19.2 S Corporation Basis and Distributions
Key Takeaways
- Track stock basis and debt basis separately; a mere guarantee of corporate debt never creates debt basis until the shareholder makes an actual economic outlay.
- Apply the loss-limitation order: basis first, then at-risk, then passive activity rules.
- With no accumulated E&P, a cash distribution reduces stock basis to zero, then becomes capital gain; debt basis is never reduced by distributions.
- Built-in gains (BIG) tax under Section 1374 is a flat 21% corporate-level tax on net recognized built-in gain during the 5-year recognition period after a C-to-S conversion.
- An S corporation is limited to 100 shareholders, one class of stock, and generally only U.S. individual, estate, or qualifying-trust shareholders.
The S corporation basis mindset
An S corporation is a pass-through, but TCP never stops at the label. It asks whether a shareholder can deduct a loss, how a distribution affects stock basis, whether debt basis exists, and how income is allocated when ownership changes. Remember the eligibility guardrails the exam loves to test: an S corporation may have no more than 100 shareholders, one class of stock (differences in voting rights are allowed), and generally only U.S. individual, estate, or certain trust shareholders — a partnership or C corporation shareholder voids the election.
Stock basis and debt basis are not interchangeable
Stock basis starts with cash or property contributed (Section 358), increases for separately and nonseparately stated income and tax-exempt income, and decreases for distributions, nondeductible expenses, and losses. Debt basis arises only from a direct shareholder loan or an actual economic outlay.
| Item | Stock basis effect | Debt basis effect |
|---|---|---|
| Cash capital contribution | Increase | No effect |
| Ordinary business income | Increase | No effect |
| Tax-exempt income | Increase | No effect |
| Cash distribution | Decrease, not below zero | No effect |
| Deductible loss | Decrease after income/distribution ordering | Decrease only after stock basis is exhausted |
| Direct shareholder loan | No stock increase | Increase debt basis |
| Guarantee of bank debt | No effect until payment | No effect until economic outlay |
Loss limitations
The loss path is sequential: (1) basis (stock then debt), (2) at-risk under Section 465, (3) passive activity under Section 469. Worked example: A shareholder has $10,000 stock basis, $4,000 debt basis, and a $20,000 passthrough ordinary loss. The deductible loss is capped at total basis of $14,000; the remaining $6,000 is suspended and carried forward by the shareholder. A common TBS error is treating a $50,000 bank-loan guarantee as $50,000 of debt basis — it is not.
Debt-basis restoration
When losses reduce debt basis below the loan's face amount, later net income first restores debt basis before it increases stock basis. This restoration matters when the shareholder repays or the corporation repays the loan: a repayment of a reduced-basis loan can trigger gain because the shareholder receives full repayment against a basis lower than face. Worked example: A $30,000 shareholder loan was reduced to $18,000 of debt basis by prior losses.
If the corporation repays the full $30,000 while debt basis is still $18,000, the shareholder recognizes $12,000 of income (capital or ordinary depending on whether the loan is evidenced by a note). TCP simulations test this ordering precisely.
Distribution rules
For an S corporation with no accumulated E&P, a nonliquidating cash distribution reduces stock basis first; any excess over stock basis is capital gain. Debt basis is never reduced by a distribution.
With accumulated E&P from prior C years, ordering follows: tax-free to the extent of the accumulated adjustments account (AAA), then dividend to the extent of accumulated E&P, then basis recovery, then capital gain. A planning question may ask whether to make an election to bypass AAA and distribute E&P first — useful to purge old E&P that could otherwise trigger the passive-investment-income sting tax or termination.
Built-in gains tax (Section 1374)
When a C corporation converts to an S corporation, Section 1374 imposes a flat 21% corporate-level tax on net recognized built-in gain during the 5-year recognition period (beginning the first day of the first S year), capped at the net unrealized built-in gain (NUBIG) measured at conversion. Worked example: NUBIG at conversion is $300,000; in year 2 the company sells an asset recognizing $120,000 of built-in gain. BIG tax = 21% × $120,000 = $25,200, and that tax also reduces the gain that passes through to shareholders. Planning: defer asset sales until after the 5-year window.
Ordering of basis adjustments
The sequence of stock-basis adjustments is itself a frequent TBS trap. The default order is: (1) increase for income items, (2) decrease for distributions, then (3) decrease for nondeductible expenses and losses. Distributions are tested before losses, so a shareholder may have enough basis to make a distribution tax-free yet still suspend a loss. A shareholder may elect to reverse items (2) and (3), but absent that election, post the distribution first. Worked example: Beginning stock basis $20,000, passthrough income $5,000, distribution $18,000, ordinary loss $12,000.
After income ($25,000) and the distribution ($7,000), only $7,000 of the $12,000 loss is allowed; $5,000 carries forward.
Ownership changes
When a shareholder sells stock mid-year, income is allocated per-share, per-day by default; the parties may elect a closing-of-the-books allocation, which assigns income to the actual period it arose. The closing-of-the-books method usually helps when income is lumpy — for example, a large gain recognized after the buyer arrives should be allocated to the post-sale period, not spread evenly across the year. Read which method the facts require, and watch for a terminating election: if the corporation revokes or loses S status mid-year, the year splits into a short S year and a short C year.
Exam checklist
- Confirm S eligibility (100 shareholders, one class, eligible owners).
- Build stock basis before debt basis.
- Never create debt basis from a guarantee alone.
- Apply losses through basis, at-risk, then passive.
- Watch AAA, accumulated E&P, BIG tax, and ownership changes.
An S corporation shareholder guarantees a bank loan made to the corporation but makes no payment on the guarantee. The shareholder wants to use the guaranteed debt to deduct a passthrough loss. What is the best TCP answer?
A former C corporation elects S status with a net unrealized built-in gain of $300,000. In year 2 of the S period it sells an asset, recognizing $120,000 of built-in gain. What is the built-in gains tax?