3 ways to avoid S corporation basis issues

Every S corporation owner has to track her basis, or the tax-relevant value of ownership in the company. 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.

You definitely want to avoid either of these situations. Here are three ways:

1. Don't have losses This may be easier said than done in some cases. Remember, an S corporation is an election to treat an existing business a certain way for tax purposes. That election is usually made once the business achieves a certain level of profitability. If you just started your business, or if it hasn’t been consistently profitable, it probably shouldn’t be an S corporation.
2. Reduce or eliminate debt S corporation owners do not increase their basis for debt the company owes, even if the debt is backed by the owner’s personal guarantee. This includes mortgages, loans, lines of credit, credit cards, taxes payable, and accounts payable. (This is different from partnerships, where partners increase their basis by their respective shares of partnership liabilities.) The owner(s) may be tempted to distribute more cash than basis—contributions plus accumulated profits, roughly—can cover. Getting (or keeping) debt off the books mitigates this temptation.
   
3. Don't take excessive distributions One of my most common pieces of advice for business owners is to take a step back and look at your business as an investor, not as its owner. Your company’s job is to generate a profit. It can reward you with some of that profit for doing a good job. But the company does not primarily exist to finance your personal life, especially if that lifestyle is beyond the means of your income from the business. Draining the company treasury to satisfy your personal needs and wants not only leads to basis issues, but it also cripples the potential value of an asset you’ve spent lots of time and energy building.

If you can avoid these three issues—maintaining profitability, reducing or eliminating debt, and taking sensible distributions—you can should avoid any basis issues in your S corporation.