Basis Basics: Planning for Taxation in S-Corporations

By: Paul G. Christensen, Esq.

Whenever an S-Corporation is created, the owners invest an amount of money, albeit often a small amount. For tax purposes the contributed capital is called basis. Basis is the amount of money at-risk to the owners. Income and losses of an S-Corporation are reported on the tax returns of the individual owners. The S-Corporation pays no income tax.

Basis: How It Is Calculated

At the close of the first tax year, the corporation’s tax income is added to the contributed capital balance or the tax loss is deducted from the contributed capital balance, any additional capital contributions are added and any withdrawals subtracted to calculate current basis. The basis balance is updated in the same manner at the end of each tax year.

Treatment of Income

Taxable income generated by the S-Corporation is taxable to the individual owners. The income to be reported for tax purposes is not determined by the amount of cash the owner took from the corporation during the year. There may be substantial net income in the corporation resulting in substantial tax to the individual owner with little or no cash flowing from the corporation to the owner. Or, the owner(s) may take substantial draws of money from the S-Corporation in a tax year in which the corporation has little or no income. The money withdrawn in such a year is not taxable absent income in the S-Corporation for that year. However, withdrawals greater than tax income will reduce basis, may themselves be taxable and may limit the ability to report future tax losses.

Treatment of Losses

Corporation losses are deductible only to the extent of each owner’s basis in their corporate ownership interest. If the basis is less than zero, no further losses may be deducted. Losses can be deducted only to the extent of basis. In this respect the availability of a tax loss to the individual owner is dependent upon the amount that owner invested in or withdrew from the business in the current and past tax years and the sum of income and losses in corporation all years since the corporation was formed.

What About Debt?

At one time it as believed that amounts owed by the business, but guaranteed by the individual owner created additional basis, because the “amount at-risk” was thereby increased. However, the current rule is that the principal debtor must be the owner and not the business. This means that even though an owner guarantees the debt of the S-Corporation, the amount guaranteed does not increase that owner’s basis. If the same debt were incurred by the owner and the amount invested in the corporation as additional paid-in capital or even loaned to the corporation, basis would be increased by a like amount. The test is to whom the lender will look for repayment. This is not always the primary name on the note, but may depend upon facts and circumstances.

Negative Basis; Now What?

The existence of negative basis not only means that any S-Corporation losses can not be deducted on the owner(s) tax returns, but further that any withdrawals creating additional negative basis will be taxable to the owner as a return of capital. Simply put, if the owner takes more than the sum of their investment and accumulated earnings net of losses, it is tantamount to a sale of a corporation interest and will result in taxable income to the owner.

What Is To Be Done?

Plan. Plan carefully. Often S-Corporation owners run their business on a method of accounting different than that used on the S-Corporation tax return. Suddenly, after the tax-year end, they realize that both the tax income/loss of the corporation and their basis in their corporation ownership interest are calculated on the cash method of accounting while management of the corporation is on the accrual method of accounting. As a result, the tax income may be greater than expected, with no cash available to be withdrawn by the owner to pay the tax. In other cases there may be a tax loss without basis available to make the loss available to the owner on their individual tax return.

Owners of S-Corporations must monitor current income, on the same method of accounting used for the corporation tax return, and their basis in their individual ownership interest(s). With good estimates of income and basis it will be possible to manage the tax attributes of the corporation and the basis of the owners’ to the best advantage.