3 times basis matters for S corporation owners

The IRS requires S corporation owners report their basis on their annual individual tax return if one or more of three things happens.

First, a quick review:

Basis is the tax-relevant value of your ownership in your S corporation. Contributions to the S corporation and profits increase your basis. Distributions from the S corporation and losses decrease your basis.

Basis cannot fall below zero; rather, losses in excess of basis are suspended, and distributions in excess of basis are treated as a capital gain and increase your taxable income. The IRS wants to make sure you’re accurately tracking your basis in case you have either of these.

So, there are three kinds of events when the IRS requires you to report your basis:

• The S corporation allocates a loss and/or deduction item to the owner. In order to claim a loss, you need to show that you have adequate stock and/or debt basis. Without sufficient basis, you cannot take the loss on your individual tax return; however, the loss is carried forward, and may be applied in a future year if you have sufficient basis.
• The owner disposes of her stock. When you sell the business—and I typically want my clients to develop their businesses as sellable assets—you must calculate your gain or loss on the sale. That gain or loss is, simply put, the difference between what you sell the business for (its market value) and what your business is worth to you for tax purposes (your basis). A higher basis means a smaller taxable gain, but you have to be able to explain how you determined that basis.
• The S corporation makes a distribution to the owner. Distributions are generally nontaxable. You’re taxed on the business’s profit, not the cash you personally receive from the business. However, if you take a distribution in excess of your basis, that amount is taxable income to you.

If any of these happens within a year, the IRS requires you to report your basis on your individual tax return.

As for the first type of event, I hope your S corporation is not routinely running a loss. If it is, you should seek out a tax advisor and discuss whether or not maintaining your S corporation is beneficial.

The second type of event—selling your stock—should be rare, but it happens. You may bring on a business partner, add a family member as a co-owner, or sell the entire business.

The third type of event—taking distributions—is extremely common. Virtually all of the S corporation owners I know rely on cash flow from their businesses for personal financial needs, so they all have a regular requirement to report their basis.

In other words, I rarely see an S corporation owner who does not have a pressing need to track her basis. (This is part of why I require all my new S corporation clients to have accurate, up-to-date bookkeeping throughout the year. This helps me monitor their basis in real time in order to avoid basis-related surprises at tax time.)