At a very basic level, the cost basis is the cost of your small business. The basis calculation consists of your financial contributions to the company plus ordinary income and losses minus distributions (like dividends and other payouts).
The cost basis is most often calculated using the First In, First Out, or FIFO method. That means it’s assumed that the first units acquired are the first ones sold. So you’ll use the original cost (aka original purchase price) of the unit, which makes it important to assign specific costs to each unit based on the order of acquisition.
The cost basis formula looks like this:
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. Additionally, businesses can choose alternative cost-basis methods to determine gains and losses, such as the average cost method.
Why is cost basis important? How does the basis affect my business and me?
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 fair market value of your business, its common stock, 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. For example, short-term investments (assets held less than one year) are taxed as capital gains.
What’s the difference between cost basis and tax basis?
Cost basis usually refers to the original cost of an asset, such as the original cost of specific shares, real estate, and other investments. For tax purposes, it’s used to calculate the short or long-term capital gains or losses when the asset is sold.
Tax basis, on the other hand, includes adjustments for the asset’s depreciation, capital improvements, and other factors. In other words, it’s the adjusted cost basis of the asset. It affects the amount that’s taxed, which can affect tax rates and have other tax implications for the current year in which the asset is sold.
Basis for S corporations
You should establish a couple of key factors for S corp owners when determining a basis. The first is ordering 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 the basis by distributions. This part is important because you can’t reduce the basis below zero.
Next, subtract out non-deductible expenses. After this, subtract out ordinary losses and deductions, which, again, cannot cause the basis go below zero.
Sounds confusing? Let’s look at this example:
Let’s say Sally is the sole shareholder of Sally’s Cupcakes, an S corporation.
In 2022:
- Sally contributed $5,000 in cash to the business
- The business had an ordinary income of $15,000
- The business had non-deductible expenses of $1,000
- Sally made a distribution to herself for $3,000
In 2022 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 2022
In 2023:
- 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 2023
We didn’t subtract the full ordinary loss amount of $12,000 because the basis cannot be less than zero.
The $2,000 of ordinary loss in excess of the basis will get suspended, which brings us to the next consideration.
The next consideration (regarding the basis for S corp shareholders) is distributions and losses in excess of basis (when you have a calculation below zero).
In the example above, in 2023, Sally had $2,000 of losses in excess of basis. This means 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 2022, the basis was calculated as $16,000.
This time, let’s say that in 2023, Sally will take 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 also need to be suspended. Therefore, it is important to understand your basis before making distributions so you don’t cause yourself a taxable event without realizing it.
Basis for partnerships
Regarding the 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, the 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 corp 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 shareholders sell their stock, they subtract their original investment from the sale price to determine the gain or loss.
The impact of debt on the basis
For both partners in the partnership and S corp owners, debt in the business can impact an owner’s basis.
For partnerships
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 tax year, and Jim and Jane’s basis was $2,000 each at the beginning of the year. Without debt basis added, both Jim and Jane would only be able to take losses of $2,000 and would each need to suspend losses of $3,000 each. If the partnership had a debt of $6,000, Jim and Jane could take those losses instead of suspending them due to the debt basis allocated.
For S corps
For S corps, the Internal Revenue Service’s (IRS’s) 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 the basis for S corp owners.
Other cost basis examples
While most stock transactions are simple, there are some scenarios that make things a little more complicated. Let’s review those.
Mergers
When a business has a merger, the merging company decides the new number of shares and thus the market value of each share, necessitating an adjustment to the initial cost basis.
An all-cash merger is akin to selling all shares, and the gain or loss is computed using the original cost basis. In cash-to-boot settlements, any fractional share from the exchange ratio prompts a cash payment for that fraction.
Stock splits
During stock splits, the overall investment remains unchanged. The existing cost basis is distributed among the increased number of shares. For instance, in a 2-for-1 split, the cost basis for each share is reduced by half. So the total cost of all shares doesn’t change during a stock split, but the price for shares of stock does change.
Bankruptcies
In Chapter 7 bankruptcy, a business’s shares become worthless, and a loss can only be recognized when the stock is sold (often for a minimal amount) or declared as worthless. In Chapter 11, the shares may still be tradable, and the cost basis might remain unaffected, contingent on the settlement terms.
Basis best practices
It’s important to calculate the owner’s basis each year. Failure to do so could result in tax liability from excess distributions or taking losses you were not allowed to take. Also, when you sell your ownership stake in the S corp or partnership, you’ll need your basis to calculate the taxable gains or losses.
Therefore, keeping track of the basis and understanding how it’s calculated is especially important for S corp owners and partners in a partnership. Now, grab that calculator. Or find an accountant for your business—working with a tax professional (such as a CPA or tax advisor) can help you evaluate tax advice to ensure you understand the specific tax consequences for your business while getting tax reporting right.