How do distributions and losses that exceed basis impact an S corporation shareholder?
An S corporation shareholder took distributions from his business, guaranteed a business loan and co-signed a loan in 2020. How does this affect his basis?
Q: How does an S corporation shareholder treat distributions and losses that are more than basis? Is S corporation shareholder basis increased by a loan guarantee?
Merv owns a clothing and general store in our town. The store is an S corporation and he is the sole shareholder; he works regularly in the store as a salaried employee. In the early part of 2020, as he’s done in previous years, Merv also took cash distributions from the business. Business picked up in the fall but overall, the store sustained a loss for 2020.
The distributions and the loss are more than Merv’s basis. How much of the loss can he claim? Are the distributions taxable? Also, Merv gave his personal guarantee on a bank loan to purchase some new store fixtures. Does the guarantee increase his basis? If Merv lends money to the business in 2021 will that give him basis this year?
A: Reduce S corporation shareholder stock basis first by distributions and then by the loss, following an ordering rule. A loan guarantee does not create or increase S corporation shareholder debt basis.
To determine whether the distributions are taxable or how much of the business loss Merv can claim, Merv’s stock basis must be adjusted according to an ordering rule.
Ordering rule to adjust S corporation shareholder stock basis
Under the ordering rule, S corporation stock basis at the beginning of the year is:
- Increased for income items and excess depletion
- Decreased for distributions
- Decreased for non-deductible, non-capital expenses and depletion
- Decreased for items of loss and deduction
Given the business’s circumstances in 2020, Merv’s stock basis at the start of 2020 is first decreased by the distributions, also referred to as nondividend distributions. The loss is then applied against any remaining basis. If the distributions exceed basis, the excess is treated as capital gain.
Here are some illustrations.
Example 1. Suppose stock basis at the start of 2020 is $20,000, Merv takes distributions of $12,000, and the business sustains a $30,000 loss. Applying the ordering rule, basis is first reduced to $8,000 ($20,000 – $12,000). Basis is then reduced to $0 by $8,000 of the loss. That means Merv can claim an $8,000 operating loss in 2020. The remaining $22,000 loss ($30,000 – $8,000) is suspended until Merv has sufficient basis to apply against the loss in a future year.
Note that the basis limitation determines how much of the loss Merv can potentially claim, but not necessarily how much he can actually deduct in 2020. The deductible part of the loss will depend on his business income, including his salary.
The nondeductible loss, if any, is a net operating loss. The suspended part of the loss ($22,000) is not deductible until he has sufficient basis even if Merv has sufficient business income to absorb it.
Example 2. What if Merv’s stock basis at the start of 2020 was only $10,000 instead of $20,000? In that case, only $10,000 of the distribution would be tax-free. The remaining $2,000 ($12,000 – $10,000) is taxable capital gain, which is reported on Form 8949 and Schedule D.
Also, since basis would be reduced to $0 before applying the loss, none of the 2020 loss could be claimed this year.
A loan guarantee does not increase S corporation shareholder basis
For an S corporation shareholder, unlike a partner in a partnership, personally guaranteeing or co-signing a loan does not increase basis. Thus, Merv’s guarantee of the loan to purchase store fixtures does not change his basis or permit him to deduct more of the loss.
Debt basis, also called loan basis, is created or increased only if the shareholder directly lends money to the corporation. A bona fide loan should have a written loan document which includes interest, an amortization schedule, etc. just as a loan from a lending institution would have.
If Merv does make a bona fide loan to the corporation in 2021 he will have debt basis. Also, although the loan guarantee does not increase basis, Merv’s debt basis would increase if he personally repays all or part of the business loan. After stock basis is adjusted in 2021, debt basis can be applied against any remaining suspended loss but not against nondividend distributions.
Owners of small businesses may frequently “lend” small amounts to their companies without a formal agreement or expectation of receiving any repayment of the loan. Such a “loan” would not likely be treated as a bona fide loan for debt basis purposes. Funds used for the business could be treated as capital contributions and increase stock basis.
See “How is an S corporation shareholder’s stock basis and debt basis determined?” and the worksheets for figuring shareholders’ stock and debt basis in the instructions to Schedule K-1 (Form 1120-S).