In previous articles S corporation stock basis has been discussed, and specifically what items will increase the stock basis and what items will decrease stock basis. However, there are ordering rules when increasing S corporation stock basis, which is very important because the taxation of a distribution from an S corporation and deductibility of a loss are dependent on a shareholder’s basis in the stock. A shareholder’s stock basis will be adjusted annually in the following order:
- Increased for income items and excess depreciation
- Decreased for corporate distributions
- Decreased for non-deductible, non-capital expenses and depletion
- Decreased for items of loss and deduction
When a shareholder is determining the taxability of a non-dividend distribution, the shareholder’s stock basis is considered, but not the debt basis in the stock. If the corporation has loss and other deduction items, and these items exceed the shareholder’s stock basis, the shareholder can deduct these excess up to their basis in loans they have personally made to the corporation. Although, a shareholder’s debt basis in their stock is computed similarly to their stock basis, some differences exist.
When a shareholder has S corporation losses and deduction items and these items exceed their stock basis and these items are claimed based off of the shareholder’s debt basis, the debt basis is reduced by the amount claimed for the loss items and deduction items. When an S corporation repays reduced basis debt to the applicable shareholder, a part or all of the loan repayments can be taxable to the shareholder.
Below is an example of the ordering rules. Josh is the sole shareholder of an S corporation and has a $20,000 stock basis and K-1 reflecting:
(20,000) Ordinary Business Income
5,000 Net Section 1231 Gain
5,000 Charitable Contributions
1,000 Non Deductible Expenses
The basis will first be increased by items of income, so the $20,000 basis is increased by the 1231 gain to $25,000. Then the basis is reduced by $15,000 of distributions to $10,000, and because the shareholder has adequate basis, the distribution is not taxable. Thereafter, the basis would be reduced by $1,000 for non-deductible expenses to $9,000. Josh has $25,000 of losses from the ordinary loss and the charitable, and this loss exceeds his stock basis. Thus, Josh would need to have adequate debt basis to take the loss. Josh would pro rate the loss and deductions to determine the amount that would currently be deductible.
It is important to properly track your basis in an S corporation. If you have tax or business questions related to your business, contact a Denver tax attorney at The McGuire Law Firm. A free consultation with a Denver tax attorney is provided to potential clients.
Contact The McGuire Law Firm to speak with a tax attorney in Denver, Colorado.