19.3 Shareholder Stock and Debt Basis

19.3 Shareholder Stock and Debt Basis

REG Area V, Group C, Topic 3 asks you to calculate a shareholder's stock basis from operations, cash contributions, and cash distributions, and to calculate changes in debt basis from current-year repayment of debt. Entity-level ordinary income, separately stated items, and the accumulated adjustments account were Section 19.2. The individual's Form 1040 placement of the K-1 is Section 15.1. At-risk and passive-activity limits still apply after basis; those are Section 16.1. Partnership §752 liability shares are not S corporation debt basis — that analog is Section 20.2.

Each shareholder keeps a personal stock-basis schedule. AAA is a corporate account. Two shareholders can have different basis in the same year because they contributed different amounts or took different distributions. Losses allowed to a shareholder cannot exceed stock basis plus debt basis (§1366(d)). Excess is suspended and carried forward until basis appears.

Stock-basis rollforward — order is the exam

§1367 adjustments are applied in a mandatory order. Doing the arithmetic with the right numbers in the wrong order is a wrong answer.

1. Beginning stock basis (cannot start below zero).
2. Increase for additional cash contributions.
3. Increase for the shareholder's share of all income items, including tax-exempt income, and certain excess depletion. Income items include ordinary income and separately stated gains and taxable income items.
4. Decrease (not below zero) for distributions that are not includible in income — the nontaxable portion under §1368.
5. Decrease (not below zero) for noncapital, nondeductible expenses, such as the meals haircut, fines, and key-person life premiums.
6. Decrease (not below zero) for items of loss and deduction, including ordinary loss, separately stated losses, charitable contributions, and §179.

Income before distributions before losses. That sequence is why a year can produce a nontaxable distribution and a suspended loss at the same time. If you reduce for the loss first, you understate the basis available for the distribution and you overstate the currently allowed loss.

Tax-exempt municipal interest increases stock basis even though it did not increase AAA. Distributions then reduce that basis. The exemption is not used a second time when cash later goes out.

Debt basis — direct loans only

Debt basis exists only for indebtedness of the S corporation to the shareholder — a direct loan of cash (or a bona fide equivalent) from the shareholder to the corporation. A guarantee of the corporation's bank loan does not create debt basis when signed. Basis appears only if the shareholder actually pays the creditor and is subrogated. The shareholder's share of a third-party loan is a partnership idea under §752; it is not an S corporation adjustment.

Losses reduce stock basis first, then debt basis. Income in a later year restores debt basis first, then stock basis — the reverse of the reduction order.

Repayment of reduced-basis debt is a gain event. If the shareholder lent $10,000, losses reduced debt basis to $4,000, and the corporation repays the $10,000, the shareholder has $6,000 of gain. Open-account indebtedness generally produces ordinary gain; a written note can produce capital gain. REG Core wants you to see the gain, not to litigate character on exotic instruments. After the year's income and loss allocations have updated debt basis, the repayment reduces remaining debt basis dollar-for-dollar, and any face repaid above that remaining basis is the gain.

Distributions — AAA, then AEP, then return of capital, then gain

§1368 tests a cash distribution after stock basis has already been increased for the year's income. The character of what the shareholder received depends on whether the corporation has accumulated earnings and profits (AEP) from C years.

No AEP (§1368(b)):

1. Tax-free reduction of stock basis to the extent of that basis.
2. Excess over basis is gain, generally capital gain.

With AEP (§1368(c)) — the REG waterfall:

1. AAA — treated as a nontaxable §1368(b) amount, but only to the extent of stock basis. Reduces AAA and reduces basis. Any AAA-sourced amount in excess of basis is gain, not a dividend.
2. AEP — taxable dividend. Does not reduce stock basis.
3. Remaining distribution — return of capital, reducing any leftover basis.
4. Remainder — gain.

The Other Adjustments Account is not a parallel cash pot that lets the corporation "distribute tax-exempt interest" a second time. Source the cash under this waterfall.

Illustration. After the year's income increase, stock basis is $25,000, AAA is $20,000, and AEP is $10,000. A $28,000 cash distribution is $20,000 nontaxable from AAA (basis falls to $5,000) and $8,000 of taxable dividend from AEP (basis stays $5,000). None of the $28,000 is return of capital or gain.

Worked: beginning stock $10,000, income $8,000, cash distribution $15,000, loss $6,000

Facts. One shareholder. Beginning stock basis $10,000. No debt basis. No AEP. Current-year income items $8,000. Cash distribution $15,000. Current-year loss and deduction items $6,000. Do not net the $8,000 and the $6,000 before applying the ordering rule — REG will give income and loss as separate items when it wants the order tested. No additional contributions. No nondeductible expenses.

Correct order.

Ending stock basis is zero. Ending debt basis is zero. The shareholder reports $8,000 of income, a $15,000 nontaxable distribution, a $3,000 currently deductible loss, and a $3,000 suspended loss.

Wrong order (loss before distribution). $10,000 + $8,000 = $18,000; minus $6,000 loss = $12,000; distribution $15,000 → $12,000 tax-free and $3,000 capital gain, with the entire $6,000 loss allowed. That is the trap. The Code requires distributions before losses so that the distribution can absorb the income-increased basis and so that a loss not supported by remaining basis is suspended.

If the shareholder also had $4,000 of debt basis from a direct loan, the $3,000 remaining loss after stock basis hit zero would reduce debt basis to $1,000, and the full $6,000 loss would be currently allowed. A later $4,000 repayment of that loan when debt basis is $1,000 would produce $3,000 of gain.

AAA still decreases for the year's losses before it decreases for the distribution — that is the corporate Schedule M-2 order from Section 19.2, and it is not the shareholder basis order. When AEP is present, compute AAA available for the distribution after those corporate loss reductions, then apply the AAA / AEP / return-of-capital / gain waterfall to the cash, always respecting the shareholder's stock basis for the nontaxable layers.

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