Why basis matters for S corporation owners

The most important number for an S corporation owner to know is basis.

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.

Example 1 Say you started an S corporation in 2021. You contributed $10,000 in cash to start the business. The business made $20,000 in profit. You took $25,000 in distributions. Your basis at the end of the year is the initial contribution, plus the profit, minus the distributions, or $5,000. -

But basis can never fall below zero. You cannot have negative basis.

So what happens if you have more in losses or take more distributions than your basis?

Losses can offset other income, reducing your tax liability, if you have sufficient basis. If you don't have sufficient basis, then the excess losses are suspended—you can't use them in the current year—and carried forward into future years. Once you increase your basis, you can take the suspended losses.

Example 2a Start with the facts in Example 1. In 2022, you don't take any distributions, but the business has a $10,000 loss for the year. Because you have $5,000 in basis, you can take the first $5,000 of the loss in 2022. The remaining $5,000 loss is suspended and carried forward to future years. -

Distributions are generally nontaxable if you have sufficient basis. If you take more in distributions than you have basis, the excess is considered a capital gain. That gain is taxable income for you.

Example 2b Start with the facts in Example 1. In 2022, the business breaks even (no profit or loss). You take a $10,000 distribution. Because you have $5,000 in basis, the first $5,000 of the distribution is nontaxable. The remaining $5,000 is a distribution in excess of basis, is reported as a capital gain in 2022, and is added to your taxable income -

One final note: distributions are taken into account before losses when calculating basis. If you take a distribution and the business has a loss in the same year, the distribution reduces your basis before the loss does.

Example 2c Start with the facts in Example 1. In 2022, you take a $10,000 distribution, and the business has a $10,000 loss for the year. Because you have $5,000 in basis, the first $5,000 of the distribution is nontaxable. The remaining $5,000 is a distribution in excess of basis, is reported as a capital gain in 2022, and is added to your taxable income. Your basis is zero, so the entire $10,000 loss is suspended and carried forward to future years. -

This is a double whammy situation: you increased your taxable income with a distribution in excess of basis, while also not being able to apply that year's loss against your taxable income.

And this is why tracking your basis, and taking into consideration when managing your S corporation's finances, is important.