12.3 S Corporations, Partnerships, and Basis

Flow-Through Tax Does Not Mean No Entity Work

S corporations and partnerships generally pay no federal income tax as separate entities, but they still file returns (Form 1120S and Form 1065) and classify items for owners on a Schedule K-1. The 2026 AICPA REG Blueprint expects candidates to calculate ordinary business income or loss, separately stated items, and the impact of current-year transactions on owner basis, and to review the entity returns against supporting source data.

The practical rule: the entity computes and reports, then the owner applies basis and personal limitations. Skip either side and the answer is incomplete. Flow-through income is taxed to owners whether or not it is distributed — a point REG tests repeatedly.

S Corporation Stock and Debt Basis

An S corporation shareholder tracks stock basis and, when a direct loan exists, debt basis. Stock basis increases for capital contributions and income items (including tax-exempt income), then decreases in this order: distributions first, then nondeductible expenses, then deductible losses. Losses are deductible only up to stock basis, and then up to debt basis.

A mere guarantee of corporate debt does not create debt basis — the shareholder must make an actual economic outlay or direct loan. Debt basis reduced by losses must be restored by later income before loan repayments are tax-free; otherwise repayment of reduced-basis debt produces income.

Worked example: a shareholder begins with $10,000 stock basis and $5,000 debt basis (direct loan). A $13,000 ordinary loss flows through. The loss absorbs $10,000 of stock basis and $3,000 of debt basis, leaving stock basis at $0 and debt basis at $2,000; the full $13,000 is deductible (subject to at-risk and passive rules).

Partnership Outside Basis and Liabilities

A partner's outside basis is broader because partnership liabilities matter. Basis starts with cash plus the adjusted basis of property contributed, increases for the distributive share of income and increases in the partner's share of liabilities, and decreases for distributions, deductible losses, nondeductible items, and decreases in liabilities. A liability shift can create or destroy basis even when no cash changes hands.

Separately Stated Items, Distributions, and QBI

Both entity types separately state items needing owner-level character or limitation treatment: capital gains and losses, Section 1231 gains, charitable contributions, Section 179 expense, tax-exempt income, nondeductible expenses, investment interest, and credits. These must be removed from ordinary business income and reported separately so the owner applies the right rules. A TBS may give a trial balance and ask what belongs in ordinary income — strip out the separately stated items first.

Distributions: S corporation cash distributions reduce stock basis and create gain only after basis is exhausted, with accumulated adjustments account (AAA) ordering if the S corporation has accumulated E&P from prior C years. Partnership cash distributions reduce outside basis and create capital gain when cash exceeds basis.

Finally, qualified pass-through ordinary income may support a qualified business income (QBI) deduction of up to 20% at the owner level, subject to taxable-income thresholds and wage/property limits. Workpaper habit: classify entity items, then update each owner's basis in order, then test loss limits, then layer QBI.

The Three Loss Hurdles and S-Corp Eligibility

Even when a K-1 reports a loss, the owner must clear three sequential hurdles before deducting it: (1) basis — stock then debt for S corporations, outside basis for partners; (2) the at-risk limit, which excludes amounts the owner is not economically liable for (such as most nonrecourse debt); and (3) the passive activity loss rules, which suspend losses from activities in which the owner does not materially participate, releasing them against passive income or on full disposition. A loss can pass the basis hurdle yet still be suspended at-risk or passive, so REG answers that stop at basis are frequently wrong.

S corporation eligibility is its own tested topic. An S corporation may have no more than 100 shareholders, only one class of stock (differences in voting rights are allowed), and shareholders limited to U.S. individuals, certain trusts, and estates — no corporate or partnership shareholders and no nonresident aliens. A timely Form 2553 election is required. Violating any limit terminates the election. Partnerships, by contrast, have no such ownership limits and offer flexible special allocations that must carry substantial economic effect to be respected.

These structural differences explain why the same dollar of loss or distribution can land differently across the two flow-through forms, which is exactly the contrast REG simulations are built to test.