Jennifer L Davis, EA, ATA, ATP
Davis & Associates, Accountants, Inc
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Office Phone: 804-425-5523
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Email:
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Website: www.DavisAccountants.com
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Admin@davisaccountants.com
Jamie Drake: jdrake@davisaccountants.com
Vanessa Evans: vevans@davisaccountants.com
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The IRS is auditing basis !
When we acquire a S Corp new client we call the
previous accountant for an interview.
We interview the client
We ask for copies of every 1120S filed historically for
the company
We manually figure our Stock and Loan basis
Bad News: You REALLY need to complete a the 1120S
Balance Sheet, even if not “required” by IRS.
We have a paperless office – We keep our Stock and
Loan basis justification “forever”.
We REQUIRE quarterly meetings.
Our Website has downloadable mileage logs and
expense reports
Adjusted Basis at beginning of the year
 Plus share of all income separately stated (including tax
exempt )
 Plus share of deduction for excess depletion of oil and gas
properties
 LESS distribution of cash or property not included in wages
 LESS share of all loss and deduction items separately
stated ( Capital Loss and Section 179 )
 LESS share of all non-separately stated losses
 LESS share of all non-deductible expenses ( meals,
entertainment, non-deductible fines and penalties )
 LESS share of depletion for oil and gas properties not in
excess of properties basis.
= Adjusted Shareholder Stock Basis Year End.
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VERY important to track Shareholder Loan
Basis.
Loans can be short or long term.
Most common type is Shareholder that pays
business expenses on a personal credit card,
submits ( with expense report ) the expenses,
but does not repay him/herself immediately.
A shareholder with positive shareholder loan
basis may take losses in excess of stock basis
but only to the extent that they have positive
loan basis.
Initial Amount Loaned to Company
PLUS additional amounts loaned
PLUS deferred interest that is being capitalized
(added to the loan) instead of being repaid
LESS loan principal repaid
LESS loan principal forgiven by Shareholder
LESS loan principal converted to stock
LESS share of net loss in excess of shareholder’s
adjusted stock basis
=Adjusted basis in S Corporation Debt at year end.
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Valid loans are documented.
◦ Without proper documentation
 IRS problems during an audit
 Loan repayments can become taxable
 Difficulties during loan renewal processes
 Trend is toward banks asking to review all loan documents
◦ Promissory notes
◦ Attorney compiled loan documents
 Demand Notes
 Terms of Payment
 If company shows profit every effort to repay loans should be proven
 Reasonable Rate of Return ( Interest ) on loans more than
$10,000
 Can be compiled annually
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Non-dividend distributions can be taken from current
year earnings or retained earnings.
Maximum non-taxable distribution each year would
be current year earnings plus retained earnings.
When this non-taxable maximum is exceeded a Loan
to Shareholder exists or possible Capital Gain
This loan to shareholder can be cleared in two ways:
◦ Shareholder makes direct payments into the company to
clear this balance
◦ If there is sufficient net income the following year many
Accountants clear the Loan to Shareholder account
immediately.
When dealing with Cash or Cash Equivalents it
is best to book distributions and
contributions to Loan Basis and prepare Loan
Documents at the end of each year.
Remember on loans of more than $10,000
there needs to be stated interest and
repayment schedules
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Loans MUST be stated, there MUST be loan
interest, and a repayment schedule must be
outlined.
Fact of Life: One shareholder will have a
higher loan balance, will receive more
interest, and will have 100% of the interest
income on their 1040 but only a percentage
of the interest deduction on their K-1.
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When dealing with a multi-shareholder S Corp is
it best to book cash / cash equivalents flowing in
and out of the company as Loans to / from
Shareholder or Capital Contributions OR
Additional Paid In Capital ????
◦ Capital Contributions can cause disproportionate
shareholder ownership and can jeopardize S Corp Status
◦ Distributions in excess of Loan Basis / Stock Basis can
result in a taxable event.
◦ Payment of loan interest to a shareholder will result in
the shareholder paying 100% of the tax on the interest
but only receiving a portion of the interest write-off on
their K-1
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The Rules for Negative Basis are :
◦ Shareholder Stock Basis is reduced, but not below
zero
◦ After that, Shareholder Loan Basis is reduced but
not below zero.
◦ Finally, any further “excess losses” are called
negative basis and are suspended indefinitely to be
used in future years after loan / stock basis has
been restored.
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Does health insurance paid by a SCorporation on behalf of a more than 2%
Shareholder decrease the shareholder basis?
Additional Note: In this case the health
insurance was NOT added to W-2 box 1.
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If Health Insurance is paid by a S Corporation
for a more than 2% shareholder the amount
paid should be listed on the K-1 on line 12S
(other deductions), reduces shareholder
basis, and flows to Schedule A.
Options: Include in W-2 box 1 and box 16.
Deducted by S Corp and included on 1040
page 1.
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Joe Smith, Mike Adams, and Harry Harris each
contribute $ 10,000 to the start up of a S Corporation
with the understanding that net income/expenses will
be divided, for tax purposes, in the following way:
Smith:
Adams:
Harris:
20%
30%
50%
They have agreed on this division of net income by way
of determining which partners will spend more time
actively participating in the business.
In accordance with IRC can Adams, Smith, and Harris
divide net income / losses in this way ?
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No. IRC is very clear that shareholders of S
corporations must divide the corporations net
income / losses in strict proportion to their share
of ownership. If a shareholder contributes
EXACTLY one-third of the company’s capital then
one-third of the net profit / loss must be
allocated to the shareholder via K-1.
Option 1: Adjust Reasonable
Compensation/Bonus to accommodate such
differences.
Option 2: LLC’s allow for unequal division of net
income / loss through By-Laws.
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Jillie Hillie and Millie Willie start a S
Corporation. Ms. Hillie contributes $10,000
cash. Ms. Willie contributes $5,000 cash plus
a laptop, printer, desk, chair, and reference
books that she purchased in 2008 for
$5,000. Are Ms. Hillie and Ms. Willie now
equal shareholders in the S Corporation ?
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No. The value of Shareholder donated
property is the LOWER of
a. The Fair Market Value of the property
b. The Shareholders Adjusted Basis in the
property
Be sure to keep detailed working papers showing
exactly how you arrived at Fair Market Value or
Adjusted Basis.
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“We converted our Sole Proprietorship to a S
Corporation. Now I have the task of moving
our business assets from one entity to
another. I believe that most of our business
property was fully depreciated under Section
179. Fair Market Value is $32,000 and
original purchase price was $ 47,000. We are
not adding any cash to the company – just
these assets. What is my Shareholder Basis?”
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Shareholder basis is ZERO.
Purchase Price + Improvements + Purchase Costs + Selling
Costs – Accumulated Depreciation = $0
Note 1: A common mistake that I find on 1120S returns is
that the Balance Sheet contains no “Capital Stock”. There
must be an amount in Capital Stock. We generally allocate
at least $100.
Note 2: Contributions of non-cash items from
Shareholders to S Corporations should NOT be shown on
the Balance Sheet as Loans From Shareholders. Rather,
they should be shown as “Additional Paid in Capital”.
◦ This is the correct procedure
◦ AND prevents your S Corporation from being too “thinly”
capitalized.
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In 2006, Suzie Smith, single shareholder of
Block Corp, (a S Corp), placed property into
Block Corp and used her Adjusted Basis in the
property to increase her LOAN Basis in Block
Corp. In 2008 she withdrew the property for
personal use. Can Suzie use the withdrawal
of this property to reduce her Loan Basis and
what would the valuation method be ?
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No. Loans can only be CASH or cash
equivalents. When property is contributed it
becomes Additional Paid in Capital.
When the property is removed it is valued at
FMV and should be shown as an asset sale.
Tax Planning Tip: Think twice before putting
appreciable property in a S Corp.
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Does Tax-Exempt income affect Shareholder
Stock basis ?
◦ Increase?
◦ Decrease?
◦ Stay the same?
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Does Tax-Exempt income affect Shareholder
Stock basis ?
◦ Increase?
◦ Decrease?
◦ Stay the same?
Tax Exempt Income increases the adjusted basis of
Shareholder Stock.
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In “Restoring Basis” to a S-Corporation which
is restored first ?
◦ Loan Basis
◦ Stock Basis
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In “Restoring Basis” to a S-Corporation which
is restored first ?
◦ Loan Basis
◦ Stock Basis
Loan Basis must be restored before Stock Basis can
be.
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Additional Cash Investments
Advance additional Cash Loans
Donate Property with a Fair Market Value AND
a positive Adjusted Basis
◦ Not a good idea to donate appreciable property
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At what point do non-deductible expenses
reduce shareholder basis ?
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a.
b.
c.
d.
After Loan Basis
Between Stock Basis and Loan Basis
Before Stock Basis AND Loan Basis
After Loss and Deduction Items
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C. Before Stock Basis AND Loan Basis.
Non-Deductible items reduce shareholder
basis before loss and deductions items,
before loan basis and before stock basis. If
these non-deductible expenses exceed basis
they do not get carried forward.
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Shareholder Risk is calculated as:
 Adjusted Stock Basis PLUS Adjusted Loan Basis
 Any loss in excess of the formula above is a
Suspended Loss and follows the rules for Suspended
Losses.
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True or False ? A shareholder Personal Loan
Guarantee is sufficient to increase
Shareholder Loan Basis.
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False.
A mere personal guarantee is not enough to
increase Loan Basis.
Further, part or all of the repayment of a
reduced Loan Basis is taxable to the
Shareholder.
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Shareholders X and Y have formed Rental
Property, Inc a Sub Chapter S Corporation.
Neither shareholders qualify as “active
participation real estate professionals” but
heard that if they formed a Sub Chapter S
Corporation they would be able to deduct
their full rental losses each year regardless of
basis, and in excess of $25,000. Is this
correct ?
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Shareholders of S Corporations with rental
property are subject to the same passive activity
loss limitations that all other entities are subject
to.
Real Estate Professional rules follow individuals
and not entities.
Passive activity income/loss for S Corps includes
income/loss from partnerships, trusts, interest,
dividends, and other investments including rental
properties.
◦ This has impacted several of my clients that have
partnership share in Title Companies or Law Firms.
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Is a non-dividend distribution in excess of
stock and loan basis taxed to the shareholder
as ordinary income ?
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Is a non-dividend distribution in excess of
stock and loan basis taxed to the shareholder
as ordinary income ?
No. Non-dividend distributions in excess of
stock and loan basis are taxed as capital
gains. Generally Long Term Capital Gains.
To determine holding period review past
years adjusted stock basis and adjusted loan
basis to determine holding period.
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If shareholder stock is sold, suspended losses
due to basis limitations are LOST ! The sales
price DOES NOT have an impact on the stock
basis. A stock basis computation should be
reviewed in the year that stock is sold or
disposed of.
This is an important planning tip for those of
us with shareholders looking to dispose of, or
sell, a business.
True or False:
If the current year has different types of losses
and deductions, which exceed stock and loan
basis, the allowable losses and deductions
must be allocated pro rata based on the size
of the particular loss and deduction items.
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True.
For more information on how to allocate see
www.irs.gov “S Corporation Stock and Debt
Basis”
True or False ?
In determining current year allowable losses,
current year allowable loss and deduction
items are combined with suspended losses
and deductions carried over from one prior
year, and this prior year and current year
losses are lumped together on Form 5256, or
other appropriate schedule.
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False ! Current year losses and deductions are
combined with ALL suspended losses and
deductions from ALL previous years. These
suspended losses retain their character. They
need to be separately stated on Schedule E or
other acceptable schedule.
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Shareholder A uses their BUSINESS credit card
for personal expenses. They have no
intention of reimbursing the company for the
personal expenditures. Which is the proper
way to account for these personal expenses:
A. Classification of the expenses as a Loan To
Shareholder
B. Classify as a distribution that reduces Loan Basis
until Loan Basis reaches ZERO and then classify as
non-dividend distributions.
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B . Classify these personal expenses as a
distribution thus effectively reducing loan
basis. Once loan basis reaches ZERO the
shareholder would need to show these
personal expenses as Non-Dividend
Distributions.
◦ Possible Problem: If both Stock and Loan Basis are
reduced to zero the excess would be a taxable
distribution as a capital gain.
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Can personal credit cards used by an S
Corporation shareholder for business
expenses be treated as a loan from
Shareholder thus creating loan basis that will
allow the shareholder to deduct losses?
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Yes
According to Rev Rul 81-187 shareholder
must experience economic outlay
Credit card in the name of the shareholder
alone
Payments are made BY the shareholder (NOT
Corporation )
Repayment by the corporation reduces loan
basis
Again,a mere personal guarantee does not
increase loan basis.
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At year end Xylophone Company showed
non-dividend distributions in excess of
Accumulated Adjustments Account by
$2,338. In accordance with Reg 1.13682(a)(4)(iii) how does this negative AAA
balance need to be accounted for ?
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A.
B.
C.
D.
AAA can show a negative amount
$2,338 in Ordinary Income
$2,338 reclassified as Loan to Shareholder
$2,338 Shareholder Capital Gain
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BOTH C and D are correct !
AAA can not show a negative amount. You can
either:
Show the excess as a Capital Gain
or
Show the excess as a Loan to Shareholder.
In LTS there must be some intention of the
shareholder to repay the loan.