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S-Corp Basis - Saving Countless Hours of Explanation During Tax Season

Posted 11/8/2019

BASIS IN STOCK

Stock Basis (especially for S-Corp) has been a big deal for many taxpayers, especially in light of the Schedule E changes in 2018.  The point of basis calculation is to limit losses to the amount of investment in the S-Corp.  For example $100 paid for stock should never have deductions or tax free distributions greater than $100 unless there is a profit to distribute.  A question I get many, many times, “if we had a sole proprietorship or a partnership would we get the loss?” and the answer is usually yes. 

WHY CORPORATE LOANS DON"T COUNT

A sole proprietor and the individual are considered one.  When the sole proprietor takes a business loan, they are personally responsible for the debt.  When the corporation borrows money, the debtor is the corporation, not the shareholder.  Even when the shareholder co-signs, they are not responsible until default.  Without default, there is no basis in the stock.  Think of it this way:  A shareholder has $100,000 gain in Ford Motor Company.  Can the shareholder simply co-sign a loan for Ford for $100,000 and avoid paying taxes on the gain?  After all, Ford is very unlikely to default on such loan.  When the loan is paid off the shareholder is free of obligation and tax?  It makes absolutely no sense to allow a co-signer to count the loan as basis until they become personally liable, otherwise no investor ever would have a gain on a stock sale. 

NOTE: If a shareholder wants to take a personal loan, contribute it to the capital account of the S-Corp and payoff the loan personally, you would have basis.  Understand that if the S-Corp makes the loan payments, you have a distribution that could be taxable.  As a side note, it is very important to understand a corporation is a separate legal entity and the accounting needs to be absolutely separate in all aspects.  Personal and business affairs must be separate, not just bank accounts, but asset titles, loan documents and any other aspect of the business.  Too often vehicles are said to belong to corporations yet the titles say otherwise, same for deeds to property and loans at a bank.  If the item is not titled solely to the corporation, it should not be on the corporate books. 

UNDERLYING SYSTEMIC PROBLEM

In an S-Corp, when the owner takes more out of the business than it can support, it becomes the tax accountant’s job to stop it (or tax it) through basis limitation rules.  In a sole proprietor and partnership it becomes the banker’s job to stop it with a foreclosure notice.  In the end, the path is the same.  Any successful business, regardless of structure, should always pursue profit and retain enough funds necessary for operational needs, asset replacement and/or expansion.  When properly managed, there should not be a basis issue.  A healthy balance sheet is often said to have less than 50% of the assets financed, A/K/A the Debt to Asset Ratio.  Financial advisers might consider this an early warning and a potential benefit of an S-Corp, not a disadvantage.   

WHY THE S-CORP IN THE FIRST PLACE

One benefit of an S-Corp is setting the owners wages below the profit level and the excess amount saves Social Security and Medicare tax when compared to a sole proprietor.  The wages need to be “reasonable” and the excess (if any) can be distributed via a dividend.  Technically there are no available dividends if there is no profit.  If the wages create a loss, then the owner has over paid taxes and created something I call “Phantom Income”.  This should be avoided in the S-Corp structure.  The IRS position is that an S-Corp should not be structured solely for tax benefits, but for “business reasons”.  What is a “business reason”?  That would be separation of liability from the shareholders assets, which I will leave to the attorneys to explain.  This separation of liability benefit is also the reason corporate debt doesn't increase shareholder basis.  They really are trade offs or different sides of the same coin.

So, when COULD an S-Corp be appropriate? 

1) When a business is pursuing profit
2) When the profit exceeds a “reasonable amount” for the owner’s wages 
3) When debt utilization is maintained at a reasonable level (like 50% of assets) 
4) Profit is retained for future needs
5) There is a good business reason (usually liability separation).  
These are only a few of many considerations.

YOUR ADVISER DID NOT FAIL YOU

If someone said they are going to have losses for many years and will be heavily leveraged by banks, then a different structure would be in order.  It is rare that anyone goes into a business with the intention of losing money for years and using bank loans to sustain themselves.  In over 30 years of being involved in finance, I can say that I don't recall anyone ever telling me they are committing 100% of their future and their family's future to a business that will lose money.  They usually have very high expectations of profits, they usually like the idea of separating liabilities (especially product liability and employee disputes), usually favor saving payroll taxes and sometimes they like the idea of being eligible for Unemployment Benefits when they have no work.     

It is not the banker's job to tell you when your business is poorly managed.  I don't think it's the tax accountants job unless the taxpayer ask for such analysis, but when it limits the deductions on the tax return the elephant in the room must be addressed.