Knowing one’s cost basis in an S corporation is a vital issue for most owners of S corporations. However, to many such shareholders, basis is not understood and not known. Part of the confusion arises from the fact that S corporations, LLC’s, and partnerships are faced with two different basis numbers – inside basis and outside basis. Both are important, but the outside basis is more likely to become an issue annually for the shareholder. Shareholders may not deduct losses from the corporation in excess of their outside basis.
Inside basis is basically the balance in the owner’s capital account. It represents the ownership interest in the corporation, but not necessarily what that ownership interest cost. Inside basis is maintained on the corporate books. It represents:
The original amount credited on the corporate books for stock purchases. Frequently, this will equal the amount invested, but it can vary when the interest is purchased from another shareholder and not from the corporation.
- Increases in the investment in the corporation through an owner’s share of the profits.
- Decreases in the investment in the corporation through distributions to an owner.
- Additional stock purchases in the corporation’s stock by an owner.
Outside basis is more complicated, as it takes in a number of additional factors and must be maintained by the shareholder. The corporation does not normally track outside basis. Unfortunately, many S corporation shareholders do not keep a record of their outside basis. Outside basis includes:
The original purchase price.
- Basis in any property contributed to the business. This is the lower of fair market value or cost of property contributed to the corporation.
- Taxable gains that are recognized on the contribution of property.
- Liabilities of the corporation assumed by the shareholder.
- Tax-exempt income of the business.
Outside basis is decreased by:
Liabilities that the business assumes.
- Business and capital losses.
- Non-deductible business expenses (that are not capital items).
- Section 179 deductions.
- The corporation’s basis in property received from the business.
- Cash withdrawals.
A word of explanation about liabilities is in order. If a shareholder agrees to be responsible for a debt of the corporation, outside basis is increased by that amount. Conversely, if the corporation agrees to pay a debt of the shareholder, the liability is assumed by the corporation and decreases outside basis. A loan guarantee does not affect basis, the debt must be transferred to change basis.
Basis may not be reduced below zero. Therefore, losses in excess of basis are not deductible. These may be suspended for use in future use when basis has been restored. The losses maintain their character (i.e. an ordinary loss carries forward as an ordinary loss).
Failure to maintain a record of outside basis can result in the shareholder deducting losses on the 1040 that are not allowable. If an IRS audit ensues, additional tax may be levied in addition to interest and penalties. This could create some undue hardships is if the shareholder cannot demonstrate the amount of basis simply because of poor record-keeping. The result could be the IRS assigning a basis on what the shareholder can prove, which would likely be grossly understated.
Corporations engage in numerous transactions over the course of a year, and the basis consequences may not always be readily apparent. In order to avoid surprises when tax time comes, shareholders should meet with their tax preparer prior to the end of the year to discuss events that have occurred during the year. In addition to covering any basis issues that have arisen, the discussion should also cover compensation, loans to and from the corporation, and Section 179 deductions.
Another problem with basis can be encountered occurs when there is a stepped-up outside basis. This frequently occurs when the shares in a corporation are inherited from a prior owner.
For example, assume that Joe Smith is the founder and sole shareholder of SmithTech, Inc. He began the company with an investment of $10,000. The company prospered and was very profitable. Joe unexpectedly dies in 2009. The stock in SmithTech, Inc. is valued at $1,000,000. His heirs receive a stepped-up basis of $1,000,000 in the corporation’s stock.
The heirs are approached by an outside investor who offers to purchase the assets of the corporation for $1,000,000. Assuming they accept the offer, there are some significant tax consequences. The corporation has sold the assets that have an inside basis of $10,000 for $1,000,000. This results in a gain on the sale of assets of $990,000 – income taxable to the shareholders. They stand to lose the benefit of the stepped-up basis in the stock, and will pay taxes on the $990,000 gain. In order to benefit from the stepped up basis, they must liquidate the corporation in the same year as the sale of the assets. They can recognize a loss on the liquidation that will offset the gain on the sale of the assets.
If they do not liquidate the corporation in the year of the asset sale, the loss on liquidation of the corporation is a capital loss, deductible at the rate of $3,000 per year. One solution would be to sell the corporation, rather than the assets.
Other situations may arise when there is a significant difference in inside and outside basis. In short, basis is a complex issue that needs professional guidance and constant attention. Shareholders should keep track of their basis and consult with their tax professional in order to avoid undesirable consequences.