S corporations are businesses with 100 or fewer shareholders that can elect to be taxed as a partnership. The benefit of being taxed as a partnership is that the business’s profits are only taxed once; the stockholders pay tax on their share of what the S corporation earned during the year. As a result, each shareholder has a “basis” in the S Corporation which measures their after-tax investment in the business. Basis is an important measure for taxing certain shareholder transactions with the business.
Stock basis is the measure of investment made by each shareholder. You begin calculating stock basis with the amount of money and property the person contributed to the business when the shareholder joined the S Corporation. Every year you increase the basis by the amount of the corporate income that you report on your taxes. This includes ordinary income, tax-exempt income (which you still must report), and excess depletion incurred on the business’s assets. The shareholder’s basis in the business is decreased by the stockholder’s share of the business’s losses and the S corporation’s nondeductible expenses. Any additional funds the stockholder transfers from the business will increase the stockholder’s basis; any distribution the stockholder receives from the S corporation will decrease his basis. This information can be found on each shareholder’s K-1, which is provided by the S corporation at the end of every tax year.
Calculating a shareholder’s basis in debt he might have extended to an S corporation follows a similar process to stock basis. You start with the amount for the original loan and increase the stockholder’s basis for any additional loans he may provide. The stockholder’s debt basis decreases for any payment the S corporation pays on the debt or if the stockholder’s share of the business’s losses exceeds his basis in his shares.
Taxing Cash from S Corporation
When an S Corporation makes a distribution or dividend payment to its shareholders, the amount received is generally not taxed by the IRS. This is because that distribution represents income that the shareholder paid taxes on in prior years. This distribution decreases basis. However, if the distribution is greater than the shareholder’s basis in the stock, the shareholder must pay tax on the difference. So if Marie has a basis of $10,000 and she receives a $15,000 distribution, she must pay tax on $5,000.
John makes a $100,000 investment in an S corporation and acquires 25 percent of the outstanding shares. Over the next three years, the business makes $400,000 annually. Each year, John adds $100,000 in income to his tax return. After three years John’s basis is $400,000. After the end of the first three years, the S corporation distributes $200,000 to John. This decreases his basis to $200,000 and he does not pay taxes on the cash he receives. In the fourth year the business sustains a $200,000 loss. At the end of the fourth year, John’s stock basis is $150,000.
- Internal Revenue Service: S Corporations
- Internal Revenue Service: S Corporation Stock and Debt Basis
- Legal Information Institute: US Tax Code – Section 1367 – Adjustments to Basis of Stock of Shareholders, Etc
- Accountants CPA Hartford: Calculation of Shareholder’s Stock and Debt Basis in S Corporation
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.