S corporation shareholders encounter particular restrictions on the amount of losses and deductions they are permitted to claim on their individual income tax returns. These constraints are primarily governed by the concept of basis, which represents a shareholder’s financial stake in the S corporation, encompassing both stock basis and, where applicable, debt basis.
Stock and Debt Basis Defined
- Stock Basis: This is initially established by the amount a shareholder invests in the S corporation, whether through contributing cash or property.
- Debt Basis: This arises when a shareholder provides a direct loan to the S corporation. Only direct shareholder loans contribute to increasing basis; loans from third parties do not, unless the shareholder is personally liable for the debt.
Annual Basis Adjustments
A shareholder’s basis is adjusted each year:
- Increases include: Allocated income, additional capital contributions, and excess depletion.
- Decreases include: Allocated losses and deductions, non-deductible expenses, and distributions received from the S corporation.
Limit on Loss Deductions
A shareholder may only deduct their share of S corporation losses and deductions up to the total of their stock and debt basis at the end of the tax year. If a shareholder’s allocated losses exceed their basis, the excess is suspended and carried forward indefinitely. These suspended losses can only be deducted in future years if the shareholder’s basis is subsequently increased (via new contributions or income allocations).
Distributions and Taxation
Distributions received from the S corporation are tax-free up to the amount of the shareholder’s stock basis. Any distributions exceeding the stock basis are typically taxed as a capital gain. It is important to note that debt basis is not considered when determining how distributions are taxed, although it is vital for calculating the allowable loss deduction.
Reporting Obligations
The IRS mandates that shareholders track and report their basis annually using Form 7203 to ensure compliance with these limitations. Crucially, the responsibility for accurately maintaining these basis records rests with the shareholder, not the corporation.
Summary Overview
| Limitation | Applies To | Effect |
|---|---|---|
| Stock & Debt Basis | Losses, Deductions | Limits deductible losses to the amount of basis |
| Distribution Limit | Distributions | Excess distributions over stock basis are taxed as gains |
| Basis Reporting | All shareholders | Annual tracking and reporting required (Form 7203) |
In conclusion, S corporation shareholders must diligently monitor their stock and debt basis. This is essential for determining the extent to which they can deduct losses and for avoiding unexpected tax liabilities on distributions received.