Stock and Debt Basis in S Corporation

If you're struggling with the technicalities of S Corp basis, you’ve come to the right place. This blog dives deep into how stock and debt basis work when reporting losses on your personal tax returns. If you’re looking for a more general overview of tax basis, check out our beginner-friendly blog here.

Let's start with the order of stock and debt basis when capturing loss on personal returns: The Schedule K-1 is a form used to allocate profits and losses from an S corporation to its shareholders. Shareholders include this form on their personal tax returns. When a K-1 shows a loss, shareholders can deduct it on their personal returns only up to the extent of their stock basis and any debt basis. Stock basis gets reduced first. After it is reduced to zero, the shareholder can use up his/her debt basis, if they have one. If the debt basis has been previously decreased by prior losses, it must be restored first before any changes are made to the shareholder's stock basis.

Example:

Alex Taylor is a shareholder in Apex Design, an S-Corporation. His basis in the stock is $10,000, and he has also issued a personal loan to the company of $50,000, which made his debt basis $50,000. In the current year, his share of the corporation’s pass-through loss is $35,000 and he can deduct it on his personal return as follows:

• Stock Basis: First, reduce her stock basis from $10,000 to $0.

• Debt Basis: Next, apply the remaining $25,000 of the loss to his debt basis, reducing it from $50,000 to $25,000.

  
  

So, after deducting the loss, his stock basis is $0, and her debt basis is $25,000.

In the following year, the company passes through $30,000 of profits to Alex. This restores his debt basis back to $50,000 (the $25,000 remaining from the previous year plus the $25,000 profit) and raises his stock basis by $5,000 (since it is what is left after debt basis was restored).

Fiscal and Calendar years: S corporation shareholders must report their share of the corporation’s profits and losses on their personal tax returns for the same tax year in which the corporation’s fiscal year ends. If the corporation’s fiscal year does not align with the calendar year, shareholders still need to report the income or loss based on the corporation's fiscal year-end.

Example:

Alex Taylor is a shareholder in Apex Design, an S-Corporation. Apex Design operates on a fiscal year ending on September 30. Since Alex uses a calendar year for his personal taxes, he will report his share of Apex's profit or loss from October 1 of the previous year to September 30 of the current year on his current-year tax return. Any income or loss from Apex for the months of October, November, and December will be reported on Alex's tax return for the following year.

Separately Stated Items: When distributing profits and losses to shareholders, any items of income or expense that are separately stated on K-1 form maintain their individual treatment and may require specific handling on the shareholder’s part. On their personal tax returns, these items are considered as if they were directly received from the same source by the S corporation. For instance, a long-term capital gain realized by the corporation is treated as a long-term capital gain for the shareholder.

Items categorized as “other income (loss)” or “other deductions” are generally treated as ordinary income or ordinary loss. While many of these separately stated items are listed on Form K-1, not all are included. Here is a starter blog that gives a more general idea.

Here is a more comprehensive list of these separately stated items:

Income:

• Foreign income and losses

• Net gains and losses from casualty or theft

• Net long-term capital gains and losses

• Net Section 1231 gains or losses

• Net short-term capital gains and losses

• Passive income and losses

• Portfolio income and losses

• Tax-exempt income

  
  

Deductions:

• Charitable contributions

• Health insurance premiums

• Investment interest expenses

• Section 179 expense deductions

Capital gains and losses:  Shareholders report them on Schedule D of their personal tax returns. In some cases, capital gains may be reclassified as ordinary income, particularly when they result from the sale or exchange of depreciable property between related parties. This occurs when a transaction involves an individual and an S corporation, where the individual owns (either directly or indirectly) 50% or more of the S corporation’s stock.

Example:

Alex Taylor owns a 51% stake in Apex Design, an S corporation. Because Alex Taylor is considered a related party, any gain he realizes from selling depreciable property to his own S Corp must be treated as ordinary income.

Property Distributions: In some situations, an S corporation may distribute appreciated property to its shareholders. When such a distribution is non-liquidating, it's treated as though the property were sold to the shareholders at its fair market value. Consequently, the gain from this transaction is passed on to the shareholders, who will then adjust their basis in the property to reflect its fair market value and pay tax on gain.

Example:

Alex Taylor is a shareholder in Apex Design, an S-Corporation. The company distributes shares of a publicly-traded company, which it has held for several years. The basis of these shares for Apex Design is $40,000, but their fair market value at the time of transfer is $60,000. As a result, Alex Taylor's basis in these shares will be adjusted to $60,000. Additionally, as the sole shareholder, Alex will recognize a long-term gain of $20,000 ($60,000-$40,000)

Cancellation of Indebtedness: When an S corporation has a debt forgiven, it realizes income from this cancellation, which is then passed through to its shareholders.

Example:

Alex Taylor borrows $5 million from a local bank to expand its design operation. Due to financial troubles, the company negotiates with the bank and settles the debt for $4 million, resulting in $1 million of forgiven debt. This forgiven amount is considered income and must be reported by the shareholders.

Conclusion

Handling your S Corporation basis correctly is crucial for ensuring accurate tax reporting. Whether it’s understanding the order of stock and debt basis or handling separately stated items, this process can be complex. If you're still uncertain about your specific tax situation, please reach out! Our virtual CPA firm has helped many S Corp owners with their accounting and tax problems. You are welcome to check out our services here