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S Corporations And Partnerships – The Importance of Basis



Basis is very important when determining gain or loss for certain transactions. It is also one of the limiting factors in determining how much loss can be deducted by partnership and S Corp shareholders.

What is basis?

For tax purposes, basis is the amount invested in a property adjusted for certain items.

Basis is usually equal to the cost, or the amount paid in cash, debt obligations, other property or services.

Basis in property is increased by capital items such as capital improvement and assessments for local improvement. Items that constitute a return of capital (e.g. non-dividend distributions, casualty and theft loss, and depreciation) should be treated as a reduction in basis.

Partnership Basis

A shareholder in a partnership may not be able to deduct the full amount of a partnership loss that is passed through to the shareholder. There are three important limitations to the amount of the loss that can be deducted on the partner’s tax return. The order of the limitations is important and they are:

1. Basis rule
This limits the loss deduction to the adjusted basis of his partnership interest. Losses disallowed by this limitation may be carried forward indefinitely.

2. At-risk limitations
The loss deduction is limited to the amount that the partner could actually lose in the activity.

3. Passive activity limitations
Deduction of passive activity losses may be limited.

The basis of partnership interest is money plus adjusted basis of any property contributed to the partnership.

A partner’s basis is increased by:

• Additional contributions (including assumption of liability)
• Partner’s distributive share of taxable and non-taxable partnership income
• Partner’s distributive share of excess deductions for depletion (excluding oil and gas wells)

A partner’s basis is decreased by:

• Distributions to the partner (including partner liability reduced or assumed by the partnership)
• The partner’s distributive share of partnership losses (including capital loss)
• The partner’s share of non-deductible partnership expenses
• The partner’s deduction for depletion for oil and gas wells (limitations apply)

A partner’s basis cannot be reduced below zero.

S Corporation shareholder stock basis

The stock basis of an S Corp shareholder must be adjusted annually as of the last day of the S Corp’s year. The corporation is not responsible for tracking the shareholder’s stock basis it is the responsibility of the shareholder.

The S Corp shareholder is subject to similar loss deduction limitations like the partnership shareholder as described earlier. It is therefore important to determine the correct amount of the shareholder’s basis to know how much loss can be deducted. The basis is also important when there is an S Corp distribution or to determine gain or loss when a shareholder disposes of his stock.

Non-dividend distribution from an S Corp is tax free up to the amount of the shareholder’s stock basis. Any excess is treated as long-term capital gain on the partner’s personal return.

An S Corp shareholder’s basis is the initial capital contribution increased by:

• Separately stated income items
• Ordinary income
• Tax-exempt income
• Excess depletion

Basis is reduced by:

• Ordinary loss
• Separately stated loss
• Expenses that are non-deductible
• Distributions (non-dividend)
• Depletion for oil and Gas property held by the S Corp.

Stock basis cannot be reduced below zero.

There is a strict ordering rule for the adjustments to basis. Adjustments must be done in the following order:

1. Increased for income items and excess depletion
2. Reduced for distributions
3. Reduced for non-deductible, non-capital expenses and depletion
4. Reduced for items of loss and deduction

S Corporation shareholder debt basis

Debt basis is the amount that has been personally lent to the corporation by the shareholder. A loan guarantee does not create debt basis.

Computation of both Stock and debt basis is a requirement for S Corporation shareholders. The variable nature of the stock basis for S Corp shareholders makes it necessary for the shareholder to keep track of the changes.

Each shareholder will receive a Schedule K-1 from the corporation reflecting the amounts of the corporation’s income, loss and deductions allocated to the shareholder for the year. The K1 does not show the taxable amount of a distribution. The shareholder’s stock basis will be used to determine the amount of a distribution that is taxable.

Reference – http://www.irs.gov/Businesses

In accordance with Circular 230 Disclosure

Mr. McCarthy is a tax professional with more than 20 years of corporate accounting experience that includes tax audits, in Jamaica, U.S. Payroll tax returns, Business and Individual tax returns, FBAR. As an Enrolled Agent he represents taxpayers before the IRS. Also trained in British Taxation while earning the qualification as a chartered accountant with the ACCA in the United Kingdom.

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