S-Corp Basis: The Effects of Distributions
An S corporation structure allows the entity to pass all income, loss, credits, and deductions down to the shareholders for federal tax reporting purposes. The shareholders will then pick up this income on the individual tax return. Tracking your shareholder basis in the S corporation is important to report the proper gains or losses on any distributions received.
What is Shareholder Basis?
Shareholder basis is the tracking of how much money you have earned, lost, withdrawn, or contributed to the company. According to IRS regulations, S corporations must report the tax basis on the K-1 that each shareholder receives, but this calculation might differ from your outside basis. Form 7203 will be required for certain shareholders. The calculation for your stock basis is as follows:
Tax Basis = Contributions + Income – Distributions – Loss
Shareholder basis should be updated on an annual basis. An adjusted stock basis takes into consideration nondeductible expenses.
How are Distributions Taxed?
S corporations are not subject to corporate taxation at the federal level. The taxation of distributions depends on each shareholder’s basis in the company.
Distributions for shareholders must be made in a certain order since the stock basis is the deciding factor on which distributions are taxable.
1. Increases must be factored in (i.e. income earned)
2. Basis is reduced by distributions taken
3. Basis is reduced for nondeductible expenses
4. Basis is reduced for loss and deduction items
The basis in the company cannot be lower than zero. If losses make the basis negative, they are carried forward indefinitely.
There are two taxable situations for S corporation distributions:
1. Distributions in excess of the basis
2. Selling stock ownership
Distributions received when there is enough shareholder basis are non-taxable to the shareholder and considered a return of capital. If the company has prior accumulated earnings and profit, which occurs from converting from a C corporation, these amounts will be taken into consideration. If no accumulated earnings and profit account exists, the taxability of distributions depends solely on the basis.
How are Distributions Treated with No W-2?
The IRS stipulates that the S corporation must reasonably compensate shareholder employees for their services before distributions are given. If no reasonable compensation exists and the shareholder receives significant distributions, the IRS may recharacterize these distributions as wages and assess employment taxes.
How are Excess Distributions Treated?
Distributions in excess of basis are treated as taxable long-term capital gains. Let’s say your current basis is $10,000 and you take a distribution of $15,000. This results in $10,000 of the distribution being tax-free and $5,000 is taxed as a long-term capital gain. The long-term capital gain rate varies between 0% to 28% depending on your taxable income. High-income taxpayers will generally be subject to higher long-term capital gain rates. IRS Topic. No. 409 covers when each tax rate is imposed. Additional tax implications of distributions in excess of your basis include:
· The disallowance of losses, which will be carried forward to future years when the basis is restored.
· Suspended losses will be lost when you sell your shares and have a negative basis.
· The termination or liquidation of interests in an S corporation will lead to a capital gain or loss on the individual tax return.
Understanding how to calculate your basis and when distributions are taxable can be tricky. This is why working with the team at Abdul Tax Consulting and Accounting Services is recommended. Reach out today to learn more.