Have you ever heard of the term “basis” as it relates to S Corporation stock ownership? If you’re not familiar with the term, you should be, especially as it relates to potentially deducting your share of losses allocated to you by an S Corporation.
Let me give you a common scenario when a new business is formed, and an S Corporation election is made:
- New business started up 1/1/17
- Business borrows $100,000 from the bank to buy equipment, furniture, etc.
- Owners do NOT contribute money personally to the business
- Business shows $50,000 loss (on paper) due to accelerated depreciation (write offs)
How much of the $50,000 loss described above can the shareholders deduct? Answer… ZERO!!
Why? S Corporation losses are limited to your BASIS. There’s that word again. What is basis? Basis is the cumulative amount of income (or losses) less distributions plus capital contributed.
In the example above, the shareholders borrowed money from the bank (i.e. didn’t contribute personally) and proceeded to lose $50,000 for the year. Their basis at the end of the year is ZERO and NONE of the losses are allowed. Essentially, based on tax law, the government is saying that YOU (Mr. Shareholder) haven’t lost anything. You borrowed the money.
Let’s change the scenario a bit and say that the shareholders contributed $100,000 instead of borrowing the $100,000. The $100,000 of capital contributed gives the shareholders BASIS. Now the losses become deductible because the shareholders have, in effect, lost something. They’ve depleted (by way of losing money) their capital so to speak.
The moral of the story is this: Be careful when you borrow money in an S Corporation especially in the start-up years. You may be banking on tax losses that aren’t available to you.
A better way to organize your business (from the start-up phase) might be as an LLC that is taxed as a partnership. Partnerships can deduct losses (related to borrowed money) because partnership basis (as opposed to S Corporation basis) IS increased by debt if the partners personally guarantee the debt. The losses described above would have been deductible in a partnership assuming the partners guaranteed the $100,000 debt.
Above said, this is the reason you should consult with a tax adviser BEFORE organizing your business. I’d love to help you avoid this trap!