What is an S Corp?
An S corporation is a corporation with an election in effect. The impact of the election is that income, loss, and deductions, pass through to the shareholder. The two main reasons for electing S corporation status are to, one, avoid double taxation on distribution. Now this is accomplished by the shareholder reporting pass-through income of the corporation, which increases his basis, which results in a tax redistribution. And then, two, to allow losses to pass through to its owners. Congress, however, did place limits on the amount of pass-through losses that a shareholder is allowed to claim.
S Corp shareholder loss limitations
There are three shareholder loss limitations. They are stock and debt basis limitations, at-risk limitations, passive activity loss limitations. Let’s talk a little about the stock and debt basis limitation. So when a shareholder is allocated a loss pass through on a schedule K-1 the first question to ask is does the shareholder have adequate stock basis. If the answer is, no, the loss is not allowed and must be suspended due to inadequate basis.
Partial Basis in S Corp Stock
If there is partial basis, part of a loss will be allowed and part of the loss will be limited. Now if the answer is, yes, the shareholder does have adequate stock and debt basis, the shareholder still needs to establish whether they are at risk or whether the loss should be limited due to the passive activity loss limitations.
What are At-risk and passive activity loss limitations?
At-risk and passive activity loss limitations apply a little bit differently than basis limitations. Basis limitations are determined at the shareholder level, whereas at-risk and passive activity loss look to the activity generating the loss and whether the shareholder is at risk or non-passive in that specific activity. We are now going to talk in a little bit more detail about stock basis, but before we move on, let’s talk a little bit about at-risk and the passive activity loss limitations.
Avoiding At-risk and passive activity loss in S Corp
So when determining whether a shareholder is at risk in an activity, it’s important to look at the source of the funds that the shareholder contributed or loaned to the S corporation. In addition, you need to look at the specific activities which generated losses and whether the shareholder is at risk in each separate activity. If the S corporation has multiple activities, the Schedule K-1 should provide adequate details the shareholder can appropriately apply the at-risk and passive activity limitations on an activity-by-activity basis.
Deducting S Corp Passive Losses
Generally there are two situations where a shareholder may have adequate stock and debt basis but is not considered at risk. Number one is borrowing money from another shareholder. If the shareholder borrows from another shareholder and contributes or loans that money to the corporation, it will allow him basis, but he will not be considered at risk in the activity. Number two is nonrecourse borrowing. So if a shareholder borrows money on a non-recourse basis and loans or contributes the money to the S corporation, again, it will allow him basis but he will not be at risk in that activity. If the shareholder is not at risk in the activity, the loss is disallowed and must be suspended due to the application of the at-risk limitations. However, if it is found that the shareholder has basis and is at risk, then the shareholder must determine whether the passive activity loss limitations apply. So let’s talk a little bit about the passive activity loss limitations.
Deducting a Passive Loss on S Corp
Generally a passive loss may only be claimed up to the amount of the shareholder’s passive income. So what is a passive activity which will generate passive income or loss? If the activity is a rental, it is presumed to be passive, and, of course, there are exceptions to that. Or if the shareholder does not materially participate in the business activity it will also generate passive income. To materially participate, a shareholder is required to substantially participate in the operations of the business activity on a regular and continuous basis. This means the shareholder must meet one of the seven hourly tests that are found in treasury Reg 1. 469-5T(a). So if a shareholder has passive losses in excess of passive income, some or all of the loss will be disallowed and suspended due to the passive activity loss limitations. So, in summary, there are three loss limitations. Again, they are stock and debt basis limitations, at-risk limitations, and the passive activity loss limitations. A shareholder must meet each limitation before they are allowed to claim a pass-through loss from the S corporation. These are shareholder not corporate limitations.
S Corp Shareholders should track suspended losses
Shareholders should track suspended losses due to basis, suspended losses due to the application of at-risk rules, and they should try the suspended losses due to the passive activity loss limitations. The fact that the shareholder gets a schedule K-1 reflecting a loss does not mean that that shareholder is automatically entitled to claim that loss. Today we’re going to focus on the discussion on stock-basis limitations and it’s ordering rules. With that, let’s take a closer look at what goes into the shareholder stock basis. The S Corporation’s income loss and deduction items are generally allocated to the shareholder using the per share/per day method. The shareholder receives a Schedule K-1 reflecting his share of the pass-through income items, the pass-through loss, deduction, and credit items and any non-dividend distributions received for the year. Now the schedule K-1 does not reflect the amount of the loss or deduction items which can be claimed or the taxable amount of the non-dividend distribution.
Allowable loss and deduction items
The amount of the allowable loss and deduction items are dependent on the shareholder having adequate stock and debt basis; whereas the taxability of a non-dividend distribution are dependent on the shareholder having adequate stock basis. So when is it important for the shareholder to know his stock basis? Well it’s important when the S Corporation allocates loss of deduction items to the shareholder, or when the S corporation makes a non-dividend distribution to the shareholder, or when the shareholder disposes of his stock. Tracking and calculating stock and debt basis is the shareholder’s responsibility. It is not a corporate responsibility. Although some corporations may provide this information for their shareholders, it is not the corporation’s responsibility. The shareholder is responsible for determining whether or not they have adequate stock basis to claim the loss and whether their distributions exceed stock basis.
Pass-through loss for deduction item
So if you’re preparing a form 1040 and their schedule K-1 reflects a pass-through loss for deduction item or it has a non-dividend distribution, you need to ascertain whether the shareholder has adequate stock and debt basis to properly prepare the 1040. The requirement to keep adequate records, which includes the records for computing and verifying basis, is contained in treasury reg 1.6001-1(a). And keeping track of S corporation stock basis is really no different than keeping track of the basis of any other asset.
How to compute a shareholder stock basis
How to compute a shareholder stock basis. As with the basis of any asset, we’re generally starting with its cost. So if you purchase the stock, the initial cost will be the amount you pay, which is the same as for a car or any other property. If you acquire the stock by contributing an asset, you know, such as cash, to the corporation, which is covered under IRC Section 351, generally you get a carry over basis, less any liabilities assumed by the corporation. If the stock is received as a gift your initial basis is equal to the donor’s basis in a gift. So when a dad gives stock to one of his kids, the kid’s basis would be dad’s basis at the date of the gift. And if the stock is inherited, generally the initial basis equals a fair market value that the stock at the date of death as recognized by the estate.
Determining Initial S Corp Stock Basis
So in determination of initial stock basis is the same whether the corporation is a C corporation or an S corporation. A shareholder stock basis and his S corporation is unique, as it is a moving target each year. Basis goes up and down based upon the S corporations pass-through allocations of income, loss, and deductions, and the distributions received by the shareholder. Also, stock basis is determined at the end of the year except when the stock is sold or disposed. So if you’ve got a copy of the Schedule K-1 handy, you might want to pull that out right now, as we’re going to be referring to it as we continue our discussion. So as was mentioned earlier, the shareholder stock basis is increased by their pro rata share of their pass-through items, and this includes ordinary income, which is reported on the Schedule K-1, Box 1. It includes separately stated income items reported on schedule K-1, Boxes 2 through 10.
S Corp separately stated income items
Now separately stated income items are required to be separately stated, as they might provide for different tax treatment by some shareholders. Examples include rental activities, which are generally passive, or interest income, which may be needed to establish investment interest expense or the net investment income tax, or even long-term capital gains, which have a different tax rate at the shareholder level.
Other S Corp Basis Stock Increases
Stock basis is also increased for tax exempt income, which is from Schedule K-1 boxes 16 A and B, and this includes interest income from state municipal bonds or life insurance proceeds. And then it will be increased for excess depletion over property basis, which is on schedule K-1 box 5C — sorry, Box 15C. Now let’s look at the items that decrease stock shareholder basis, although it cannot be reduced below zero. So first ordinary losses on schedule K-1, Box 1, separately stated loss and deduction items on Schedule K-1, Box 2 through 12D, and 14L or 14M, which are for foreign taxes paid or accrued, nondeductible expenses, which include things like penalties, non-deductible portions of travel and entertainment, life insurance, and these are on Schedule K-1, Box 16C. Basis is also reduced by non-dividend distributions, which is schedule K-1, Box 16B. And finally, it is decreased for depletion for oil and gas, which is reported to the shareholder on schedule K-1, Box 17R. Now each of these items increase or decrease a shareholder stock basis is reflected on the shareholder’s individual schedule K-1 and represents the shareholder’s pro rata share of income loss and deduction items. With that, I’m going to go and ask Susan to discuss non-dividend and dividend distribution.
Distributions received by the shareholder of an S Corporation
Distributions received by the shareholder, which may or may not be pro rata in any given year equal the fair market value of assets distributed, which can consist of cash or property. Let’s discuss a few items to consider as they relate to distributions. First, as stated on the previous chart, basis is decreased by non-dividend distributions. An S corporation can have both dividend and non-dividend distributions. Generally, an entity that has always been taxed as an S Corp will only have non-dividend distributions, but if the corporation ever operated as a C corporation or if the entity acquired a C corporation with a carryover basis; for example, through a merger, then it can acquire C Corp earnings and profits, which, when distributed, are dividend distributions. The S corporation is responsible for determining the amount of total dividend distributions, the total distributions that are dividend, and the total distributions that are non-dividend. A non-dividend distribution is reflected on the Schedule K-1, Box 16D. They reduce stock basis but not debt basis. But they do not reduce stock basis below zero.
S Corp Shareholder Dividend Distribution
If a shareholder receives a dividend distribution it should be reported on the 1099-DIV. The dividend distribution does not increase or decrease a shareholder’s stock basis. Another item I’d like to mention regarding distributions is that distributions can be disproportionate in a given year. But keep in mind, an S Corp can only have one class of stock, so if I am a 20% shareholder, I’m entitled to 20% of the distribution and liquidation rights of the company. I can receive more or less in a given year but over the life of the company it should balance out. Finally, payments to a shareholder for services rendered by the shareholder should be wages, subject to employment taxes. They’re not distributions. So back to the stock basis computation. It was discussed that basis is increased by ordinary and separately-stated income items, but stock basis is not increased if a shareholder fails to report pass-through income. This is an exception to the rule. There is an exception to the rule if the shareholder’s not required to file. For example, we’ve got grandma who owns 5% of an S Corp. and is allocated $1,000 worth of income. Grandma only has — only other income she has is social security income. So grandma is not required to file a tax return, but she is allowed to increase her stock basis by the $1,000 allocated S Corp. income.
S Corp Stock Basis Loss
On the flip side, basis is reduced by losses, even when a shareholder fails to claim the losses. When a shareholder receives no tax benefit from the loss; for example, assume a shareholder has allocated a charitable contribution expense from the S corporation. The shareholder claims standard deduction, so he doesn’t itemize his deductions. As a result, the shareholder receives no benefit for the allocated charitable contribution. In this case, stock and/or debt basis must be reduced by the allocated charitable contribution, even though the shareholder received no benefit from that deduction. Also, basis is reduced even when the shareholder must defer the loss under either the at-risk or the passive activity loss limitations. For example, let’s assume a shareholder has an ordinary loss of $5,000, which the shareholder has adequate stock basis to claim. However, the shareholder does not materially participate in the business and has no other passive income. Stock basis is reduced by the $5,000 despite the fact the shareholder is not allowed to claim the loss due to the passive activity rules, which results in the shareholder having a suspended passive activity loss carry forward. The shareholder will be allowed to carry over that suspended passive loss indefinitely or until he has passive income or the activity is completely disposed of, which will trigger the suspended loss. Now let’s look at the ordering rule. Allowable loss and deduction items are limited to stock and debt basis.
S Corp Non-dividend distributions
Non-dividend distributions are tax free up to the extent of stock basis. As both items of loss and deductions and distributions reduce stock basis, there must been an ordering rule for items that increased and decrease stock basis in order to apply the stock and debt basis limitations. As such, for stock basis, stock basis will be adjusted in the following order, number one, it will first be increased for income items and excess depletion, then it will be decreased for non-dividend distributions, but not below zero. Any non-dividend distribution in excess of stock basis will result in capital gains. Remember that a distribution will not look to debt basis, only stock basis. Next, stock basis is decreased for non-deductible items but not below zero. Nondeductible items in excess of stock basis and debt basis will generally evaporate at the end of the year, meaning they’re not carried forward to offset basis in future years. And finally, stock basis is decreased for items of loss and deduction, but not below zero. The loss and deduction items in excess of stock basis are generally suspended and carried forward. If you missed it, basis cannot go below zero.
Suspended loss and deduction items
Suspended loss and deduction items due to basis retain their character and are carried over indefinitely or until all of the shareholder stock is disposed of. Suspended loss and deduction items are treated as loss and deduction items incurred in the subsequent year. The loss in deduction items are not netted against that year’s income items of the same character. Suspended losses due to basis in the year of disposition are lost forever. So a common error made by a shareholder is when suspended losses are treated as triggered in a complete disposition. A shareholder cannot claim losses in excess of basis, even if they dispose of their stock. So remember, a shareholder can have suspended losses due to a basis limitation, due to an at-risk limitation, and due to passive activity loss limitations. Each of these pools must be separately maintained because they have different rules. So, for example, upon disposition, suspended losses due to basis are lost. However, if a loss is suspended due to passive activity loss limitation, the disposition will trigger the previously suspended loss in deduction items, and this is because basis was already reduced by the suspended passive loss in deduction items. And shareholders often confuse these two rules and they incorrectly claim losses suspended by basis when they dispose of their stock. So a shareholder can make an election to change the normal stock basis ordering rules. If an election is made under Treasury Reg 1.1367-1(g), it allows a shareholder to claim loss and deduction items before non-deductible expenses. So under the normal stock basis ordering rules, if the non-deductible expenses exceed the stock and debt basis, the excess goes away, as there’s no provision requiring that they are carried forward. So on the other hand, the cost of making the election under the regulation, is there any unused nondeductible expenses are carried forward until they are used to reduce stock or debt basis.
Suspended Loss Election
Now once the election is made the shareholder must continue to use that ordering rule unless the IRS approves a change back to the current law ordering rule. I have seen it done but rarely, usually if the shareholder makes a selection when the corporation is in its final year of operation. Now although debt basis is beyond the scope of today’s forum, there are a few items we did want to cover, such as losses in deductions which exceed a shareholder stock basis are allowable to the extent of the shareholder basis and loans, and that debt basis is computed similar to stock basis, but there are some differences. So when considering stock basis versus debt basis, it’s important to remember that they are not the same thing and they must be tracked separately. And a couple of examples, include distributions look to stock basis only; loan repayments, look to debt basis only; and reduced basis debt is restored by current year net increases.
Now in order for a shareholder to obtain debt basis the debt must be bonafide indebtedness from the shareholder to the corporation. So in other words, the shareholder personally loaned the money to the corporation. So therefore, corporate debt does not give it shareholder debt basis. A corporation is a legal entity and is separate from its owners. A loan guarantee or a co-made loan is not sufficient to allow shareholder debt basis. So with corporate debt, loan guarantees or co-made loans the debt is between the corporation and the third party or the corporation and the shareholder jointly and the third party, and it’s not between the corporation and the shareholder. So, again, a shareholder is only allowed debt basis to the extent that he or she has a bonafide indebtedness between them and the corporation. So losses and deductions claimed against a shareholder’s debt basis reduce the shareholder’s basis in the debt. And if an S corporation repays reduced basis debt to the shareholder, part or all of that repayment is taxable to the shareholder.
Tracking and calculating the basis is the shareholder’s responsibility, not the S corporation’s.
Tracking and calculating the basis is the shareholder’s responsibility, not the S corporation’s. Basis generally starts with costs, and basis goes up and down based on the schedule K-1 pass-through income, loss, and deduction items. You’ll also recall that the S corporation stock basis is adjusted at year end in the following order: Increased for income items and excess depletion, then decreased for non-dividend distributions, then decreased for non-deductible items, and finally, decreased for items of loss and deductions. And losses and deductions which exceed a shareholder’s stock basis are allowable to the extent that the shareholder’s basis in loans, and losses and deductions in excess of stock and debt basis are suspended and carried over to future years.