler, CPA
Jack A. Kaler, CPA is a Senior Staff Accountant with GranthamPoole, specializing in small businesses and real estate. For more information on the above article or any other tax-related topics, please contact your GranthamPoole tax advisor or Advisory Services Team Leader, Mike A. Carraway, Jr., CPA at 601.499.2400 or firstname.lastname@example.org.
The above does not represent tax advice. Each situation is fact-dependent, and you should seek the advice of a competent advisor. GranthamPoole PLLC is a provider of tax, accounting, advisory and strategic services, partnering with clients across a broad spectrum of industries and sizes.