With an S Corporation, there are three shareholder loss limitation rules. Each limitation must be met, in the following order, before a shareholder is allowed to claim a flow-through loss deduction.
1. Stock and Debt Basis Limitations
2. At Risk Limitations
3. Passive Activity Loss Limitations
S Corporation Shareholders are Required to Compute Both Stock and Debt Basis EACH year, which increases or decreases based upon the S corporation's operations.
This is important for the following reasons:
In order for a shareholder to claim a flow through loss or deduction item, they need to have adequate stock and or debt basis.
In order for a shareholder to determine whether or not a non-dividend distribution is non-taxable, they need to demonstrate they have adequate stock basis. When a shareholder receives a non-dividend distribution, 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).
As with any asset, when the stock is sold or disposed of, basis needs to be established in order to determine the proper gain or loss on the sale or disposition.
When computing stock basis, the shareholder starts with their initial capital contribution to the S Corporation or the initial cost of the stock they purchased.
A shareholder's stock basis is increased for the following items:
Ordinary business income
Separately stated income items
Tax exempt income
A shareholder's stock basis is decreased for the following items:
Ordinary business loss
Separately stated loss items
Non-deductible non-capital expenses
There is an ORDERING RULE that must be followed in computing stock basis as follows:
Stock Basis is adjusted annually, as of the last day of the S corporation year, in the following order:
1st-Increased for all income items
2nd-Decreased for non-dividend distributions
3rd-Decreased for non-deductible non-capital expenses
4th-Decreased for loss and deduction items.
As stated earlier, when determining the taxability of a non-dividend distribution, the shareholder looks solely to his/her stock basis (debt basis in 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 debt basis (which are shareholder loans personally made the the S corporation).
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.
It is important to note that if an S corporation repays reduced debt basis to the shareholder, part or all of the repayment is taxable to the shareholder.
Also, for a shareholder to have debt basis, the shareholder must personally make a (real) loan of money to the corporation. A loan guarantee is not sufficient to create debt basis.
The loss and deduction items in excess of stock and debt basis:
Retain their character
Are treated as loss and deduction items in the subsequent tax year and will be allowed if the shareholder has increased and or restored stock and or debt basis
Carryover indefinitely or until all of the shareholder's stock is disposed of
Tracking stock and debt basis each year will help the shareholder plan for potential distributions and losses and deductions and ensure there are no unexpected and no unintended surprises at tax time.
This article was written by Donald M. Scherzi, CPA, CFP, LLC
Mike Lupo, SCORE Counselor
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