Shareholder loss limitations An S corporation is a corporation with a valid "S" election in effect. The impact of the election is that the S corporation's items of income, loss, deductions and credits flow to the shareholder and are taxed on the shareholder's personal return. The two main reasons for electing S corporation status are: Avoid double taxation on distributions. Allow corporate losses to pass through to its owners. There are four shareholder loss limitations: Stock and debt basis limitations At risk limitations Passive activity loss limitations Excess business loss limitation Each limitation is addressed in the order shown above and must be met before a shareholder is allowed to claim a pass-through loss. The fact that a shareholder receives a K-1 reflecting a loss does not mean that the shareholder is automatically entitled to claim the loss. S corporation shareholders are required to compute both stock and debt basis The amount of a shareholder's stock and debt basis in the S corporation is very important. Unlike a C corporation, each year a shareholder's stock and/or debt basis of an S corporation increases or decreases based upon the S corporation's operations. The S corporation will issue a shareholder a Schedule K-1. It is important to understand that the K-1 reflects the S corporation's items of income, loss and deduction that are allocated to the shareholder for the year. The K-1 shows the amount of non-dividend distribution the shareholder receives; it does not state the taxable amount of a distribution. The taxable amount of a distribution is contingent on the shareholder's stock basis. It is not the corporation's responsibility to track a shareholder's stock and debt basis but rather it is the shareholder's responsibility. If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder's stock basis. Debt basis is not considered when determining the taxability of a distribution. Loss or deduction pass-through items If a shareholder is allocated an item of S corporation loss or deduction, the shareholder must first have adequate stock and/or debt basis to claim that loss and/or deduction item. In addition, it is important to remember that, even when the shareholder has adequate stock and/or debt basis to claim the S corporation loss or deduction item, the shareholder must also consider the at-risk and passive activity loss limitations and therefore may not be able to claim the loss and/or deduction item. S corporation stock and debt basis Importance of stock basis It is important that a shareholder know his/her stock basis when: The S corporation allocates a loss and/or deduction item to the shareholder. In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and/or debt basis. The S corporation makes a non-dividend distribution to the shareholder. In order for the shareholder to determine whether the distribution is non-taxable they need to demonstrate they have adequate stock basis. The shareholder disposes of their stock. As with any asset, including S corporation stock, when the asset is sold or disposed of, basis needs to be established in order to reflect the proper gain or loss on the disposition. Since shareholder stock basis in an S corporation changes every year, it must be computed every year. Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, may be used to figure a shareholder’s stock and debt basis. Computing stock basis In computing stock basis, the shareholder starts with their initial capital contribution to the S corporation or the initial cost of the stock they purchased (the same as a C corporation). That amount is then increased and/or decreased based on the pass-through amounts from the S corporation. An income item will increase stock basis while a loss, deduction, or distribution will decrease stock basis. A shareholder's stock is increased by (using 2022 Form 1120S Schedule K-1 box items): Type of increase Location of basis increase amount on Schedule K-1 1. Ordinary income Box 1 2. Separately stated income items Boxes 2 - 10 3. Tax exempt income Boxes 16A & 16B 4. Excess depletion Box 15C A shareholder's stock basis is decreased, but not below zero, by: Type of reduction Location of basis reduction amount on Schedule K-1 1. Ordinary loss Box 1 2. Separately stated loss items Boxes 2 – 12S 3. Nondeductible expenses Box 16C 4. Non-dividend distributions Box 16D 5. Depletion for oil and gas Box 17R NOTE: Only non-dividend distributions reduces stock basis, dividend distributions do not. The corporation is responsible for telling the shareholder the amount of non-dividend and dividend distributions. Box 16D of Schedule K-1 reflects non-dividend distributions. Form 1099-DIV is used to report dividend distributions; dividends are not reported on the shareholder's Schedule K-1. Most distributions from an S corporation are non-dividend distributions. Dividend distributions can occur in a company that was previously a C corporation or acquired C corporation attributes in a non-taxable transaction (i.e., merger, reorganization, QSub election, etc.). The order in which stock basis is increased or decreased is important. Because both the taxability of a distribution and the deductibility of a loss are dependent on stock basis, there is an ordering rule in computing stock basis. Stock basis is adjusted annually, as of the last day of the S corporation year, in the following order: Increased for income items and excess depletion; Decreased for distributions; Decreased for non-deductible, non-capital expenses and depletion; and Decreased for items of loss and deduction. When determining the taxability of a non-dividend distribution, the shareholder looks solely to his/her stock basis (debt basis is not considered). For loss and deduction items, which exceed a shareholder's stock basis, the shareholder is allowed to deduct the excess up to the shareholder's basis in loans personally made to the S corporation. Debt basis is computed similarly to stock basis but there are some differences. If a shareholder has S corporation loss and deduction items in excess of stock basis and those losses and deductions are claimed based on debt basis, the debt basis of the shareholder will be reduced by the claimed losses and deductions. If an S corporation repays reduced basis debt to the shareholder, part or all of the repayment is taxable to the shareholder. Stock basis example Mark, the sole shareholder of an S corporation, has $15,000 of stock basis on January 1, 2021. Mark received a 2021 K-1 reflecting the following: Location on K-1 Amount Type of income or loss Box 1 (20,000) Ordinary business income (loss) Box 9 4,000 Net section 1231 gain Box 12 A 5,000 Cash contributions (60%) Box 16 C 1,000 Non-deductible expenses Box 16 D 12,000 Distributions For this example, assume Mark does not have any debt basis. Using the ordering rule, stock basis is first increased by items of income - so the initial stock basis of $15,000 is increased by the $4,000 net section 1231 gain. The stock basis before distributions is $19,000. Second, reduce stock basis by distributions of $12,000. Since the shareholder has adequate stock basis before distributions, the distribution will reduce stock basis to $7,000 and the $12,000 distribution is non-taxable. Third, stock basis is reduced by the $1,000 of non-deductible expenses. Stock basis before loss and deduction items is $6,000. Mark has ($25,000) of loss and deduction items: ($20,000) ordinary loss $5,000 charitable contribution Since loss and deduction items exceed stock basis, look to see if the shareholder had valid debt basis. Since there is no debt basis in our example, the loss and deduction items are pro-rated to determine the amount currently allowable: 20,000/25,000 * 6,000 = ($4,800) ordinary loss 5,000/25,000 * 6,000 = $1,200 charitable contribution Basis calculation step Addition or reduction Net basis January 1, 2021 stock basis 15,000 Net section 1231 gain 4,000 Stock basis before distributions 19,000 Non-dividend distributions (12,000) Stock basis before nondeductible expenses 7,000 Nondeductible expenses (1,000) Stock basis before loss and deductions 6,000 Ordinary business loss {20/25 * 6} (4,800) Cash contributions {5/25 * 6} (1,200) December 31, 2021 stock basis 0 Therefore, although the corporation allocated Mark a ($20,000) ordinary loss, he should reflect on his 2021 Schedule E only ($4,800) due to the stock and debt basis limitations. Determination of allowable and suspended ordinary business loss for 2021 Ordinary business loss component Amount 2021 ordinary business loss (20,000) Allowable 2021 ordinary business loss (4,800) Suspended ordinary business loss (15,200) In addition, although Mark was allocated a cash contribution of $5,000, he would only be allowed to take $1,200 on his 2021 Schedule A, subject to the 1040 or 1040-SR contribution deduction limitations. Determination of allowable and suspended cash contribution for 2021 Cash contribution component Amount 2021 cash contribution 5,000 Allowable 2021 cash contribution 1,200 Suspended cash contribution 3,800 Under IRC §1366(d)(2), any loss suspended because of lack of stock and debt basis shall be treated as incurred by the corporation in the succeeding taxable year with respect to that shareholder. For 2022 Mark’s K-1 reflected the following: Location on K-1 Amount Type of income or loss Box 1 35,000 Ordinary business income (loss) Box 12 A 1,000 Cash contributions (60%) Box 16 C 5,000 Non-deductible expenses Mark’s basis in his stock at the beginning of the year is $0. Losses suspended in a previous year are treated as being incurred in the next tax year and can only be deducted when basis is increased. Stock basis is computed as follows: 2022 Stock basis calculation assuming $30,000 basis before losses and deductions Basis calculation step Addition or reduction Net basis January 1, 2022 stock basis 0 Ordinary Income 35,000 Stock basis before distributions 35,000 Non-dividend distributions 0 Stock basis before nondeductible expenses 35,000 Nondeductible expenses (5,000) Stock basis before loss and deductions 30,000 Ordinary business loss – 2021 carryover (15,200) Cash contributions – current year (1,000) Cash contributions - 2021 Carryover (3,800) December 31, 2022 stock basis 10,000 Although the K-1 will only show the current year income items, the shareholder will be allowed to take the losses previously suspended due to the stock basis limitations. Suspended losses should not be combined with amounts but listed on a separate line on the Form 1040 or 1040-SR, Sch. E PDF, Supplemental Income and Loss, or the appropriate schedule when possible. Suspended ordinary loss carryover is not netted with the current year ordinary income when applying the stock basis ordering rules. See Treas. Reg. §1.1366-2(a)(3)(i). If the stock basis before losses and deductions had only been $17,500 instead of $30,000, the following losses and deductions would have been allowed in 2022: 2022 Stock basis calculation adjustment assuming $17,500 basis before losses and deductions Basis calculation step Cash contribution amount Addition to or reduction of basis Net basis Stock basis before loss and deductions 17,500 Ordinary business loss - 2021 carryover {15,200/20,000 * 17,500} (13,300) Current year cash contribution 1,000 2021 carryover cash contribution 3,800 Total cash contributions {4,800/20,000 * 17,500} (4,200) December 31, 2022 stock basis 0 The carryover to 2023 would be: Determination of allowable and suspended ordinary business loss for 2022 Ordinary business loss component Amount 2022 ordinary business loss (based on 2021 carryover) (15,200) Allowable 2022 ordinary business loss (13,300) Suspended ordinary business loss (1,900) Determination of allowable and suspended cash contribution for 2022 Cash contribution component Amount 2022 cash contribution (based on current year and 2021 carryover) 4,800 Allowable 2022 cash contribution 4,200 Suspended cash contribution 600 The loss and deduction items in excess of stock and debt basis: retain their character, are treated as loss and deduction items incurred in the subsequent tax year and will be allowed if stock or debt basis is increased or restored, and carryover indefinitely or until all the shareholder's stock is disposed of. Once a shareholder disposes of all of their stock, any suspended loss and deduction items are lost and cannot be deducted. Important things you should know: A non-dividend distribution in excess of stock basis is taxed as a capital gain on the shareholder's personal return. It is a long-term capital gain (LTCG) if the S corporation stock has been held for longer than one year. Non-deductible expenses reduce a shareholder's stock and/or debt basis before loss and deduction items. If non-deductible expenses exceed stock and/or debt basis, they are not suspended and carried forward. If the current year has different types of loss and deduction items, which exceed stock and/or debt basis, the allowable loss and deduction items must be allocated pro rata based on the amount of the particular loss and deduction items. A shareholder is not allowed to claim loss and deduction items in excess of stock and/or debt basis. Loss and deduction items not allowable in the current year are suspended due to basis limitations and are carried over to the subsequent year. Suspended losses and deductions due to basis limitations retain their character in subsequent years. Any suspended loss or deduction items in excess of stock and/or debt basis are carried forward indefinitely. In determining current year allowable losses, current year loss and deduction items are combined with the suspended loss and deduction items carried over from the prior year, though the current year and suspended items should be separately stated on the Form 1040 or 1040-SR Schedule E or other appropriate schedule on the return. A shareholder is only allowed debt basis to the extent he or she has personally lent money to the S corporation. A loan guarantee is not sufficient to allow the shareholder debt basis. If a shareholder contends he or she has contributed or loaned substantial funds to the S corporation, consideration should be given to whether the shareholder had the financial means to make the contribution or loan. Part or all of the repayment of a reduced basis debt is taxable to the shareholder. If a shareholder sells their stock, suspended losses due to basis limitations are lost. Any gain on the sale of the stock does not increase the shareholder's stock basis.
