How is shareholder basis calculated and why is it important?
The calculation starts on the first day of the S Corp and adjusts year after year until the S Corp no longer exists. Net taxable income plus shareholder contribution increase basis while net income losses and distribution decrease basis. Knowing your shareholder basis will help determine the cash value you can take in the form of distributions from your business and treat it as a return on capital.
We typically recommend that you keep at least one to two months' worth of revenue in your business bank account at all times to avoid accidentally incurring additional tax liabilities.
And the fat one:
Cash value: can depend on many factors and the actual dollar amount will fluctuate throughout the life of the business. Examples of activities that increase your basis are net taxable income (gross receipts minus qualified expenses), contributions to the business by its shareholder, and retained earnings are three of the common types.
Gross receipts: probably the easiest definition in this article as it is the total revenue generated from your business activity before taking into account expenses.
Qualified expense: can vary and the list could on and on and on and on and on... and well you get the point. These expenses are costs that the business is eligible to deduct to reduce taxable income on the business tax return. The most common example of NON-qualified business expenses would be charitable contributions, income tax paid, and penalties.
Shareholder contributions: These are assets (typically cash) that a shareholder is handing the right to ownership to the business and is left in the business to be used solely at the business's discretion. Retained earnings: oh yeah that thing, that was said what now feels like a while ago is the financial timeline of the business from the start to end of business that accumulates net income/loss minus distributions into one number.
Two common examples of activities that decrease your basis are distributions and reporting a loss for the business.
Distributions: are the complete opposite of shareholder contributions. These are assets (typically cash) that are taken out of the business for personal use or expenses that are not business related. Distributions are not taxable assuming that you have enough shareholder basis. So you may be wondering "How do I know if I have enough basis? Or how much can as distributions?". The short answer is that at Collective we track it for you but I promise to show you some examples shortly, stay tuned.
So why is reporting a loss for the business decreasing basis? Assuming that you have enough shareholder basis (there he goes again with that shareholder basis) then if your business is reporting a loss, you can report the loss on your individual tax returns and it would help reduce your taxable income from other sources.
Tracking shareholder basis is very important when you are an owner of an S Corp because if your basis becomes a negative value then any amount that is negative will be double taxed at capital gain rates.
"Well, that escalated quickly didn't it? Did it turn up a notch? That quickly got out of hand?" There is one definition left that we left stranded since mentioned way back when, in the first paragraph which is return on capital. Return on capital, in this context, is the asset (typically cash) you receive as an individual from the business up to your shareholder basis amount. As long as your distributions are treated as a return on capital then the distributions are not taxable. Yes, you read that right, the distributions are not taxable.
You've made it this far through the article and you may have the same question as Steve Urcle "Did I do that?", when it comes to taking distributions in excess of basis. The quick smell test to see what's your shareholder basis is to log in to your QBO account and then go to reports, then balance sheet, then change the date range to today, the accounting method to cash, then select "run report". Once the report has been generated, scroll down to the line item that says "total equity" and if that number is positive then generally speaking you are in the clear but if that number is negative then we need to talk.
If you're like me then you are a numbers person and thus far I've only given you definitions. I'm not Webster so click here to access our deck on a shareholder basis which will provide examples of how it gets calculated. I promise that we will only use addition and subtraction with your occasional multiplication. I mean we are not the theoretical mathematician here.
The goal of the article and deck is not to make you experts in the topic of shareholder basis. Instead, we just want you to be aware of its existence as we may base some of our recommendations solely on your shareholder basis value. If you have any questions (or at least once you have compiled all of the questions, as I'm sure this article raises more questions than answers) please send us an email at [email protected] and we would be happy to assist.
Disclaimer: The information contained in this document is provided for informational purposes only and should not be construed as financial or tax advice. It is not intended to be a substitute for obtaining accounting or other financial advice from an appropriate financial adviser or for the purpose of avoiding U.S. Federal, state or local tax payments and penalties.