S Corporation Shareholder Stock and Debt Basis Limitations

An S corporation allows business income, losses, deductions, and credits to pass through to shareholders for their personal tax returns, avoiding income tax at the corporate level. A shareholder’s ability to deduct these passed-through losses is governed by their “basis,” which represents their economic investment in the corporation. This basis, composed of stock and direct loans, acts as a ceiling on deductible losses under Internal Revenue Code Section 1366. It is the shareholder’s responsibility to track their basis, a calculation necessary when claiming a loss, receiving a corporate distribution, or disposing of their stock.

Calculating Shareholder Stock Basis

A shareholder’s stock basis is a dynamic figure that changes annually based on corporate activities and shareholder transactions. The initial basis is determined by how the stock was acquired. If a shareholder contributes property, including cash, to form the corporation, their initial basis is the amount of cash plus the adjusted basis of the property contributed. For those who purchase stock from an existing shareholder, the initial basis is the purchase price.

From this initial amount, basis is adjusted at the end of each corporate tax year. Items that increase stock basis include the shareholder’s pro-rata share of all corporate income items, both separately stated and non-separately stated income. Tax-exempt income, such as proceeds from a life insurance policy, also increases a shareholder’s stock basis. Additional capital contributions made during the year add to stock basis.

Conversely, other items decrease stock basis, such as distributions of cash or property from the corporation that are not classified as dividends. A shareholder’s share of corporate losses and deductions, both separately stated and non-separately stated, also reduces stock basis. Non-deductible expenses that are not capital expenditures, such as certain fines or penalties, also reduce basis. Shareholders track these calculations on IRS Form 7203, Shareholder’s Stock and Debt Basis Limitations.

For example, assume a shareholder starts the year with a stock basis of $20,000. During the year, the S corporation allocates $10,000 of ordinary income to the shareholder and the shareholder makes an additional capital contribution of $5,000. These items increase basis to $35,000. The corporation then makes a $7,000 cash distribution, which reduces basis to $28,000, representing the amount available to absorb potential losses.

Establishing Shareholder Debt Basis

When a shareholder’s stock basis has been reduced to zero, they may be able to deduct additional corporate losses against their debt basis. Debt basis is only created when a shareholder makes a direct, bona fide loan to the S corporation. A bona fide loan implies a genuine debtor-creditor relationship, evidenced by formal documentation like a written promissory note that specifies the lender, borrower, loan amount, interest rate, and a repayment schedule.

Certain arrangements do not create debt basis. A shareholder who personally guarantees a corporate loan from a third-party lender does not get debt basis for the amount of the guarantee, as the loan is from the bank to the corporation. Pledging personal assets as collateral for a corporate loan similarly fails to create debt basis. The shareholder has not made an actual economic outlay until they are required to make a payment on that guarantee.

Loans from a related entity, even one wholly owned by the shareholder, to the S corporation do not create debt basis for that individual shareholder. The loan must be directly from the shareholder. Undocumented cash advances from a shareholder can create “open account debt.” If the year-end balance of such open account debt exceeds $25,000, tax regulations require it to be treated as a formal note in the subsequent year, necessitating separate tracking.

Applying the Basis Limitation Rules

The ability to deduct pass-through losses and the tax treatment of distributions both depend on a shareholder’s basis. Tax regulations provide a strict ordering sequence for making year-end basis adjustments. This order can significantly impact the amount of loss a shareholder can deduct and whether a distribution is taxable.

At the close of the tax year, a shareholder must first increase their stock basis for all income items and any additional capital contributions, including both taxable and tax-exempt income. After these positive adjustments, the next step is to decrease stock basis for any distributions of cash or property. Debt basis is not considered when determining the taxability of a distribution; only stock basis matters for this step.

After basis has been increased for income and decreased for distributions, it is reduced by the shareholder’s share of losses and deductions. Losses are deductible only to the extent of the shareholder’s remaining stock basis. If the losses exceed stock basis, the shareholder can then apply the excess loss against their debt basis.

Any loss that exceeds the shareholder’s combined stock and debt basis is a “suspended loss.” This loss is not permanently disallowed but is carried forward indefinitely to subsequent tax years. It can be used when the shareholder generates sufficient basis. For example, if a shareholder with $10,000 of stock basis and $5,000 of debt basis has a corporate loss of $20,000, they can deduct $15,000. The remaining $5,000 loss is suspended.

Restoring Basis to Deduct Suspended Losses

A shareholder with suspended losses from prior years can deduct them in a future year by generating additional basis. These suspended losses are treated as if they were incurred in the current year and are combined with any new losses for the basis limitation. The primary methods for creating basis are making an additional capital contribution or a new loan to the corporation.

The corporation’s future performance also restores basis. Net income earned by the S corporation in a subsequent year increases shareholder basis, which can then absorb the suspended losses from a prior year. For instance, if a shareholder has a $5,000 suspended loss carryforward and the corporation generates $8,000 of income allocable to them, the income creates enough basis to allow the full deduction of the prior-year loss.

A specific rule applies when debt basis has been previously reduced by losses. If the corporation has net income in a future year, that income must first be used to restore the reduced debt basis to its original principal amount. Any remaining net increase can then be used to increase the shareholder’s stock basis, as the income does not automatically restore stock basis first.

This restoration rule also has implications for loan repayments. If a corporation repays a loan for which the shareholder’s debt basis has been reduced, the repayment can trigger taxable income. The shareholder recognizes gain to the extent the repayment exceeds the shareholder’s reduced basis in the note.