A Small Business Owner’s Guide to Understanding S-Corp and Partnership Shareholder Basis.
As a small business owner, understanding the concept of Shareholder Basis is crucial, especially if your business is structured as an S Corporation or a partnership. Many shareholders have found themselves owing a considerable amount of taxes because they did not understand this concept. Here is everything the average S Corporation business owner needs to know on this important topic.
What is Shareholder Basis?
In simple terms, your “basis” as a shareholder is essentially the amount of your investment in the company for tax purposes. It’s used to determine the taxable gain or loss when you sell your shares or when the company distributes profits to you.
How is Basis Calculated?
Initial Investment: Your basis initially starts with the amount you’ve invested in the company. This could include the cash you’ve put in, the fair market value of any property you’ve contributed, and the amount of any debt the company has taken on for which you are personally responsible.
Increases in Basis: Your basis can increase over time. This typically happens when you contribute additional money or property to the business, or if the company earns income. Even if this income is not distributed to you, your share of the company’s income increases your basis.
Decreases in Basis: Your basis can also decrease. This happens if you take money out of the company in the form of distributions, if the company incurs losses, or if you are relieved of any of the company’s debt for which you are personally responsible.
How Partnerships Differ
The major difference between the basis for a partner and an S Corporation shareholder occurs if the business borrows money. A partner is allowed to include their share of the borrowed funds in their basis, while an S Corporation shareholder cannot add borrowed money to their basis. As an example, consider a business with two owners who each put in $20,000 cash as an initial investment and then the company borrows another $20,000. For each S Corporation shareholder, the starting basis will be $20,000. For each partner in a partnership, the basis would be $40,000.
Why is Knowing Your Basis Important?
Tax on Distributions: When the company makes a profit and distributes some of those profits to you, you need to know your basis to determine if those distributions are taxable. If the distribution is less than your basis, it’s generally not taxable. However, if it’s more than your basis, the excess could be taxable as a capital gain.
Loss Deductions: If the company incurs losses, you can generally deduct your share of those losses on your personal tax return, but only up to the amount of your basis. If your basis is zero, you can’t take any loss deduction.
Sale of Shares: If you decide to sell your shares in the company, your basis is used to determine your gain or loss on the sale for tax purposes.
How Basis is Reported
When the S Corporation files a tax return (1120S), all shareholders receive a K-1 form to show profits, losses and deductions allocated to the shareholder. The K-1 does not state the taxable amount of the distribution, which is contingent on the stock basis. As mentioned earlier, the main purpose of basis is to determine if distributions are taxable or if losses are deductible. The basis for each shareholder is calculated annually and must be tracked from day one of ownership. S Corporation shareholders use Form 7203 to figure the potential limitations of their share of the S corporation’s deductions, credits, and other items that can be deducted on their individual returns.
Important Things to Know About Shareholder Basis
Prioritize Excellent Record-Keeping: Keeping thorough and precise records is critical. Detailing every investment, contribution, distribution, and the share of the company’s financial activities is essential. This diligent record-keeping is not just for accurate basis calculations; it’s a shield in the event of tax audits.
Grasp the Fluid Nature of Shareholder Basis: Shareholder basis isn’t set in stone; it’s a dynamic figure. Contributions and the company’s earnings can boost it, while distributions and company losses can reduce it. It’s vital that you stay attuned to these shifts to avoid negative tax consequences.
Exercise Caution with Distributions: Be careful about making hasty distributions. Distributions that surpass your shareholder’s basis may trigger capital gains taxes. Always ask a tax professional to evaluate the tax implications before proceeding with substantial distributions.
Deducting Business Losses: Although shareholders can usually deduct their portion of the company’s losses, such deductions are limited to the extent of their basis. Losses beyond their basis are not a lost cause; they can be carried forward, but only with rigorous record-keeping.
Incorporate Basis in Long-Term Planning: Be sure to factor in your basis in long-term business strategies. Whether considering the sale of shares or planning for business succession, a higher basis might equate to less taxable gain. Collaborating with financial advisors for strategic planning can optimize your positions for these significant events.
Final Thoughts
Basis can be a complex area of tax law, and it’s specific to each shareholder based on their unique situation and history with the company. Keeping accurate and detailed records is crucial to tracking your basis correctly. It’s highly recommended to work with a tax professional to ensure your basis is calculated properly and all tax implications are correctly addressed.
Many business owners get into trouble when they classify money paid to them as a distribution, but they have exceeded their basis. This can result in tax penalties and interest. Please be sure to speak with a trusted tax advisor.
