What is Basis? How Do I Calculate It?
At a very basic level, basis is the cost of your business. The calculation of basis consists of your financial contributions into the company plus ordinary income and losses minus distributions (like dividends and other payouts).
|Your financial contributions to your business + your income/losses – distributions (like dividends) = BASIS|
While that calculation is pretty simple, calculating basis may get more complicated in certain scenarios, because there are different rules for different legal entity types and the impact of debt in determining basis.
Why is basis important? How does basis affect me and my business?
As a business owner, it is important to understand and consider your basis in the ownership of the business, because basis determines the following things:
- The price of your business (or your part in the business) when you are ready to sell it
- The taxability of distributions (this means how dividends and other payouts are taxed)
- The depreciation of assets in your business
While the basis is simple in concept, there is some significant nuance to understanding the implications of certain conditions in calculating basis, especially when it comes to different entity types.
Basis for S-Corporations
For S corps owners, there are a couple of key considerations, you should establish when determining a basis. The first is the ordering of income, losses, deductions, and distributions.
In the basis calculation for S corps, first add in ordinary income and separately stated income items on the K-1 statement. Then, decrease basis by distributions. This part is important because you can’t reduce the basis below zero.
Then, subtract out non-deductible expenses. After this, subtract out ordinary losses and deductions, which, again, cannot cause the basis go below zero.
Sound confusing? Let’s look at this example:
Let’s say Sally is the sole shareholder of Sally’s Cupcakes, a S corporation.
- Sally contributed $5,000 in cash into the business
- The business had ordinary income of $15,000
- The business had non-deductible expenses of $1,000
- Sally made a distribution to herself for $3,000
In 2019 the basis for Sally’s Cupcakes would be calculated and ordered as follows:
$5,000 contribution + $15,000 ordinary income – $3,000 distribution – $1,000 non-deductible expenses= basis of $16,000 in 2019
- Sally had an ordinary loss of $12,000
- The business had non-deductible expenses of $1,000
- Sally takes a distribution of $5,000
The basis would be calculated and ordered as follows:
$16,000 starting basis – $5,000 distribution – $1,000 non-deductible expenses – $10,000 of the ordinary loss (we’ll explain why the ordinary loss number appears this way below) = basis of $0 in 2020
We didn’t subtract the full ordinary loss amount of $12,000 because basis cannot be less than zero.
The $2,000 of ordinary loss in excess of basis will get suspended, which brings us to the next consideration.
The next consideration (with regards to basis for S corp shareholders) is distributions and losses in excess of basis (this is when you have a calculation that goes below zero).
In the example above, in 2020 Sally had $2,000 of losses in excess of basis. What this means is that she has to suspend that $2,000 of losses and carry them to future years until she has a basis to take that loss.
Another hypothetical scenario that is important to consider is when you have distributions in excess of basis.
Let’s use the Sally’s Cupcakes scenario from above again.
Remember that in 2019, basis was calculated as $16,000.
This time, Let’s say that in 2020, Sally takes a distribution of $19,000.
In this instance, Sally can take $16,000 of distributions to offset her starting basis, and the remaining $3,000 would become taxable to Sally as a distribution in excess of the basis.
Sally will pay capital gains tax on that $3,000 of excess distributions. Also, because those distributions brought her basis to zero, all of her losses would need to be suspended, as well. Therefore, it is important to understand what your basis is before making distributions so you don’t cause yourself a taxable event without realizing it.
Basis for Partnerships
When it comes to basis for partnerships, the same rules apply for partnerships as with S corps. What differs in partnerships, is that there are two sets of basis:
- The first, outside basis, drives taxation and follows along with the same rules as S corps.
- The other basis, inside basis (also known as the partner’s capital account), shows the equity investment in the partnership. Unlike outside basis, inside basis can be below zero if losses and distributions are in excess of the basis in the capital account.
Basis for C-Corporations
The basis determination for C corps is much simpler because C corp owners are not allocated income and losses and therefore the basis is determined by the value of the investment made into the C corp. When a shareholder sells their stock, they will subtract their original investment from the sale price to determine the gain or loss.
The impact of debt on basis
For both partners in the partnership and S corp owners, debt in the business can impact an owner’s basis.
For partners, debt can be allocated to them to increase their basis. For example, let’s say Jim and Jane’s Restaurant, a partnership owned equally by Jim and Jane, had $10,000 in ordinary losses during the year and Jim and Jane’s basis was each $2,000 at the beginning of the year. Without debt basis added, both Jim and Jane would only be able to each take losses of $2,000 and would each need to suspend losses of $3,000 each. If the partnership had debt of $6,000, Jim and Jane would be able to take those losses instead of suspending them due to the debt basis allocated.
For S Corps
For S corps, the rules are more restrictive: debt basis only occurs if the shareholder made a legitimate loan directly to the business. Other debt outside of that cannot be allocated as basis for S corp owners.
Basis best practices
It’s important to calculate the owner’s basis each year. Failure to do so could result in having tax liability from excess distributions or taking losses that you were not allowed to take. Also, when you sell your ownership stake in the S corp or partnership, you will need to know what your basis is in order to calculate the capital gains or losses. Therefore, keeping track of basis and understanding how it’s calculated is especially important for S corp owners and partners in a partnership. Now, go grab that calculator (or find an accountant for your biz).