S corporation Capital Accounts
Income, losses, and other items, are passed-through an S corporation to each shareholder according to his percentage of ownership in the corporation.
Each shareholder's ownership percentage is reflected in his own individual capital account (e.g., Jack Jones, Capital) which is set up after the S corporation is formed.
Each shareholder's capital account must be maintained accurately in order to allow for an accurate allocation to each shareholder of all pass-through items and to be able to compute gain or loss should a shareholder sell his stock.
- Initial basis in your stock: When an S corporation is formed, each investor will generally contribute money and/or property to the corporation in return for stock.
- A capital account is set up for each shareholder (John Smith, Capital, Jack Jones, Capital, etc,)
- Each shareholder's initial stock basis equals his initial investment.
- Adjusted basis in your stock: After the initial investment is made, each shareholder's capital account may be adjusted up or down for certain items (e.g., up for income items, down for losses, distributions, etc).
- The remaining balance represents the shareholder's adjusted basis in his stock.
Tax basis represents the total of two items: (1) stock basis and (2) loan basis (also called debt basis).
For example, if you invest $10,000 for stock in the S corporation and also personally lend the S corporation $2,000, your tax basis is $12,000 (stock basis of $10,000 plus loan basis of $2,000).
Tax basis is increased by certain pass-through items (i.e. net income) and decreased by certain pass-through items (i.e. losses and deductions). In addition, the components of your tax basis, stock basis plus loan basis (if any), must be reduced in the following order:
- Stock basis first, but not below zero
- Loan basis next, but not below zero
- You invest $10,000 for 100 shares of stock and lend the S corporation $2,000
- Your friend Jack invests $10,000 for 100 shares of stock
- Each of you own 50% of the stock, and therefore, will share in the income, deductions, credits, gains, and losses equally (50% each).
- Your tax basis is $12,000 (stock basis of $10,000 and loan basis of $2,000)
- Jack's tax basis is $10,000 (equal to his stock basis)
- At the end of the tax year the corporation has $50,000 of net income
- You and Jack are each allocated $25,000 (50% each) of the net income
- Schedule K-1 is issued to you and Jack after the end of the tax year reporting the allocation of net income.
What you and Jack must do:
- You and Jack each report your $25,000 share of net income on Schedule E, which is attached to Form 1040. This is true even if no funds were actually distributed to either of you.
- Both you and Jack increase your stock basis to $35,000 (original investment of $10,000 plus $25,000 share of net income).
- Your tax basis is now $37,000 (stock basis of $35,000 [$10,000 plus $25,000] plus $2,000 loan basis)
- Jack's tax basis is $35,000 which is equal to his stock basis ($10,000 plus $25,000). Jack did not lend any money to the S corporation, and therefore, has no loan basis.
Had you or Jack received a distribution of $25,000 each, both of you would have to reduce your stock basis by $25,000. Although the distribution itself is tax-free because it did not exceed your stock basis, you both included your $25,000 share of the profits in your income by reporting it on Form 1040 Schedule E.
Key Points You Should Know
- Schedule K-1 shows the amount of non-dividend distributions to shareholders; it does not state the taxable amount of a distribution.
- Only non-dividend distributions affect stock basis; dividend distributions do not.
- The taxable amount of a non-dividend distribution depends solely on the shareholder's stock basis; loan basis (also called debt basis) is not considered. Loan basis represents what a shareholder has personally lent to the S corporation.
- If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder's stock basis. If the distribution exceeds the shareholder's stock basis, the excess amount is a capital gain (short-term or long-term depending on how long the stock was held. If one year or less, it's a short-term capital gain, if held more than one year, it's a long-term capital gain).
- Dividend vs non-dividend distributions: A dividend distribution may occur if the S corporation was a C corporation prior to converting to an S corporation, and at the time of conversion the C corporation had "retained earnings" (this is the name of the capital account that corporations maintain to accumulate profits). If the S corporation subsequently distributes those pre-conversion retained earnings to shareholders, such distribution would be a dividend distribution and would not affect S corporation shareholders' stock basis. Instead, the S corporation would issue Form 1099-DIV to report the distribution and the recipients of the dividend would report it on their personal income tax returns.
Stock basis and loan basis:
- It is not the corporation's responsibility to track a shareholder's stock basis or loan basis; it is the shareholder's responsibility.
- You may not reduce your stock basis or loan basis (if any) below zero.
- If a shareholder sells their stock, suspended losses due to basis limitations are lost.
- Any gain on the sale of stock does not increase the shareholder's stock basis.
- Part or all of the repayment of a reduced debt is taxable to the shareholder.
Repayment of Loan to Shareholder by S corporation
If you personally lend money to your S corporation you will either create a loan basis if it's the first time you've lent money to the business, or add to your existing loan basis if you previous lent money to the business which has not been fully repaid.
In any event, when the S corporation pays you back, you may have to include all or part of the repayment in taxable income depending on the amount by which the repayment amount exceeds your loan basis.
- An S corporation has a $10,000 loss.
- The S corporation has one shareholder who has an $8,000 stock basis and a $3,000 loan basis (the shareholder personally lent his company the $3,000).
- The S corporation repays the shareholder his $3,000 loan.
- To deduct the full $10,000 loss, the shareholder must have sufficient basis; which he does, he has a tax basis of $11,000 (stock basis of $8,000 and loan basis of $3,000).
- The shareholder must first reduce his stock basis, but not below zero. So, he subtracts $8,000 of the loss from his $8,000 stock basis, bringing it down to zero.
- Next, he reduces his loan basis by the remaining $2,000 of loss, bringing his loan basis down to $1,000.
- Since the shareholder's loan basis was reduced to $1,000 and the loan repayment amount was $3,000, the loan repayment results in $2,000 of taxable income for the shareholder ($3,000 minus loan basis of $1,000)
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- Return to the Tax Basics for Startups Table of Contents to find related links.