When I discuss S-Corporation basis with my clients, there is often confusion about what that term means and how it affects their taxes.
In today’s article, I’ll explain the basis for an S-Corporation and why it’s an important number to keep your eye on as a small business owner.
What is the basis for an S-Corporation?
To put it very simply, an S-Corporation owner’s basis in their company is the measure of how much money or property the owner has invested in the business at any given time. That investment, or basis, can increase based upon annual income, contributions, and the purchase of stock. The basis can decrease based upon any losses, distributions, or loans taken throughout the year.
Why does basis for an S-Corporation matter?
Your basis in your S-Corporation is important because it will determine whether any business losses are deductible and whether any distributions you’ve taken are taxable.
Since an S-Corporation is a pass-through entity, you won’t be able to deduct any losses that are greater than your basis in your S-Corporation. However, if you have excess losses that you aren’t able to deduct, you can roll those over to the following years if your business is still intact and you have enough basis at that time to cover the amount of previous losses. The IRS calls these carryover losses “suspended losses,” and they should be reported on a Form 1040, Schedule E.
In terms of distributions, if you receive money from your business as a non-dividend distribution (dividend distributions usually only happen in C-Corporations) and the amount is less than your basis in the S-Corporation, then that distribution isn’t taxable.
However, if you receive non-dividend distributions that exceed your basis, the amount that exceeds your basis is taxed as a capital gain. This can cost you 20% to 37% in taxes depending on whether or not your distribution is a long-term or short-term capital gain. The distribution will be taxed as a short-term capital gain, which is a much higher rate, if your distribution is taken within one year of your initial investment in your S-Corporation. In other words, to avoid forking over more money in taxes, do not take distributions that exceed your basis unless it absolutely can’t be avoided.
How do I calculate my basis in an S-Corporation?
Calculating your basis can be very difficult, especially if you aren’t doing the calculations at or near the time you started your business. It’s important to keep in mind that your basis in the business should never hit $0. Below is a list of some amounts that will go into calculating your basis. I would suggest that you gather the documents you’ll need to make this calculation and then contact an accountant to make sure you’re not missing anything. Your basis calculation should be made in the following order:
- Start with the total cash amount you contributed to start up the business.
- Add the value of any property you’ve contributed. You’ll need to determine the adjusted basis and fair market value of the property and use whichever amount is lower. You’ll need to tell your accountant how much you paid for the property, whether or not you’ve used the property in the operation of another business, and if applicable, provide a list of improvements you’ve made to the property.
- Add any contributions you’ve made to the business each year (cash and property).
- Add your net income for each year.
- Subtract your non-dividend distributions from each year.
- Subtract your share of net losses from each year.
How do I report my basis to the IRS?
You’ll report your annual basis calculations when you file your Form 1120-S individual tax return each year. As part of that form, each S-Corporation shareholder will complete a Schedule K-1 form to list deductions, profits, and losses distributed to the shareholder.
If you haven’t calculated your basis in your S-Corporation, I suggest you do that sooner rather than later. I also suggest you work with an accountant to make the basis calculation and to continually monitor your basis.
It might seem like common sense to you that you don’t want to take more money out of your business than you have invested in it, but as your business grows, this may become more difficult to track. Knowing your basis now will help you avoid any tax problems later. If you’d like more information about tax topics important to S-Corporation owners, I have a special section on my blog just for you.
