Sub Chapter S Shareholder Basis Considerations Jennifer L

Sub Chapter S Shareholder Basis Considerations Jennifer L Davis, EA, ATP Davis & Associates, Accountants, Inc

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Thoughts on Basis The IRS is auditing basis ! When we acquire a S Corp new client we call the previous accountant for an interview. We interview the client We ask for copies of every 1120 S filed historically for the company We manually figure our Stock and Loan basis Bad News: You REALLY need to complete a the 1120 S Balance Sheet, even if not “required” by IRS. We have a paperless office – We keep our Stock and Loan basis justification “forever”. We REQUIRE quarterly meetings. Our Website has downloadable mileage logs and expense reports

Shareholder Stock Adjusted Basis at beginning of the year Plus share of all income separately stated (including tax exempt ) Plus share of deduction for excess depletion of oil and gas properties LESS distribution of cash or property not included in wages LESS share of all loss and deduction items separately stated ( Capital Loss and Section 179 ) LESS share of all non-separately stated losses LESS share of all non-deductible expenses ( meals, entertainment, non-deductible fines and penalties ) LESS share of depletion for oil and gas properties not in excess of properties basis. = Adjusted Shareholder Stock Basis Year End.

Shareholder Loan Basis VERY important to track Shareholder Loan Basis. Loans can be short or long term. Most common type is Shareholder that pays business expenses on a personal credit card, submits ( with expense report ) the expenses, but does not repay him/herself immediately. A shareholder with positive shareholder loan basis may take losses in excess of stock basis but only to the extent that they have positive loan basis.

Calculation of Loan Basis Initial Amount Loaned to Company PLUS additional amounts loaned PLUS deferred interest that is being capitalized (added to the loan) instead of being repaid LESS loan principal forgiven by Shareholder LESS loan principal converted to stock LESS share of net loss in excess of shareholder’s adjusted stock basis =Adjusted basis in S Corporation Debt at year end.

Loan Considerations Valid loans are documented. ◦ Without proper documentation IRS problems during an audit Loan repayments can become taxable Difficulties during loan renewal processes Trend is toward banks asking to review all loan documents ◦ Promissory notes ◦ Attorney compiled loan documents Demand Notes Terms of Payment If company shows profit every effort to repay loans should be proven Reasonable Rate of Return ( Interest ) on loans more than $10, 000 Can be compiled annually

Distributions vs. Loan to Shareholder Non-dividend distributions can be taken from current year earnings or retained earnings. Maximum non-taxable distribution each year would be current year earnings plus retained earnings. When this non-taxable maximum is exceeded a Loan to Shareholder exists or possible Capital Gain This loan to shareholder can be cleared in two ways: ◦ Shareholder makes direct payments into the company to clear this balance ◦ If there is sufficient net income the following year many Accountants clear the Loan to Shareholder account immediately.

Shareholders Loans in S Corps with Single Shareholders When dealing with Cash or Cash Equivalents it is best to book distributions and contributions to Loan Basis and prepare Loan Documents at the end of each year. Remember on loans of more than $10, 000 there needs to be stated interest and repayment schedules

Shareholder Loans in S Corps with Multiple Shareholders Loans MUST be stated, there MUST be loan interest, and a repayment schedule must be outlined. Fact of Life: One shareholder will have a higher loan balance, will receive more interest, and will have 100% of the interest income on their 1040 but only a percentage of the interest deduction on their K-1.

Group Discussion When dealing with a multi-shareholder S Corp is it best to book cash / cash equivalents flowing in and out of the company as Loans to / from Shareholder or Capital Contributions OR Additional Paid In Capital ? ? ◦ Capital Contributions can cause disproportionate shareholder ownership and can jeopardize S Corp Status ◦ Distributions in excess of Loan Basis / Stock Basis can result in a taxable event. ◦ Payment of loan interest to a shareholder will result in the shareholder paying 100% of the tax on the interest but only receiving a portion of the interest write-off on their K-1

Negative Basis and Suspended Losses The Rules for Negative Basis are : ◦ Shareholder Stock Basis is reduced, but not below zero ◦ After that, Shareholder Loan Basis is reduced but not below zero. ◦ Finally, any further “excess losses” are called negative basis and are suspended indefinitely to be used in future years after loan / stock basis has been restored.

Question Number 1 Does health insurance paid by a SCorporation on behalf of a more than 2% Shareholder decrease the shareholder basis? Additional Note: In this case the health insurance was NOT added to W-2 box 1.

Solution Number 1 If Health Insurance is paid by a S Corporation for a more than 2% shareholder the amount paid should be listed on the K-1 on line 12 S (other deductions), reduces shareholder basis, and flows to Schedule A. Options: Include in W-2 box 1 and box 16. Deducted by S Corp and included on 1040 page 1.

Question Number 2 Joe Smith, Mike Adams, and Harry Harris each contribute $ 10, 000 to the start up of a S Corporation with the understanding that net income/expenses will be divided, for tax purposes, in the following way: Smith: Adams: Harris: 20% 30% 50% They have agreed on this division of net income by way of determining which partners will spend more time actively participating in the business. In accordance with IRC can Adams, Smith, and Harris divide net income / losses in this way ?

Solution Number 2 No. IRC is very clear that shareholders of S corporations must divide the corporations net income / losses in strict proportion to their share of ownership. If a shareholder contributes EXACTLY one-third of the company’s capital then one-third of the net profit / loss must be allocated to the shareholder via K-1. Option 1: Adjust Reasonable Compensation/Bonus to accommodate such differences. Option 2: LLC’s allow for unequal division of net income / loss through By-Laws.

Question Number 3 Jillie Hillie and Millie Willie start a S Corporation. Ms. Hillie contributes $10, 000 cash. Ms. Willie contributes $5, 000 cash plus a laptop, printer, desk, chair, and reference books that she purchased in 2008 for $5, 000. Are Ms. Hillie and Ms. Willie now equal shareholders in the S Corporation ?

Solution Number 3 No. The value of Shareholder donated property is the LOWER of a. The Fair Market Value of the property b. The Shareholders Adjusted Basis in the property Be sure to keep detailed working papers showing exactly how you arrived at Fair Market Value or Adjusted Basis.

Question Number 4 “We converted our Sole Proprietorship to a S Corporation. Now I have the task of moving our business assets from one entity to another. I believe that most of our business property was fully depreciated under Section 179. Fair Market Value is $32, 000 and original purchase price was $ 47, 000. We are not adding any cash to the company – just these assets. What is my Shareholder Basis? ”

Solution Number 4 Shareholder basis is ZERO. Purchase Price + Improvements + Purchase Costs + Selling Costs – Accumulated Depreciation = $0 Note 1: A common mistake that I find on 1120 S returns is that the Balance Sheet contains no “Capital Stock”. There must be an amount in Capital Stock. We generally allocate at least $100. Note 2: Contributions of non-cash items from Shareholders to S Corporations should NOT be shown on the Balance Sheet as Loans From Shareholders. Rather, they should be shown as “Additional Paid in Capital”. ◦ This is the correct procedure ◦ AND prevents your S Corporation from being too “thinly” capitalized.

Question Number 5 In 2006, Suzie Smith, single shareholder of Block Corp, (a S Corp), placed property into Block Corp and used her Adjusted Basis in the property to increase her LOAN Basis in Block Corp. In 2008 she withdrew the property for personal use. Can Suzie use the withdrawal of this property to reduce her Loan Basis and what would the valuation method be ?

Solution Number 5 No. Loans can only be CASH or cash equivalents. When property is contributed it becomes Additional Paid in Capital. When the property is removed it is valued at FMV and should be shown as an asset sale. Tax Planning Tip: Think twice before putting appreciable property in a S Corp.

Question Number 6 Does Tax-Exempt income affect Shareholder Stock basis ? ◦ Increase? ◦ Decrease? ◦ Stay the same?

Solution Number 6 Does Tax-Exempt income affect Shareholder Stock basis ? ◦ Increase? ◦ Decrease? ◦ Stay the same? Tax Exempt Income increases the adjusted basis of Shareholder Stock.

Question Number 7 In “Restoring Basis” to a S-Corporation which is restored first ? ◦ Loan Basis ◦ Stock Basis

Solution Number 7 In “Restoring Basis” to a S-Corporation which is restored first ? ◦ Loan Basis ◦ Stock Basis Loan Basis must be restored before Stock Basis can be.

Restoring Basis Additional Cash Investments Advance additional Cash Loans Donate Property with a Fair Market Value AND a positive Adjusted Basis ◦ Not a good idea to donate appreciable property

Question Number 8 At what point do non-deductible expenses reduce shareholder basis ? ◦ ◦ a. b. c. d. After Loan Basis Between Stock Basis and Loan Basis Before Stock Basis AND Loan Basis After Loss and Deduction Items

Solution Number 8 C. Before Stock Basis AND Loan Basis. Non-Deductible items reduce shareholder basis before loss and deductions items, before loan basis and before stock basis. If these non-deductible expenses exceed basis they do not get carried forward.

At Risk Rules Shareholder Risk is calculated as: Adjusted Stock Basis PLUS Adjusted Loan Basis Any loss in excess of the formula above is a Suspended Loss and follows the rules for Suspended Losses.

Question Number 9 True or False ? A shareholder Personal Loan Guarantee is sufficient to increase Shareholder Loan Basis.

Solution Number 9 False. A mere personal guarantee is not enough to increase Loan Basis. Further, part or all of the repayment of a reduced Loan Basis is taxable to the Shareholder.

Question Number 10 Shareholders X and Y have formed Rental Property, Inc a Sub Chapter S Corporation. Neither shareholders qualify as “active participation real estate professionals” but heard that if they formed a Sub Chapter S Corporation they would be able to deduct their full rental losses each year regardless of basis, and in excess of $25, 000. Is this correct ?

Solution Number 10 Shareholders of S Corporations with rental property are subject to the same passive activity loss limitations that all other entities are subject to. Real Estate Professional rules follow individuals and not entities. Passive activity income/loss for S Corps includes income/loss from partnerships, trusts, interest, dividends, and other investments including rental properties. ◦ This has impacted several of my clients that have partnership share in Title Companies or Law Firms.

Question Number 11 Is a non-dividend distribution in excess of stock and loan basis taxed to the shareholder as ordinary income ?

Solution Number 11 Is a non-dividend distribution in excess of stock and loan basis taxed to the shareholder as ordinary income ? No. Non-dividend distributions in excess of stock and loan basis are taxed as capital gains. Generally Long Term Capital Gains. To determine holding period review past years adjusted stock basis and adjusted loan basis to determine holding period.

Important IRS Note • If shareholder stock is sold, suspended losses due to basis limitations are LOST ! The sales price DOES NOT have an impact on the stock basis. A stock basis computation should be reviewed in the year that stock is sold or disposed of. This is an important planning tip for those of us with shareholders looking to dispose of, or sell, a business.

Question Number 12 True or False: If the current year has different types of losses and deductions, which exceed stock and loan basis, the allowable losses and deductions must be allocated pro rata based on the size of the particular loss and deduction items.

Solution Number 12 True. For more information on how to allocate see www. irs. gov “S Corporation Stock and Debt Basis”

Question Number 13 True or False ? In determining current year allowable losses, current year allowable loss and deduction items are combined with suspended losses and deductions carried over from one prior year, and this prior year and current year losses are lumped together on Form 5256, or other appropriate schedule.

Solution Number 13 False ! Current year losses and deductions are combined with ALL suspended losses and deductions from ALL previous years. These suspended losses retain their character. They need to be separately stated on Schedule E or other acceptable schedule.

Question Number 14 Shareholder A uses their BUSINESS credit card for personal expenses. They have no intention of reimbursing the company for the personal expenditures. Which is the proper way to account for these personal expenses: A. Classification of the expenses as a Loan To Shareholder B. Classify as a distribution that reduces Loan Basis until Loan Basis reaches ZERO and then classify as non-dividend distributions.

Solution Number 14 B. Classify these personal expenses as a distribution thus effectively reducing loan basis. Once loan basis reaches ZERO the shareholder would need to show these personal expenses as Non-Dividend Distributions. ◦ Possible Problem: If both Stock and Loan Basis are reduced to zero the excess would be a taxable distribution as a capital gain.

Question Number 15 Can personal credit cards used by an S Corporation shareholder for business expenses be treated as a loan from Shareholder thus creating loan basis that will allow the shareholder to deduct losses?

Solution Number 15 Yes According to Rev Rul 81 -187 shareholder must experience economic outlay Credit card in the name of the shareholder alone Payments are made BY the shareholder (NOT Corporation ) Repayment by the corporation reduces loan basis Again, a mere personal guarantee does not increase loan basis.

Question Number 16 At year end Xylophone Company showed non -dividend distributions in excess of Accumulated Adjustments Account by $2, 338. In accordance with Reg 1. 1368 -2(a)(4)(iii) how does this negative AAA balance need to be accounted for ? ◦ ◦ A. B. C. D. AAA can show a negative amount $2, 338 in Ordinary Income $2, 338 reclassified as Loan to Shareholder $2, 338 Shareholder Capital Gain

Solution Number 16 BOTH C and D are correct ! AAA can not show a negative amount. You can either: Show the excess as a Capital Gain or Show the excess as a Loan to Shareholder. In LTS there must be some intention of the shareholder to repay the loan.