Basis, Limitation of Losses and Additional Tax Exposure – Belk on Business – Episode 190

There are a number of ways that one can look at a company’s balance sheet and determine the health of the business and financial discipline of the business owner. One way is to look at the shareholder’s basis in the company, handling of debt and it’s methods or process of making distributions.

Most small businesses owners run their business checkbook like their personal checkbook. Not only can this be detrimental to the financial health of the company but also can create unexpected tax issues (and asset protection issues). Also, the shareholder needs to be aware for tax planning purposes when they can recognize losses and when they can take distributions without an additional tax exposure.

Basis in an entity (tax implications for this podcast will be primarily focused on an entity taxed as an S Corp) is a number that you must track. There are two types of basis, stock basis and debt basis.

Stock basis is calculated as follows:

Cash and property contributed

Plus/minus: Net income/loss

Minus : distributions

There is no such thing as sweat equity. The stock must be purchased via cash or property contribution. To create basis for someone who worked to earn shares, they should receive compensation then purchase the shares to establish basis.

Debt basis consists primarily of either loans by the shareholder or payments on company loans by the shareholder.

If you have a negative stock basis, there will be a limitation on losses and if any distributions were taken in excess of basis will be taxed as ordinary income. You could end up in a situation where you can’t recognize the losses and distributions taxed as ordinary income.

Loans must be bona fide loans which among other things, must include the following:

- expectation of payment

- Loan terms (loan amount, payment amount, interest rate, maturity date)

- Remedies for default

- The loan must be truly intended to be a loan

- Whether shareholder is subordinate to general creditors

- Enforcement by the lender (shareholder)

If a shareholder makes a payment on a company loan, it increases the shareholder’s debt basis. Simply being a guarantor on a loan does not generate debt basis.

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