IRC 1367: Adjustments to Stock Basis for Shareholders Explained

For S corporation shareholders, stock basis determines the taxability of distributions and the deductibility of losses. Internal Revenue Code (IRC) Section 1367 governs these annual adjustments, ensuring income, losses, and other transactions are properly accounted for.

Increases to Stock Basis

A shareholder’s stock basis increases through additional investments, corporate earnings, and other pass-through items. These adjustments affect how much can be withdrawn tax-free and the extent of deductible losses.

Shareholder Contributions

When a shareholder contributes cash or property to an S corporation, stock basis increases by the amount contributed. These contributions include direct cash infusions, asset transfers, or the assumption of corporate liabilities. Under IRC Section 351, a shareholder generally does not recognize gain or loss when transferring property in exchange for stock if they control at least 80% of the corporation immediately after.

For example, a $50,000 cash contribution increases stock basis by $50,000. If property is contributed, the adjustment is generally based on the property’s adjusted basis rather than its fair market value, unless the corporation assumes liabilities. Proper documentation is essential to avoid misreported taxable gains or denied loss deductions.

Pass-Through of Income

Income earned by an S corporation is allocated to shareholders based on ownership percentage, increasing stock basis even if earnings are not distributed. This includes ordinary business income, capital gains, dividends, and tax-exempt income. Under IRC Section 1366, shareholders report these earnings on personal tax returns, whether or not they receive distributions.

For instance, if a shareholder owns 30% of an S corporation that earns $200,000 in net taxable income, they report $60,000 on their individual return, increasing stock basis by the same amount. Tax-exempt income, such as municipal bond interest, also increases basis but does not contribute to taxable income. Losses and deductions cannot reduce stock basis below previously recognized tax-exempt income.

Other Additions

Certain other items also increase stock basis, including gains from stock or asset sales, income from debt forgiveness, and depreciation recapture under IRC Section 1245.

For example, if an S corporation has a loan forgiven by a creditor, the resulting cancellation of debt income increases stock basis if included in pass-through income. Similarly, if a depreciated asset is sold at a gain, the recaptured depreciation is passed through as ordinary income, increasing basis.

Tracking these adjustments ensures accurate reporting when calculating taxable gains on stock sales or determining allowable loss deductions. Shareholders should maintain detailed records.

Decreases to Stock Basis

Stock basis decreases due to losses, non-deductible expenses, and distributions, affecting the taxability of withdrawals and the deductibility of losses.

Pass-Through of Losses

Losses incurred by an S corporation reduce stock basis dollar for dollar. These include ordinary business losses, capital losses, and separately stated deductions such as charitable contributions and Section 179 expense deductions. However, losses are deductible only up to the shareholder’s stock basis and, if applicable, their debt basis under IRC Section 1366(d).

For example, if a shareholder has a stock basis of $40,000 and the corporation passes through a $50,000 loss, only $40,000 is deductible in the current year. The remaining $10,000 is suspended and carried forward until sufficient basis is available. If the shareholder later contributes additional capital or the corporation generates taxable income, the suspended loss can be used.

Non-Deductible Expenses

Certain expenses reduce stock basis even though they are not deductible for tax purposes. These include fines, penalties, expenses related to tax-exempt income, and certain life insurance premiums paid on behalf of shareholders.

For instance, if an S corporation pays $5,000 in penalties for late tax filings, stock basis is reduced by $5,000 without generating a deductible expense. Similarly, if the corporation earns $10,000 in tax-exempt municipal bond interest and incurs $1,000 in related investment expenses, the $1,000 reduces stock basis despite being non-deductible.

Distributions

When an S corporation distributes cash or property, stock basis decreases by the amount of the distribution. If the distribution does not exceed stock basis, it is tax-free. Any excess is taxed as a capital gain under IRC Section 1368.

For example, if a shareholder has a stock basis of $30,000 and receives a $25,000 cash distribution, basis is reduced to $5,000 with no immediate tax consequences. If the distribution were $35,000, the first $30,000 would reduce basis to zero, and the remaining $5,000 would be taxed as a capital gain.

Distributions of appreciated property follow similar rules, with the fair market value of the property reducing basis. Accurate tracking prevents unexpected tax liabilities.

Ordering Rules for Adjustments

The order in which stock basis adjustments occur affects the tax impact of an S corporation’s activities. The IRS requires a specific sequence to ensure consistency.

Adjustments begin with increases, accounting for all income items, including taxable earnings and tax-exempt income, before any reductions. This prevents shareholders from prematurely exhausting basis with deductions, which could limit their ability to offset future income.

Next, deductible losses and deductions are applied, reducing stock basis as allowed. If a shareholder lacks sufficient basis to absorb all losses in a given year, any excess is suspended and carried forward.

Non-deductible expenses are then subtracted. These reduce basis but do not generate immediate tax savings. If non-deductible expenses were deducted first, they could limit the ability to recognize deductible losses, leading to unnecessary deferrals of tax benefits.

Distributions are the final adjustment. This ensures that shareholders do not receive tax-free distributions exceeding their available basis before accounting for all other adjustments. If distributions were applied earlier, shareholders could risk reducing basis prematurely, potentially triggering taxable gains.

How Debt Basis Interacts

Stock basis is not the only factor determining deductibility of losses—debt basis also plays a role. Debt basis arises when a shareholder personally lends money to the corporation. Only direct loans from the shareholder create debt basis; third-party loans guaranteed by a shareholder do not, unless the shareholder makes actual payments on the debt.

When a shareholder lends money to the corporation, the loan amount establishes debt basis. Unlike stock basis, debt basis is not affected by corporate income or distributions, but it can be reduced by pass-through losses. If a shareholder’s stock basis is exhausted, losses reduce debt basis dollar for dollar.

Once debt basis is reduced, it must be restored before the shareholder can recognize any loan repayments as a tax-free return of capital. If a shareholder receives a repayment while having insufficient debt basis, the repayment may be taxed as ordinary income instead of a nontaxable return of principal.