Shareholder’s Initial Stock Basis in an S Corporation

Shareholders must keep thorough and accurate records to support their stock basis. (See Treas. Reg. § 1.6001-1(a) and they are responsible for proving they have sufficient basis in order to:

• Deduct S corporation losses,

• Receive distributions without triggering tax, and

• Minimize or avoid gain on the sale of their stock.

  
  

This requirement is supported by case law, including Burnet v. Houston, 283 U.S. 223 (1931), and Welch v. Comm’r, T.C. Memo. 2012-179.

When the IRS Calculates Stock Basis

During the IRS audit, the revenue agent will independently calculate stock basis in the following situations:

- The S corporation generates a loss (triggering shareholder loss limitations),

- There is a negative Accumulated Adjustments Account (AAA) balance (suggesting potential zero stock basis),

- Large distributions occur (raising the risk of distributions exceeding stock basis),

- The shareholder sells stock (necessitating determination of gain or loss),

- A stock subscription receivable appears on the balance sheet.

The IRS begins its calculations of basis from the very beginning—the acquisition of stock. In fact, the very top of Form 7203 includes a checkbox asking how the initial stock was acquired. This question is designed to jumpstart the IRS's research on the shareholder’s starting basis.

Determining Initial Stock Basis

Initial basis depends on how the shareholder got the stock. Common acquisition methods include:

• Stock Purchase

If a shareholder buys the stock, their basis is the price they paid—just like buying any asset. Reference: IRC § 1012

• Contribution to Corporation (IRC § 351 Transaction)

In an IRC § 351 transaction, generally no gain or loss is recognized when property is transferred to a corporation solely in exchange for its stock. The initial stock basis is the carryover basis of the assets transferred to the corporation, less any liabilities assumed by the corporation. Reference: IRC § 358(a)

• Gift

The initial stock basis for stock received as a gift is the basis in the hands of the donor just prior to the gift plus any gift tax paid by the donor (subject to certain limitations). Reference IRC § 1015(d)(6).

For instance, if a father gives stock to his son, the son’s basis equals the father’s basis at the date of the gift plus any gift tax paid by the father.

• Bargain Purchase of Stock (Part Gift - Part Sale Transaction)

It is not unusual for a shareholder to transfer stock to a family member at a price below its fair market value (FMV). When this happens, the transaction is treated as part sale and part gift. The gifted portion is calculated as the difference between the stock’s FMV and the price actually paid by the family member.

The recipient’s tax basis in the stock is generally the greater of (1) the amount paid for the stock or (2) the seller’s adjusted basis in the stock. If any gift tax is paid, it may also be added to the basis.

However, if the stock is later sold at a loss, special rules apply: the loss is limited to the lower of the seller’s adjusted basis or the FMV of the stock at the time of transfer. To determine gain on the sale portion of the transaction, the seller's entire adjusted basis in the stock is allocated to the shares sold. This basis reduces the amount realized in calculating any gain or loss. However, because the sale was made to a related party, any loss on the transaction is disallowed—even if the adjusted basis is greater than the sale proceeds. In such cases, a claimed loss would not be permitted.

• Inheritance

Generally, the initial stock basis for stock received through inheritance equals the FMV of the stock at the date of death, or alternate valuation date, if the estate elects one. Reference IRC § 1014.

• Compensation

The initial stock basis for stock received as compensation is the amount paid for the stock plus the amount of compensation included in income. Reference Treas. Reg. § 1.83-4(b).

• Conversion from C Corporation to S Corporation

Determining initial stock basis is the same whether the corporation issuing the stock is a C corporation or an S corporation. When a corporation converts from a C corporation to an S corporation, the basis of stock and debt in the C corporation continues to be the shareholder’s basis in the S corporation stock and debt.

Please note: A shareholder is not allowed stock basis in stock received from the S

corporation in exchange for a note receivable from the shareholder (sometimes referred to as a stock subscription receivable). The shareholder receives stock basis in those shares only as payment is made to the S corporation on the note. Rev. Rul. 81-187.

• Conversion from Partnership to S Corporation

When a partnership or LLC taxed as a partnership converts to an S Corporation, the following steps are deemed to occur:1. The partnership transfers all of its assets to a newly formed corporation in exchange for all of the corporate stock.2. The partnership liquidates and distributes the corporate stock to the partners.3. The partners’ (now shareholders’) basis in the S corporation stock is now equal to the partners’ basis in the partnership interest immediately before the partnership liquidation, less any liabilities transferred to the S corporation, plus any gain recognized.

CAUTION: If the partnership liabilities exceed the adjusted basis of the assets, there is a recognized gain under IRC 357 References: Rev. Rul. 2004-59, Treas. Reg. 301.7701-3

Special Notes

• Stock Purchased with Loans from Other Shareholders

When stock is purchased using a note, the purchaser’s cost equals the purchase price, even though the shareholder has not fully paid for the stock. This is true even when the purchase of stock is between related parties and even when the related party seller recognizes the gain on the installment method. Although the related party seller reports the gain over time under the installment method, the related party purchaser is entitled to stock basis equal to the full purchase price, assuming the purchase price does not exceed the FMV.

Although the shareholder may receive basis, the individual shareholders must still establish that they are sufficiently at risk before claiming losses or deductions. Under the at-risk rules, a shareholder is not considered at risk for amounts borrowed from a person having an interest in the activity (i.e., another shareholder), other than as a creditor.

Exception: Shareholders do not increase their S corporation stock basis by contributing their own note. Therefore, if the shareholder purchases stock from the S corporation using a note, the shareholder does not obtain stock basis until payments on the note are made.Resource: Rev. Rul. 81-187

Final Thoughts:

Accurate initial stock basis is critical for S corp tax compliance. Since the IRS starts from acquisition, tax professionals must ensure basis is well-documented from day one to support deductions, distributions, and gain calculations.