S Corporation Basis

Basis in S corporation stock and debt is important from a tax planning standpoint for three reasons.

Basis (a) limits the amount of corporate loss that can be deducted by shareholders,

(b) Determines the gain or loss upon disposition of the stock or upon repayment of the debt, and

(c) Governs the amount of distributions that can be received from an S corporation free of tax.

The GAO has reported that properly calculating and tracking basis is one of the biggest challenges facing shareholders.

Most of the tax planning relating to shareholder basis in stock or debt revolves around the timing of contributions to capital and timing of loans to the corporation to maximize the stockholder's ability to deduct losses.

Determining Original Basis in S Corporation Stock

A shareholder's initial basis in shares of S corporation stock depends on how the shares are acquired. The most common methods of acquisition follow:

a. Outright Purchase. The basis is the initial cost of the shares.

b. As a Party to the Capitalization of the Corporation b. As a Party to the Capitalization of the Corporation. The basis of the stock has the same basis as the property contributed, plus gain recognized on the transfer (IRC Sec. 351).

c. By Gift. The basis in the hands of the donee is usually the same as the basis in the hands of the donor.

Certain exceptions exist if gift tax is paid on the transfer, or if the donor's basis is greater than the fair market value and the stock later is sold at a loss.

For example, under Reg. 1.1366-2(a)(6), basis of S stock received by gift is limited to the stock's fair market value at the date of gift for purposes of determining the deductibility of losses.

d. By Inheritance. The basis is generally the fair market value on the date of death, or alternate valuation date if so elected (IRC Sec. 1014).

Under IRC Sec. 1367(b)(4)(B), the stepped-up basis in inherited S corporation stock is reduced to the extent the stock's value is attributable to “income in respect of a decedent” (IRD).

For decedents dying in 2010 only, the modified carryover basis rules of IRC Sec. 1022,

rather than the stepped-up basis rules, could apply if the executor or administrator of the estate so elected

[IRC Secs. 1022, 6018, and 6075, each as amended by the 2010 Tax Relief Act Sec. 301(a) or (c)].

e. By Holding the Stock on the Date a C Corporation Elects S Status.

The basis in stock upon electing S status will equal the shareholder's original basis in the stock, adjusted for certain transactions that occurred before electing S status.

For example, original stock basis may be adjusted for C corporation distributions that exceeded earnings and profits [IRC Sec. 301(c)(2)], stock dividends, reorganizations (IRC Sec. 358), and partial liquidations (Rev. Rul. 56-513).

f. Stock Received for Services f. Stock Received for Services. Basis in stock received in exchange for services is measured by the stock's FMV, rather than by the value of the services [Reg. 1.61-2(d)(2)].

Obtaining Stock Basis Requires Economic Outlay

The shareholder must experience an actual economic outlay to acquire basis.

This means that, before basis can be increased, “there must have occurred some transaction which when fully consummated left the taxpayer poorer in a material sense” (Rev. Rul. 81-187; see also Silverstein; Maloof; and Bergman).

Giving only a note to the corporation or subscribing for more stock without making payment does not increase basis.

An S shareholder may increase stock or debt basis by contributing capital or lending funds to the corporation.

Because of the economic outlay rules, the shareholder must make the contribution or loan directly to the corporation.

A loan to an S corporation from a bank or other third party does not provide debt basis, even if the shareholder guarantees the loan.

Making Annual Adjustments to Basis

The first step in calculating stock basis is to determine the shareholder's original basis.

Thereafter, stock basis is adjusted when a shareholder buys or sells stock in the corporation or contributes capital to the corporation.

Also, each shareholder's basis is adjusted each year by various items of corporate income, loss, and deduction, and by distributions to the shareholder in accordance with the following rules [IRC Secs. 1367(a) and 50(c)(5); Reg. 1.1367-1].

a. Stock basis is increased by the stockholder's share of:

(1) nonseparately stated income;

(2) separately stated items of income (including tax-exempt income);

(3) the excess of the shareholder's deduction for depletion over the allocable basis in the property subject to depletion (this does not apply to oil and gas depletion that is determined at the shareholder level); and

4) the addition to an asset's basis when recapture of general business credits causes such an addition under IRC Sec. 50(a)(1).

b. Stock basis is decreased by nondividend distributions that are not includable in the shareholder's income, i.e., distributions other than distributions of AE&P.

c. Finally, stock basis is decreased by the stockholder's share of:

(1) nonseparately stated loss;

(2) separately stated items of deduction or loss;

(3) any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account;

(4) the shareholder's deduction for depletion on any oil and gas property to the extent such deduction does not exceed the shareholder's proportionate share of the corporation's basis in the property; and

(5) the reduction in an asset's basis when general business credits cause such a reduction under IRC Sec. 50(c)(1).

Adjusting Basis at End of Year

Basis adjustments are normally made at the end of the corporation's taxable year [Reg. 1.1367-1(d)].

Basis first is increased by pass-through income items, then decreased by nontaxable distributions, and, finally, decreased by pass-through items of loss and deduction [IRC Sec. 1368(d)(1); Reg. 1.1367-1(f)].

The order is important because it causes the tax effects of distributions to be determined by reference to basis at the end of the corporation's year.

Also, this order dictates that a shareholder's stock basis in a fiscal year S corporation is determined at the end of the corporation's tax year, rather than the shareholder's tax year.

If a shareholder disposes of stock during the corporation's tax year, adjustments to the basis of such shares of stock are effective immediately before the disposition.

If the corporation elects under IRC Sec If the corporation elects under IRC Sec. 1377(a)(2) to use specific accounting upon the complete disposition of a shareholder's interest,

Or elects under Reg. 1.1368- 1(g)(2) to use specific accounting when certain stock is disposed of, issued, or redeemed,

The basis adjustment rules apply as if the tax year consisted of separate tax years, with the first year ending on the date of the disposition [Reg. 1.1367- 1(d)(3)].

Basis cannot be reduced below zero [IRC Sec. 1367(a)(2)] Basis cannot be reduced below zero [IRC Sec. 1367(a)(2)]. When S corporation stock is disposed of, gain or loss is determined by reference to a basis amount that is either zero or a positive number.

Example: Adjusting stock and debt basis for nonseparately stated and separately stated items

New Leaf is a calendar year S corporation New Leaf is a calendar year S corporation. At the beginning of the current tax year, Paul, the sole shareholder, has stock basis of $29,000, and debt basis of $45,000. Paul's debt basis has not been reduced by post-1982 pass- through losses.

The corporation shows the following items for the year:

Ordinary income from business activity (nonseparately stated income) $ 50,000 Tax-Exempt Interest Income 7,000 Interest (Portfolio) Income 6,000 Nondeductible portion of meals expense 1,750 Life insurance premiums 2,200 Investment interest expense 3,300 Charitable contributions 2,000 Section 179 deduction 750

The life insurance premiums are for a term policy owned by the corporation. The policy pays in the event of Paul's death, and the corporation is the beneficiary.

The life insurance policy has no cash surrender value, and the premiums are nondeductible.

The corporation made distributions of $55,000 to Paul during the year.

Nonseparately and separately stated items of income, including tax-exempt income, increase basis.

Next, nontaxable distributions reduce basis.

Finally, basis is reduced by items of loss, deduction, and nondeductible expenditures [IRC Sec. 1367(a)].

Stock Basis Debt Basis   Balances - Beginning of Year 29,000 45,000 Income and gain items: Nonseparately stated income 50,000 - Tax-exempt Income 7,000 Interest income 6,000 Balances, before distributions and loss items 92,000

Distributions (55,000) - Balances, before loss and deduction items 37,000 45,000 Loss and deduction items: Nondeductible portion of meals expense (1,750) Life insurance premiums (2,200) Investment interest expense (3,300) Charitable contributions (2,000) Section 179 deduction (750)   Balances, end of year 27,000

Debt basis remains the same because the corporation did not experience losses that reduced stock basis to zero.

Also, distributions reduce stock basis but have no effect on debt basis.

It is the shareholder's responsibility, rather than the corporation's, to determine the proper stock or debt basis.

The details necessary to determine a shareholder's basis are not always readily available to the corporation;

For example, when a shareholder purchases stock from another shareholder, the purchase (and resulting cost basis) usually occurs without the knowledge or participation of the corporation.

On the other hand, the accumulated adjustment account (AAA), previously taxed income (PTI), and accumulated earnings and profits (AE&P) balances are calculated at the corporate level.

Normally, however, the practitioner representing the corporation will track the shareholders' bases since most S corporations are relatively small, closely held entities.

If the corporation has AE&P, the taxability of distributions is determined by reference to the accumulated adjustments account (AAA) and stock basis.

Comparing Adjustment to Stock Basis and AAA

The AAA generally is increased and decreased by the same adjustments made to shareholder basis (but not in the same order).

Pass-through items of income, gain, loss, deduction, or credit affect stock basis and AAA in the same way, with three important exceptions:

a. Tax-exempt income increases basis, but does not increase the AAA.

b. Expenses attributable to tax-exempt income reduce basis, but do not decrease the AAA.

c. Federal taxes paid by the S corporation that are attributable to prior C corporation years reduce basis, but do not decrease the AAA.

AAA is always adjusted in a different order than basis AAA is always adjusted in a different order than basis. The following slides summarizes how basis and the AAA (if there is no net negative adjustment) are adjusted annually.

Basis Adjustments Increased by items of income and gain Decreased by distributions Decreased by items of loss and deduction

AAA Adjustments Increased by items of income and gain Decreased by items of loss and deduction Decreased by distributions

Because tax-exempt income and directly related expenses do not affect the AAA, tax- exempt income cannot be distributed tax free until the corporation has distributed its AE&P.

Capital contributions and stock purchases increase stock basis, but do not affect the AAA.

Basis cannot be reduced below zero [IRC Sec. 1367(a)(2)].

However, the AAA can have a negative balance caused by corporate losses and deductions (but not by distributions) [IRC Sec. 1368(e)(1)(A); Reg. 1.1368- 2(a)(3)(ii) and (iii)].

S corporations maintain an accumulated adjustments account (AAA) that tracks the amount of undistributed income that has been taxed to the shareholders after 1982.

The AAA (to the extent of basis) can be distributed to the shareholder free of further tax.

taxability of distributions is determined without reference to the AAA if the S corporation does not have accumulated earnings and profits (AE&P).

However, practitioners should keep track of the AAA balance in any event, because part or all of the amount in the AAA can be distributed tax-free after the S corporation election terminates.

Also, it may be necessary to adjust the AAA balance when certain redemptions or mergers occur.

Making Distributions When the Corporation Has AE&P

If the corporation has AE&P, more tiers are required to determine the taxability of distributions.

If there is AE&P, distributions are applied in the following order:

(a.) A nontaxable distribution of AAA;

(b.) A dividend, to the extent of AE&P;

(c.) A nontaxable reduction of stock basis, to the extent of remaining stock basis and, finally;

(d. ) Capital gain from the deemed disposition of stock [IRC Sec (d.) Capital gain from the deemed disposition of stock [IRC Sec. 1368(c)].

If the shareholder's stock basis is less than the AAA, distributions are nontaxable to the extent of stock basis and capital gain (up to the amount of AAA) to the extent the distributions exceed stock basis [IRC Sec. 1368(c)(1)].

If the shareholder's stock basis is more than AAA, distributions are nontaxable to the extent of AAA, and then subject to dividend treatment to the extent of AE&P.

If the shareholder has basis in stock but there is no AAA, the first tier in essence is skipped, and the distributions are subject to dividend treatment to the extent of AE&P.

The corporation also can have previously taxed income (PTI) from years beginning before 1983 that can be distributed free of further tax to the extent of a shareholder's stock basis. PTI is distributed after AAA, but before AE&P.

An S corporation can elect to bypass AAA in order to distribute AE&P before distributing AAA.