There were 4.8 million S corporation returns filed during the government’s 2016 fiscal year. There are no recent statistics on the number of shareholders in these S corporations; I’m guessing about 5 to 10 million (many only have 1 to 3 shareholders). Owners of S corporations can deduct corporate losses that are passed through to them, but only to the extent of their basis in stock (funds they contributed to the corporation) and debt (loans they’ve made to the corporation). If losses passed through to owners are greater than their basis, no current deduction any amount in excess of basis can be claimed. The unused loss carries forward and can be used when stock or debt basis is increased or restored.
How to figure basis
It’s up to a shareholder, not the corporation, to keep track of basis in stock and debt. This requires an annual adjustment to each category.
Stock. The basis in stock is increased by amounts reported in Part III of Schedule K-1 to the owner for:
- Ordinary income (line 1)
- Separately stated income items (lines 2-10)
- Tax-exempt income (Codes A and B of line 16)
- Excess depletion (Code C of line 15)
The basis of stock is reduced (but not below zero) by:
- Ordinary loss (line 1)
- Separately stated loss items (lines 2-12, Code O, and Codes L and M of line 14)
- Nondeductible expenses (Code C of line 16)
- Non-dividend distributions (Code D of line 16)
- Depletion for oil and gas (Code R of line 17)
Debt. This includes only direct loans from a shareholder to his/her corporation. It does not include loan guarantees that a shareholder makes for third party loans to the corporation. In figuring basis, losses first reduce equity; then they offset debt. If there’s more than one loan to the corporation, basis in the loans are reduced proportionally. The basis in debt that has been previously reduced can be increased when there is sufficient income or gain (regulations detail how this is done).
IRS focusing on losses in excess of basis
The LB&I, the IRS division for large businesses, has found that shareholders are claiming losses and deductions to which they are not entitled because they do not have sufficient stock or debt basis to absorb these items. LB&I has developed technical content to aid revenue agents as they examine the issue, including the issuance of soft letters encouraging voluntary self-correction. Likely the same information will be used by agents in the SB/SE division to look at shareholder losses.
New tax form?
As it now stands, it’s up to an S corporation shareholder and/or the owner’s tax professional to keep track of basis. The AICPA has recommended that the IRS develop a tax form that can be used to track basis. The form would be a required attachment to the shareholder’s income tax return.
S corporations remain a popular entity choice for small businesses. (Whether it’s a better choice than a limited liability company is a topic for another blog.) Owners in these corporations need to work with their tax advisors to comply with basis rules.