Key Takeaways
- Shareholders have two types of basis: stock basis and debt basis.
- Stock basis starts with initial investment and is adjusted annually.
- Losses are deductible only to the extent of stock basis plus debt basis.
- Distributions are tax-free to the extent of stock basis.
- The Accumulated Adjustments Account (AAA) tracks undistributed S corp earnings.
- Basis cannot go below zero; excess losses are suspended.
Shareholder Basis Calculation
Why This Matters for the Exam
Shareholder basis is the most tested S corporation topic. It determines loss deductibility and whether distributions are tax-free. Master the ordering rules.
Expect at least 4-5 questions on basis.
Why Basis Matters
Shareholder basis determines:
| Purpose | Rule |
|---|---|
| Loss deductibility | Losses limited to basis |
| Distribution taxation | Tax-free to extent of basis |
| Gain on sale | Gain = Proceeds - Basis |
Two Types of Basis
| Basis Type | Source |
|---|---|
| Stock basis | Investment in stock |
| Debt basis | Direct loans TO the S corp |
Important: Unlike partnerships, S corp shareholders do NOT get basis from:
- Entity-level debt (even if personally guaranteed).
- Loans from third parties to the corporation.
Stock Basis Calculation
| Starting Point | Adjustment |
|---|---|
| Initial investment | Cash + FMV of property contributed |
| + Additional contributions | Later capital contributions |
| + Income items | Ordinary income, capital gains, tax-exempt income |
| - Distributions | Cash and property distributed |
| - Losses and deductions | Ordinary loss, capital loss, §179, etc. |
| - Non-deductible expenses | 50% meals, penalties, fines |
| = Ending basis | Cannot go below zero |
Ordering Rules (Critical!)
The annual adjustments occur in this specific order:
| Order | Adjustment |
|---|---|
| 1 | Increase for income items |
| 2 | Decrease for distributions |
| 3 | Decrease for non-deductible expenses |
| 4 | Decrease for losses and deductions |
Why Order Matters: Income is added first, which may allow larger tax-free distributions or more loss deduction.
Stock Basis Example
| Transaction | Amount | Basis |
|---|---|---|
| Beginning basis | $50,000 | |
| + Share of income | +$30,000 | $80,000 |
| - Distribution | -$25,000 | $55,000 |
| - Share of loss | -$40,000 | $15,000 |
| Ending basis | $15,000 |
Debt Basis
| Debt Basis | Description |
|---|---|
| Created by | Shareholder loans directly TO the S corp |
| Purpose | Allows additional loss deductions |
| Order | Stock basis first, then debt basis |
| Restoration | Income restores debt basis before stock basis |
Key Difference from Partnerships:
- Partnership: Basis from entity debt.
- S Corp: No basis from entity debt—only direct shareholder loans.
Debt Basis Example
| Scenario | Result |
|---|---|
| Stock basis: $0 | Cannot deduct losses from stock |
| Shareholder loaned $20,000 to S corp | Debt basis: $20,000 |
| Share of loss: $15,000 | Deduct $15,000 against debt basis |
| Debt basis after: $5,000 | Remaining debt basis |
Losses in Excess of Basis
| Situation | Treatment |
|---|---|
| Loss > Stock + Debt Basis | Excess loss is suspended |
| Suspended loss | Carries forward indefinitely |
| Future basis | Can deduct when basis restored |
Accumulated Adjustments Account (AAA)
AAA is a corporate-level account (not shareholder-level) that tracks:
| AAA Purpose | Description |
|---|---|
| What it tracks | Undistributed S corp earnings since S election |
| Use | Determines tax treatment of distributions (former C corps) |
| Can go negative | Yes (unlike basis) |
AAA Adjustments:
| Increase | Decrease |
|---|---|
| Ordinary income | Distributions |
| Capital gains | Losses and deductions |
| Non-deductible expenses |
Real-World Scenario
Scenario: A shareholder has $30,000 stock basis and $10,000 debt basis. Their share of S corp loss is $50,000.
- Deductible loss: $30,000 (stock) + $10,000 (debt) = $40,000.
- Suspended loss: $10,000 ($50,000 - $40,000).
- Ending stock basis: $0.
- Ending debt basis: $0.
- Suspended $10,000: Carries forward until basis is restored.
On the Exam
Expect 4-5 questions on basis, typically:
- Calculation Questions: "Calculate ending shareholder basis."
- Loss Limitation Questions: "How much loss can be deducted?"
- Distribution Questions: "How much is tax-free?"
- Debt Basis Questions: "What creates debt basis for S corp shareholders?"
- Ordering Questions: "What is the order of basis adjustments?"
The key is to remember: Stock basis first, then debt basis for losses. Order: income → distributions → non-deductible → losses. No basis from entity debt.
A shareholder has $30,000 stock basis. The S corp distributes $40,000. What is the tax consequence?
What increases a shareholder stock basis in an S corporation?
What is the order of basis adjustments for S corporations?