Accounting On Us
Basics of Basis
Understand Basis to avoid nasty tax surprises
Brock R. Yates, CPA, MT
The Basics of Basis – try and say that five times fast! The concept of tax basis is one that can baffle even the most seasoned tax professional. However, it is something that taxpayers and professionals alike must understand to avoid some nasty tax surprises that could arise. Let’s look at what basis is, the rules about how it is calculated, and what it means for taxpayers.
What is Basis?
Think of basis as your ownership stake in something. Usually, in the tax world, basis refers to one’s ownership in a business entity or asset. If you’ve ever traded stocks, you’ve heard the term basis. It is simply what you paid for the stock. For example, if you bought Amazon stock at $100 per share, first off, congratulations, you’ve likely made a fortune, but secondly, your basis in those shares is $100 each.
Basis is important in this scenario because it is how your gain or loss is calculated if you sell the shares at any point. If you sell the shares for $105 each, you have a taxable gain of $5 per share, not $105, which is your sales price. You subtract your basis of $100 from the sales price to calculate gain. Similarly, if you sold the shares for $95 instead, you have a $5 per share loss.
Closely Held Businesses
Great, you think. That’s easy (ignoring any potential stock splits, reverse stock splits, stock dividends or anything else that can mess with the ease of stock basis). But what if you own your own business? How does basis apply here? And why is it important?
Good questions, and as with nearly every answer in the tax world, the answer depends on several factors. The largest factor in calculating your basis is what type of entity you own, be it a C Corporation, S Corporation, Partnership, or Single Member LLC (commonly referred to as a disregarded entity). From there, certain nuances in each entity structure determine how basis is calculated and what it means for the owners of the business.
Owners of C Corporations have the easiest time in calculating their basis. It is simply whatever they put into the business as their investment. This includes cash, as well as the tax basis of any assets, like vehicles, they put into the business. If they contribute more money or assets to their C Corporation, their basis increases. Caution should be given to contributing assets encumbered with debt, but that is outside the scope of this article. Basis does not change for any income the business produces or any dividends that are paid out to the shareholders. Take our Amazon example above for instance. Amazon is a C Corporation, and shareholders buy shares and have a static basis in their ownership.
When a C Corporation shareholder sells his shares to another person, he recognizes gain to the extent his sales price exceeds his basis. Simple enough. So why are we dedicating an entire article to this concept? As you will see, when you have other entity structures, basis becomes infinitely more important and complex.
Owners of S Corporations need to pay special attention to their tax basis. As with C Corporations, a shareholder’s tax basis in his/her S Corporation stock is increased by money or assets contributed to the business. However, given that an S Corporation is a “Flow-Through” business, meaning the income or loss from the operations is recognized at the shareholder level, the individual’s basis is adjusted by that income or loss.
For example, let’s say I start an S Corporation by investing $100 cash to the business. In my first year, as with many businesses, I have a net loss of $30. My basis at the end of year one is calculated as:
- Opening Basis – $100
- Less: Year 1 Loss – (-$30)
- Basis – End of Year 1 – $70
In year 2, my business becomes profitable and has an income of $50. As you might guess, my basis is now increased by the income I recognized ($70 beginning basis plus $50 = $120).
One of the wonderful things about S Corporations is the ability to distribute money to shareholders tax-free. The major caveat to this is that you must have sufficient tax basis in order to distribute that money, as a distribution reduces your tax basis in the same way that a taxable loss would. In the example above, say in year two after accounting for my income, I distribute $100 to myself as a tax-free distribution. My tax basis at the end of year two is $20 ($120 basis before distribution less $100 taken out). If I were to take out more money as a distribution than I have tax basis, the excess would be included on my income as a capital gain. All too often we prepare a tax return where a shareholder was unaware of this rule and used their company as a personal cash register, only to realize they distributed funds in excess of their basis, and now have a large capital gain to recognize. So be sure to know your basis or ask your Henry+Horne tax professional before distributing money to yourself!
As you can see, basis is calculated annually and on a go-forward basis in S Corporations. It changes with income, losses, and contributions and distributions to and from the business. The shareholders themselves are responsible for knowing their basis in their corporations, which oftentimes creates issues when we try to onboard new clients. Our question of “What is your tax basis?” is usually followed up with an answer of “What is tax basis?” However, since you are a diligent reader of our newsletters, you will be ahead of the game!
Partnership basis functions very similarly to S Corporation basis, which makes sense because like S Corporations, partnership income is recognized at the partner level. Basis is increased for taxable income and contributions of money and assets to the business and decreased for losses and distributions from the business. As with S Corporation basis, it should be tracked annually and factors into what can be distributed tax-free or what the gain on a sale of your partnership interest would be.
The largest difference between S Corporation and Partnership basis relates to debt – we will discuss the details of that in just a bit.
As an owner of an S Corporation or Partnership, it is important to know that if your business loses money, the loss offsets your ordinary income, but only if you jump through a few hoops. One of these hoops is a sufficient basis. Basis cannot be reduced below zero, so if you have exhausted all your tax basis with losses or distributions, any future losses are suspended until your business earns income or you invest more money or property into the business, both of which increase basis.
There are three kinds of debt that we generally deal with in the tax world: Nonrecourse, Qualified Nonrecourse, and Recourse. Without going into a whole dissertation, it’s key to know that nonrecourse debt will generally not require repayment in the event of default, qualified nonrecourse debt functions like regular nonrecourse except it secures real estate, and recourse debt must be paid back by the guarantor(s) in the event of default.
That said, if you are a partner in a partnership, debt that is allocated to you is added to your tax basis. How debt is allocated to you is beyond the scope of this article, and there are several exceptions (i.e., nonrecourse debt is considered not “at-risk,” and thus may disallow losses to partners), but this is a general idea of how debt factors into partnership basis. Please consult with your Henry+Horne tax advisor before making any decisions regarding debt and your partnership basis.
For S Corporations, the debt discussion is a bit less complicated – debt in the business or debt you personally secure for the business does NOT increase your tax basis. Instead, there is a separate debt basis “bucket” that can only be impacted by physical outlays of money by shareholders to the company. You cannot get a loan in the name of the S Corporation, secure it, and get basis. Instead, you must take the loan personally, loan the money to the Corporation, and then receive debt basis that way.
Debt basis in an S Corporation functions separately of the stock basis in the corporation, and only changes if either the stock basis goes to zero, in which case you begin to adjust debt basis, or the loan is paid back to the shareholder. If repayment to the shareholder is made when debt basis is reduced or depleted, there could be a capital gain to recognize. Let’s look at an example:
In year 1: A’s stock basis in his S Corporation is $50. He loans $500 to his S Corporation and receives $500 in debt basis. He expects to be repaid, and there is an executed note with a stated market interest rate, so it is truly debt basis.
In year 2: the corporation loses $300. A’s stock basis is reduced to $0, and the remaining $250 of loss decreases his debt basis down to $250. At this point, if any part of the loan were to be repaid, the repayment would be 50% taxable as capital gain (since 50% of the debt basis is used up).
In year 3: the corporation has $400 of income. Assume no payments were made on the debt. First, the $250 of debt basis is restored, so A’s debt basis is back to the original $500. From there, the remaining $150 of income increases A’s stock basis to $150.
If $100 of the loan was paid back in year 2, only $150 of debt basis would be restored, since the principal remaining on the loan is $400 instead of $500. Whatever excess income is left is simply added to stock basis.
While the preceding discussion covered some of the most important tenants of basis, we’ve only scratched the surface of this incredibly complex topic. Be sure to chat with your Henry+Horne tax advisor if you own a business and have questions or concerns about your tax basis.