Question

Shareholders are required to have a basis before losses are deducted. Describe why this would be important, and how losses are handled.

Answer 1

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:

1. Avoid double taxation on distributions.
2. Allow corporate losses to pass through to its owners.

There are three shareholder loss limitations:

1. Stock and Debt Basis Limitations
2. At Risk Limitations
3. Passive Activity Loss Limitations

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 C 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.