September 2020: Stock & Debt Basis-Overview, Examples and Planning Tips for Partners and Shareholders (S-Corporations)

 In Advisory/Consulting, Michigan Accountant, Taxation

Building on my August 2020 newsletter, I want to tackle a tax topic specific to Partners (Partnerships) and Shareholders in S-Corporations, namely, Stock and Debt Basis. This is a fairly complex topic, so I’m not going to go into a lot of detail. This letter is to provide an overview of what Stock and Debt Basis is, the importance of each with a brief explanation as to how Partnership or Shareholder Basis could be used as a tax planning tool.

Stock Basis

Let me use a simple analogy to describe Stock and Debt Basis. Basis in an S-Corp. or Partnership can be thought of as “skin in the game.” It has to do with the amount of economic exposure a Shareholder or Partner has if it contributes or loans money or property to their respective S-Corp. or Partnership. If the contribution/loan makes the Shareholder or Partner poorer in an economic sense, then they are said to have Basis or skin in the game in their respective companies.  With regard to Partnerships, I’m focusing here on what is termed, outside Basis. Inside Basis refers to the Partnership’s basis in the assets of the Partnership. If a Partner or Shareholder contributes money or property to their Partnership or S-Corp. they receive Basis equal to the amount of money contributed or the adjusted Basis of the property contributed by the Partner or Shareholder. I’ll focus on contributions and distributions of money. The tax treatment of property is beyond the scope of a short newsletter!

Let’s assume that Ray starts an LLC and elects S-Corporation status for Federal tax purposes. Ray contributes $20,000 initially to his S-Corp. He takes a reasonable salary and receives a distribution of $5,000. As this is the first year of operations, his share as Sole Shareholder (100%) of the S-Corp’s losses is $30,000. Let’s also assume that his S-Corp. has non-deductible expenses (meals limited to 50%) of $1,500. These non-deductible expenses reduce Ray’s Stock Basis.

First Year

Contributions $20,000
Distributions ($5,000)
Non-Deductible Expenses (Meals @ 50%) ($1,500)
Ray’s Basis Limitation $13,500
Ray’s Share of S-Corp. Loss ($30,000)
Ray’s Deductible Loss Limited to His Basis ($13,500)
Ray’s Stock Basis-Year End $0

In general, losses, separately stated deductions (more on this later) and non-deductible expenses reduce Stock and Debt Basis. Stock Basis is cumulative and cannot go below zero. The significance of the amount of basis limitation means that Ray is limited to deducting only $13,500 of the S-Corp’s $30,000 loss against other income that Ray earned on his personal-1040. This also assumes that Ray actively participated in his S-Corp’s operations…there are specific rules and caveats to this in the Internal Revenue Code and we will assume he did, to focus on this topic-Basis. The residual amount of loss-$16,500 ($30,000-13,500) is suspended on Ray’s current year return and carried forward to use against his future S-Corp’s earnings. This is in addition to the 20% Qualified Business Income (QBI) deduction, against future S-Corp. earnings (under the Tax Cut & Jobs Act of 2018) but I digress.

Let’s assume in the second year, Ray contributes $17,500 and takes a distribution of $10,000. The S-Corp. has a much better year and earns $33,000.

Second Year

Ray’s Stock Basis at Beginning of Year $0
Contributions $17,500
Ray’s Share of S-Corp’s Earnings $33,000
Distributions ($10,000)
Non-Deductible Expenses (Meals @ 50%) ($2,000)
Prior Year Suspended Loss ($16,500)
Ray’s Stock Basis-Year End $22,000

Some observations. Ray’s contribution and his share of S-Corp. earnings allow Ray to deduct the prior year suspended loss of $16,500 against the S-Corp’s profit of $33,000; $33,000-16,500 = $16,500. This, in turn, reduces Ray’s end of year Basis to $22,000. There is a difference in the order to which a Shareholder’s share of S-Corp. losses and gains (profits) are allocated. In the case of losses, distributions and non-deductible expenses are netted against contributions, first to determine the amount of basis limitation and deductible loss the shareholder can take on his 1040 return. In the case of S-Corp. gains/profits, these gains/profits are added to the Shareholder’s Basis before distributions and non-deductible expenses to arrive at Ray’s year-end Stock Basis.

Another important twist. Let’s revise the first year example.

Contributions $10,000
Distributions ($15,000)
Non-Deductible Expenses (Meals @ 50%) ($1,500)
Ray’s Basis Limitation $0
Ray’s Share of S-Corp. Loss ($30,000)
Ray’s Deductible Loss Limited to His Basis $0
Ray’s Stock Basis-Year End $0

Here, Ray has a tax problem. He has no Stock Basis to recognize and deduct any of the $30,000 loss in the current year and since his distributions exceed his contributions, he’s on the hook for $5,000 in long-term capital gains! Obviously, not a good scenario. The non-deductible expenses ($1,500) will not carry-over to the succeeding year unless the Shareholder elects to re-order the sequence of adjustments.

Debt Basis

Debt Basis has several important differences versus Stock Basis. First and foremost, a Shareholder in an S-Corp. must contribute money that is loaned to the Shareholder, where the loan is in the Shareholder’s name. It is not sufficient (based on court rulings that have attempted to challenge this) that the Shareholder guarantee a loan to the S-Corp. The loan must be in the Shareholder’s name and the Shareholder must be personally responsible for payment of the loan to the creditor. Second, there must be an agreement between the Shareholder and S-Corp. that specifies the terms and conditions of the loan to the S-Corp. including a schedule of re-payments to the Shareholder with interest. Partnerships are different. A Partner can take a basis in the debt of the Partnership by guaranteeing the loan to the Partnership. A few other notable distinctions, follow-the mechanics and pitfalls using Debt Basis can create real problems.

In the last example, where Ray was unable to deduct any of the $30,000 loss because he lacked Stock Basis. If Ray had a properly executed agreement where he personally loaned $25,000 to the S-Corp. he could take a $25,000 deduction against this $30,000 loss. In this case, taking a $25,000 deduction against the $30,000 loss reduces his Debt Basis from $25,000 to $0. Following this and here’s the kicker, Ray MUST increase his Debt Basis before he can recognize any subsequent loan re-payments from the S-Corp. Failure to do so, would force Ray to recognize these re-payments as income before his Debt Basis is increased! The IRS will not allow Shareholders to use their Debt Basis as a tax benefit and immediately following, get re-paid for their loan before their Basis is increased. Tricky. The order in which Basis is replenished is Debt Basis first, followed by Stock Basis. If you have both Stock and Debt Basis, seek a qualified tax professional for their advice and assistance!

Stock and Debt Basis as a Tax Planning Tool  

I’m going to keep this brief. The timing of when and the extent to which losses can be recognized can be planned. Shareholders and Partners can, through their tax professional suspend and utilize losses in future years or seek to increase their Stock and Debt Basis to take deductions for losses (in the current year) that were suspended in prior years and carried forward. Obviously, this should only be considered as part of an overall tax planning strategy that considers the timing and amounts of all deductions and tax positions at the Shareholder level. This is key because separately stated deductions impact each Shareholder differently. Non-separately stated deductions occur at the Partnership or S-Corporation level. Separately stated deductions occur at the Partner or Shareholder level, in other words, these deductions are recognized on their individual 1040 returns. Partner’s or Shareholder’s Stock and Debt Basis could allow them to recognize the timing and amount of losses and deductions that are separately stated. In conjunction with other known corporate plans (for those that in turn flow-through to each Partner or Shareholder) it could provide the most tax-advantaged strategy over a period of several years.

That’s all for now.

If you like what you see and would like to learn more about Stock/Debt Basis or any other tax-related topic, contact me at mike@easllc.co or (734) 778-8429

Until next Month, and Best Regards,

 

Mike Faremouth

 

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