If you're an S corporation shareholder, a partner in a partnership, or a member of a limited liability company (LLC), one tax rule applies to you: You can only deduct operating losses that are passed through to you for the year to your extent of basis. As the end of the year draws near, it's vital to understand how you figure your basis for tax purposes and what steps you can take now to ensure that any anticipated losses for the year will be deductible.
An S corporation shareholder's basis is comprised of basis from stock and debts owed by the corporation to the shareholder. The starting point is the amount of cash and value of property contributed to the corporation. For example, if a shareholder starts the business by contributing $10,000 cash in exchange for stock in the corporation, his/her initial basis is in the stock. There are numerous adjustments that impact basis, reflecting such actions as annual share of corporate net income (including tax-exempt income) or loss and charitable contributions by the corporation. But debt that the corporation owes to a third party (e.g., a bank loan to the corporation) has no impact on the shareholder's debt.
Final regulations, which became effective on July 23, 2014, make it clear that only bona fide debt owed by the corporation to the shareholder can be taken into account for basis purposes. This depends on the facts and circumstances. Courts have said that a bona fide loan results when there is actual economic outlay standard, which requires that a shareholder be made "poorer in a material sense." When one shareholder owns two or more S corporations and there are intra-company loans that shift to the shareholder by distributing a note for the loan to him or her, the shareholder can increase basis only if the shareholder has bona fide indebtedness.
Note: A shareholder's guarantee of a third-party loan to the corporation does not increase the shareholder's basis unless and until the shareholder is called upon to make a payment on the loan (i.e., the corporation defaults).
Partnerships and LLCs
As in the case of an S corporation shareholder, a partner's initial basis is comprised of the cash and property contributed to the partnership in exchange for a partnership interest. Then basis is adjusted annually for certain actions, such as the partner's distributive share of partnership interest and any added cash or property put into the partnership. However, unlike in the case of an S corporation, a partner can increase his/her basis in the partnership interest by the partner's allocable share of partnership debt (i.e., third-party loans to the partnership).
Basis goes up and down annually. It's vital to keep a good record of an owner's basis (especially if you change accounting firms).
Reconstruct basis. If you haven't been doing a good job tracking your basis, work with a knowledgeable tax professional who can reconstruct it using past Schedule K-1s you have received over the years. Check your old tax returns for copies of old Schedule K-1s if you have switched preparers.
Year-end actions. Review basis now to make sure that any anticipated business losses will be deductible.
- For S corporations, owners should consider lending additional funds to the corporation to increase basis. It may be possible to restructure a third-party loan to the corporation to make the shareholder primarily liable for the debt, as long as this is done before the end of the year. It may also be possible to have the business donate appreciated property, which can produce double tax benefits: If a 2013 rule is extended for 2014 (this won't be known until after the November election), then the shareholder's deduction for his/her share of the donation is based on the property's value, but the shareholder only reduces basis by his/her share of the corporation's adjusted basis of the property.
- For partnerships and LLCs, owners can add funds to their business or have the business borrow additional funds from third parties to increase basis.
Keeping track of basis in pass-through entities is not only important for deducting losses. It's also vital for determining the amount of distributions that can be taken from the business without current taxation. And it's essential for figuring gain or loss when an owner sells his/her interest in a pass-through entity.