If you are the owner of an S Corporation, the corporation pays no federal income tax. Instead, you enjoy a pass through of corporate profit or loss on your individual income tax return where it is taxed at your individual rate. This rate can vary depending upon your other tax transactions and the amount of corporate profit or loss you are declaring.
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But did you know that you can write off corporate losses only to the extent of basis in the corporation? For this reason it is important that either you or your tax professional track basis every year to determine eligibility for deducting losses.
Stock basis is determined by a complex formula. Essentially, you begin with the initial value of your stock, the amount of which is determined when you become a shareholder. Each year you must combine certain elements from the financial statements to come up with an end of year basis for each shareholder. The elements you combine are: initial stock value plus ordinary income (profit) for the year less distributions less nondeductible expenses less ordinary business losses plus capital contributions.
Let’s examine some of the terminology.
You accountant can provide you with your intital stock value.
Ordinary income or loss is the difference between your total sales for the year less your total expenses and includes depreciation expense.
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Distributions are draws that you take as a shareholder aside from your salary or wages. Salary and wages do not play a role in determining basis. Distributions may also include amounts paid out on your behalf not deductible by the corporation such as health and disability insurance premiums or contributions into an IRA or SEP IRA or SIMPLE plan.
Nondeductible expenses include 50% of meals and entertainment expenses, fines and penalties on delinquent payroll, sales, and excise taxes, fines for illegal activities like parking tickets.
Contributions are monies and other property that you assign to the corporation.
So let’s say you are the sole shareholder and your initial outlay for corporate stock is $10,000. During the year you have taken distributions of $30,000. This is aside from your regular salary totaling $120,000. Nondeductible expenses total $5,000. The business shows a profit for the year of $50,000.
Adding these elements together $10,000 – 30,000 – 5,000 +50,000 = $25,000. Your ending basis in the corporation is $25,000. You do not have to worry about the impact of basis this year because the business is not showing a loss.
However, let’s take a look at the subsequent year. You start the year with a beginning basis of $25,000. But it turns into a bad year. You put in $50,000 of your own money to help with cash flow. You suffer a loss for the year of $90,000. You therefore end the year with a negative basis, –$15,000.
What happens now? The IRS says, “A shareholder is not allowed to claim loss and deduction items in excess of stock and/or debt basis. Loss and deduction items not allowable in the current year are suspended due to basis limitations and are carried over to the subsequent year.”
You can’t take the loss. But at least you don’t lose it completely. You are allowed to carry it forward.
If you take distributions in excess of basis, they would be required to be reported on Schedule D of your income tax return as a long term capital gain if you’ve held the stock for more than one year.
Basis is a complicated issue. For S Corporations, other items to track include debt basis, passive activity loss limitations and at risk limitations. Check with your tax pro for more information. You can also read up on this topic at the IRS website: S Corporation Stock and Debt Basis.