It’s All About Basis Bulletin: Avoiding Audit of Personal Returns

Shareholder or Partner basis in the business put simply is - at a point in-time, do you have financial risk of losing what you invested in the business?

What is ‘Invested in the business’?

When you are starting a corporation or partnership, the initial shareholders or partners put cash, property and/or loans in some case, to start up the business. If the business closed at the same time and the owner was not returned any cash or property, all that they invested is lost. Similarly at any point in the future, this investment could become worthless. This is the risk, which is reflected in shareholder or partner basis. This basis is used to:

a. determine the amount you can take as a loss on your personal taxes,

b. calculate any capital gain if you receive a shareholder or partner cash or property distribution greater than the amount of your basis,

c. report the gain or loss if you sell your shares or interest in the business or if the business terminates.

Basis does not stay constant:

Profit,  Loss, risk

Shareholder or partner basis changes based on activity of the business as follows:

  • Increases when profits are earned, you receive separately stated income (interest, dividend, rental income, or capital gains), make additional investment or received tax exempt income.
  • Decreases when the company has an operating loss, separately stated income, incurs nondeductible expenses, pays shareholder non-dividend distributions or makes distributions to partners.
  • An additional basis change occurs when you have depletion of oil/gas (increase) or the excess oil/gas depletion (decrease). However most small businesses do not have this activity unless through investments by the business in partnerships or businesses which passes through these items on a K-1 statement.
  • The shareholder/partner basis cannot decrease below zero (see Taking Losses later)

Nondeductible expenses:

Nondeductible expenses decrease basis because they are either not business related or are considered personal expenses. These items are not shown on your operating income statement for tax purchases and are shown on the pass-through IRS K-1 statement if they can be used on the personal return.

  • This includes contributions in cash or property to charity or non-profits directly paid by the business.

  • 50% of the meals and entertainment for non-employee events or activity. Allowable employee events or meals are deductible as expenses at 100% to the business. These two items should be separated on the expenses listed on the business (book) income statement.

  • IRS tax penalties are not a deductible expense on a tax return and must reduce the basis to the owners equally.

  • Partner health insurance is not deductible by the business and reduces basis. Shareholder health insurance included as income on the corporation payroll and reported on the W2 is deductible by the business.

  • Shareholder/partner life insurance (not group life insurance) is not deductible and reduces basis.

  • Personal use of a company vehicle may or may not be deductible and may either reduce basis or be considered income on the W2 of an S Corp shareholder or on the personal return.

  • Payment of personal expenses by the business is non-deductible. Some Corporation owner/officers who are employees may have company paid expenses that are De minimis. These are small expenses that can be deducted by the business.

De minimis Employee benefits – For S Corp shareholders who are also employees, you can exclude the value of a De minimis benefits you provide from the employee's wages and it is not a nondeductible item for basis. Care must be taken as facts and circumstances may determine if a De minimis expense if the shareholder is the only employee. A De minimis benefit is any property or service you provide to an employee that has so little value (taking into account how frequently you provide similar benefits to your employees and the number of employees) that accounting for it would be unreasonable or administratively impracticable. Examples of De minimis benefits provided to all employees include the following

  • Personal use of an employer-provided cell phone provided primarily for non- compensatory business purposes,

  • Occasional personal use of a company copying machine if you sufficiently control its use so that at least 85% of its use is for business purposes,

  • Holiday gifts, other than cash, with a low fair market value,

  • Group-term life insurance payable on the death of an employee's spouse or dependent if the face amount is not more than $2,000,

  • Meals provided under allowable circumstances,

  • Occasional parties or picnics for employees and their guests,

  • Occasional tickets for theater or sporting events, and

  • Transportation fare - commuting benefits.

Note: Cash and cash equivalent fringe benefits (for example, use of gift card, charge card, or credit card), no matter how little, are never excludable as a De minimis benefit, except for occasional meal money or transportation fare.

Taking Losses on Personal Returns

If at the end of the year the S Corp shareholder or partner has basis in the business and the business has losses, these losses can be taken on the personal tax return in most cases. This topic is not simple and many factors determine the deductible nature of losses.  Here are some key factors:

1. Stock/partner Basis and Debt Basis – Stock/partner basis is the at-risk investment in the business and any positive balance after increase and decrease for the year are factored. Stock/partner basis never can go below zero. If it does go below zero, the losses are suspended and cannot be applied to the personal return. If a shareholder or partner has provided a Bona Fide shareholder loan to the business, this loan has a debt basis for the individual investor which can be used if there are changes that cause stockholder/partner basis to go below zero.

2. Ordering rule – There are order rules used to determine the taxability of losses.

Distributions - When determining the taxability of a non-dividend distribution or partner distribution, only his/her stock/partner basis can be used. Example: If during the tax year $20,000 is distributed to the owner and there is $15,000 stock/partner basis and $30,000 loan basis, only the $20,000 and $15,000 are matched to come up with a $5,000 capital Gain. (See capital gain later).

Loss and deduction items – if there are nondeductible expenses or capital losses which exceed a shareholder's stock basis, the shareholder is allowed to deduct the excess up to the shareholder's basis in loans personally made to the S corporation. Partners are able to do the same but in some cases have more flexibility to use their share of partnership loans.

Non-deductible expenses reduce a shareholder's stock and/or debt basis before loss and deduction items. If non-deductible expenses exceed stock and/or debt basis, they are not suspended and are carried forward.

3. How losses are taken on the personal return – A shareholder or partner basis report will show the allowed and disallowed losses at the end of the year.

  • Disallowed losses are suspended and, if partial, they are prorated based on the character of the losses. Allowed losses are reported by preparing the personal return Form 6198 and showing total losses (carry over from prior year plus current year), current year profit, and additional cash or property contributions by the owner.
  • Part or all of the losses may be deducted if profits or owner contributions occur. Operating losses, other losses and nondeductible expenses will be prorates only if part of the losses can be taken. This means charity contributions will be suspended if there is no basis to take them.

Restoring stock and loan basis

Any future profit must first return any reduced loan basis to the original principal balance of the loan. After that, the profit will reduce the suspended losses until above zero. Any reduced suspended losses are reported on the personal return on Form 6198 and zeros out the profit in that year, dollar for dollar. Contributions of cash or property to the business when loan basis has been reduced also restores loan basis. Recording on the balance sheet does not change the original loan face amount. All basis recording is done on shareholder or partner basis reports.

Sale of stock/partner interest or business termination

If a shareholder sells their stock, suspended losses due to basis limitations are lost. Any gain on the sale of the stock does not increase the shareholder's stock basis. If the loan with reduced basis is not repaid when the shareholder stock/partner interest is sold or the business terminates, the business has a cancelation of debt with an adjustment to the reduced basis adjustment. The loan basis for determination of personal return business debt loss is adjusted.

Summary Actions for Owners

The take-away in this bulletin is that documenting and managing shareholder/partner basis has both a financial and tax impact on your business. To be able to track and report basis, it is important that the end of the year statements and records provided to your tax preparer itemize any amounts that affect basis. These include shareholder/partner loans, contributions, distributions, meal expenses, company paid health or life insurance, personal use of company vehicles, company payment of business expense, charity contributions, loan payments itemized by principle and interest, and adjustments to balance sheet equity items.

Some specific guidance in these areas:

  • Document separately meal expenses and employee benefits for officers, shareholders or partners.

  • Document and report all contributions separately on your balance sheet or on a separate statement or worksheet

  • Separate business loans from Bona Fide shareholder/partner loans and report separately the loan principle and interest payment.

  • On the Equity section of your balance sheet:

    • all original changes in contributions and distributions should be clearly shown,

    • retained earnings should only reflect prior year operating retained earnings combined with current year operating gain or loss,

    • any changes in balance items should be recorded to an Adjustment to Retained Earnings line or to the income statement and a statement included detailing these adjustments.

  • Determine if you have a Bona Fide shareholder/partner loan before you take certain losses or deductions greater than your stock/partner basis

About the Author

Liberty Tax Service

Founded in 1997 by CEO John T. Hewitt, Liberty Tax, Inc. (NASDAQ: TAX) is the parent company of Liberty Tax Service. Liberty Tax’s online services are available through eSmart Tax, Liberty Online and DIY Tax, and are all backed by the tax professionals at Liberty Tax locations and its nationwide network of approximately 35,000 seasonal tax preparers.