People often get confused about the S corporation election status. Most people think S corporation is another form of legal entity. S Corporation is a tax election and not a legal entity. As an S Corporation your legal entity could be that of a LLC or a C Corporation. LLCs or corporations choose to make the S election for 2 main reasons namely:

• Avoid the double taxation treatment on distributions. A C corporation pays tax at the corporate level and also on the personal level when profits are distributed to owners as dividends.
• Take advantage of corporate losses on the personal income tax level.

As an S corporation, income, loss, deductions and credits flow to the shareholder and are taxed on the shareholders personal return. However, there are limitations on the loss you can deduct on your personal tax return. Just because you made a loss on your s corporation does not mean you get to deduct it from your taxes.

Moreover S corporation shareholders are required to compute both stock and debt basis. Unlike a C corporation, each year a shareholders stock and debt basis goes up or down. The amount is affected by business income and expenses. Any distributions made above basis are taxable to the shareholder as a capital gain. Even though shareholders get K-1, it does not state the taxable amount of a distribution. It is not the corporation responsibility to track basis, rather, the shareholder has the responsibility of making sure his/ her basis is updated annually.

Importance of keeping track of stock basis

Keeping track of stock basis is important for the following reasons:

• To claim a non-taxable distribution, the shareholder will need to show he/ she has adequate basis.
• To claim the loss on a schedule K-1, the shareholder will need to ensure there is adequate basis
• The shareholder wishes to sell the stock someday. In order to determine gain or loss, the stock basis will need to be known.

Computing stock basis

Stock basis starts with the initial contributions made to the corporation. This amount is increased or decreased based on transactions that flow through to the shareholder. Stock basis is adjusted annually, as of the last day of the S corporation year. Stock basis is adjusted in the following order:

• Increase stock basis by income items and excess depletion
• Decrease stock basis by distributions
• Decrease stock basis by non-deductible, non-capital expenses
• Decrease stock basis by any loss or deductions

Let’s do an example: Sally Jo owner of Sally, Inc., Sally Jo ended the year with the following information on her schedule K-1:

• Ordinary business income $40,000
• Cash distributions: $5,000
• Non-deductible expenses – $3,000
• Charitable contributions – $2,000

This is Sally’s Jo’s first year and she has no beginning stock basis. Sally Jo’s stock basis will be computed as follows:

 

Note that only non-taxable distributions reduce stock basis. Any non-dividend distribution in excess of stock basis is taxed as a capital gain on the shareholders personal tax return. If the S Corporation has been held longer than a year then it will be a long term capital gain.

As always, consult with your CPA for more personable advice.