The Effect of Basis on Tax Losses in an S-Corporation
By Raffi Yousefian, CPA | Published on 08/06/2021
S-corporation owners are constantly wondering why they are unable to claim the loss that is reported on their K-1. In this article, we will explain a rather simple topic that frequently confuses shareholders in an S-corporation due to faulty explanations containing unnecessary tax jargon by describing why shareholder losses from an S-corporation are limited due to not having “basis”, and how you can create “basis” to be able to claim the losses.
What is a taxable loss?
A taxable loss is the excess of deductible expenses over gross receipts. Realistically, a loss is impossible, without someone fronting the losses through a loan or capital infusion because the money needs to come from somewhere. Losses from an S-corporation can be used to offset your other sources of taxable income subject to some limitations. The first of these limitations is having enough “basis”. To claim these losses, the IRS wants to ensure you are fully responsible for funding these losses. In other words, the IRS wants to make sure you’re getting a deduction for what you paid for.
So, how is basis determined and how are losses from an S-corporation limited? What can you do to avoid the trap of not being able to deduct losses from an S-corporation? Let’s jump in…
What is Basis?
Basis measures the amount that the S-corporation’s owner(s) is treated as having invested in the S-corporation and is comprised of two components: stock basis and debt basis.
The stock basis is calculated as follows:
+Capital Contributions to the S-corporation
+Taxable income recognized from the S-corporation
+Tax-exempt income from the S-corporation
-Distributions from the S-corporation
-Nondeductible expenses from the S-corporation
-Taxable losses recognized from the S-corporation
We can further understand the theory behind this calculation through a few scenarios. These scenarios assume you already understand that the taxable income from an S-corporation passes through to owners instead of the tax being assessed on the S-corporation.
Assume you start a business with a $1,000 capital contribution, and in year 1 you generate $5,000 income and distribute $5,000 of that to yourself in cash. Your stock basis at the end of year 1 would be:
$1,000 capital contribution + $5,000 taxable income – $5,000 distribution = $1,000 Stock Basis
If you distribute the remaining $1,000 in cash to yourself, your stock basis would be reduced to zero. This works out perfectly because it ensures you are never double taxed on the income generated by the S-corporation. The additional $1,000 distribution, if taken, is simply a return of the money you invested, and the $5,000 that is truly profit is the only component that is taxed.
Instead of $5,000 taxable income, the business incurred a taxable loss of $1,000 in year 1, therefore you were unable to take any distributions. Your stock basis at the end of year 1 would be:
$1,000 capital contribution – $1,000 allowable taxable loss = $0 Stock Basis
The $1,000 taxable loss can be claimed on your personal tax return in year 1 because you funded the entire loss of $1,000 with your capital contribution. In other words, you had basis of $1,000 before absorbing the loss, then you ended the year with $0 stock basis. If you liquidated the company at the end of the year with $0 in stock basis then there would be no other personal income tax implications.
Using the same details as Scenario 2, assume that you did not contribute $1,000 to start the business — instead you borrowed money from a hard money lender to fund the $1,000 with a personal guarantee. Your stock basis at the end of year 1 would be:
$0 capital contribution – $0 allowable taxable loss = $0 Stock basis
Because you did not contribute any of your own money, you do not have enough basis to claim the $1,000 loss. Now you are probably thinking “But I will eventually have to pay the hard money loan back with my own money, so I did in essence fund the losses.” Unfortunately, the losses will be suspended and carried forward until you pay the loan back with your own money.
The only way to create basis without contributing cash is to lend cash directly to the S-corporation.
The debt basis is calculated as follows:
+Loans made directly to the S-corporation
-Loan repayments from the S-corporation
-Taxable losses applied towards debt basis from the S-corporation
We can better understand the theory behind this calculation using the same scenarios as above except we will replace the $1,000 capital contribution with a $1,000 loan to the S-corporation.
Assume you start a business with a $1,000 loan, and in year 1 you generate $5,000 income and distribute $5,000 of that to yourself in cash. Your stock and debt basis at the end of the year would be as follows:
$0 Capital Contribution + $5,000 taxable income – $5,000 distribution = $0 Stock Basis
$1,000 loan – $0 loan repayment – $0 allowable taxable loss = $1,000 Debt Basis
If you repay the remaining $1,000 in cash to yourself at the end of year 1, your debt basis would be reduced to zero. Again, this works out perfectly because it ensures you are never double taxed on the income generated by the S-corporation. The additional $1,000 payment in year 2 is simply a payback of the loan, and the $5,000 that is truly profit is taxed only once.
Instead of $5,000 taxable income, the business incurred a loss of $1,000 in year 1, therefore you were unable to take any distributions. Your stock basis at the end of year 1 would be:
$0 capital contribution – $0 allowable taxable loss = $0 Stock Basis
You would not have enough stock basis to claim the $1,000 loss on your personal tax return. Since you did not fund the loss with capital contributions, you can’t claim the loss using stock basis. However, if the business liquidates at the end of year 1, then you will never see your $1,000 again, therefore you did essentially use your own money. The good news is that the IRS recognizes that you are out of pocket for the amounts loaned, and allows you to claim the $1,000 loss using your debt basis. As a result, your debt basis will look like this at the end of year 1:
$1,000 loan – $0 loan repayment – $1,000 allowable taxable loss = $0 Debt Basis
In other words, you had basis of $1,000 before absorbing the loss, then you ended the year with $0 debt basis. If you liquidated the company at the end of the year with $0 stock and debt basis then there would be no other personal income tax implications.
The catch with debt basis is that if the company recovers and the loan is repaid, then you have to recapture the losses that were previously claimed using debt basis.
Using the same details as scenario 2, assume that in year 2, your business generates $2,000 in taxable income, and $1,000 of that is used to pay back the money you loaned to the company. Your basis break-out will look like this:
$0 Beginning Stock Basis + $0 Capital Contributions + $2,000 taxable income = $2,000 stock basis
$0 Beginning Debt Basis – $1,000 loan repayment + $1,000 recapture income = $0 debt basis
Using the basis mechanism, the IRS has ensured that the $1,000 loss you took in year 1 is reversed and recognized as taxable income in year 2 since you eventually did not go out of pocket for that loss. Between year 1 and year 2 this is the overall cumulative effect:
Taxable Income/(Loss) Recognized
Year 1 – Loss
Year 2 – Taxable Income
Year 2 – Loss Recapture
Net Taxable Income Recognized
See how nicely this works out? The IRS ensures that (1) you are taxed on what is truly profit over the two years, and (2) you are not deducting losses for expenses you did not truly go out of pocket for. Overall, you are better off by $2,000 over the two years and the tax system correctly measures this outcome.
How to create debt basis
As you saw from the example above, a personal guarantee is not considered debt basis until the debt is satisfied by the shareholder. Contrary to loans in a partnership, debt basis in an S-corporation can only be created for loans made directly to the S-corporation by a shareholder.
The real reason why I wrote this article is to write this one sentence:
Loans from a related entity (even if 100% owned by the same shareholders) do not create debt basis for shareholders in the S-corporation!
Therefore, if you need to fund the losses of a sister or affiliated company that is an S-corporation, you must first distribute the cash from the lending entity, then transfer that cash to the sister company as a loan or capital contribution to create debt basis or stock basis, respectively.
If you own multiple companies and at least one is incurring losses, then I recommend sharing this fact with your bookkeeper before it is too late.
What if you have already loaned money to an affiliated S-corporation directly from the company to fund their losses? If your accountant prepared your personal tax returns correctly, then you probably have not been able to create enough basis in the sister company to absorb the losses on your personal returns. Fortunately, you have a few options to fix the issue.
First, get profitable. The loss entity can use suspended losses (due to basis limitations) to offset future taxable income. This will allow you to take advantage of the suspended losses and pay back the sister company that lent the money to fund the losses.
Second, liquidate the loss entity. By liquidating the loss entity, the suspended losses due to basis limitations might be able to get used up depending on how the entity is liquidated. For example, if you liquidate and pay back any debt owed by the S-corporation to affiliated or non-affiliated lenders, then those payments could create basis to free up the losses. Obviously, this is a worst-case scenario in which you would be required to pay back all of your lenders out of pocket. Alternatively, if you sold the company at a gain, that gain could create basis which would allow you to use up prior period losses.
If profitability or liquidation is not in sight, then you could distribute the note receivable from the lending S-corporation to its shareholders. By transferring the note receivable to the shareholders, you are creating debt basis for them because now the shareholders directly assume the risk of loss. This is the only method that will work. Other techniques such as distributing cash from the lending S-corporation then contributing that cash to the sister company, then having the sister company pay back the loan is a circular transaction and will not be recognized by the IRS. The only legitimate way to create basis without liquidating or generating profit is to transfer the note, and the note has to be a bona fide note with an reasonable interest rate, clear terms, etc. for this method to work.
Hopefully, your S-corporation is not incurring losses. But if it is, then it is important to make sure you are funding these losses correctly so you can claim them against your other sources of taxable income. The tax system is designed to tax your overall well-being. If you earned $100k in salary and re-invested that $100k in a business that didn’t generate any income, then you are not any better off until that business generates income. Therefore you shouldn’t have to pay tax until that happens. The basis rules are designed to ensure this outcome.
Feel free to contact us if you have detailed questions about your situation.
Raffi Yousefian is a licensed CPA who advises and provides outsourced accounting and tax solutions for small businesses at RY CPAs.