Understanding the Basics of Basis in Business Taxes
Nov 1, 2024
So your business lost money this year. That’s a bummer, but at least you can deduct the loss on your taxes, right? Not so fast, your accountant tells you. You don’t have enough basis to deduct the loss.
Basis? What’s that? If you’re confused, you’re not alone. When it comes to business taxes, the simple concept of basis is one of those tricky tax rules that often trips business owners up. So let’s break it down in simple terms and get you up to speed on how basis works, what impacts your basis, and why you need to keep an eye on it to avoid surprises down the road.
What is basis?
In the simplest terms, basis is the amount of your investment in your business for tax purposes. It determines things like how much loss you can deduct and whether distributions (money you take out of your company) are taxable.
As you contribute to or withdraw from the business, your basis goes up and down like the balance on your bank account.
What increases and decreases basis?
Your basis isn’t a static number. It changes over time based on your business activities and transactions.
Here’s how it works:
- Increases in basis occur when you put more money into your business, such as through your initial investment and additional capital contributions, or when the company earns income.
- Decreases in basis happen when you take money out of the business (distributions) or the company incurs losses.
So, if you’re running a profitable business and reinvesting, your basis goes up. Your basis goes down when you pull money out or have a net loss.
Example: calculating basis for s corporation
Let’s go through a simple example to show how to calculate the basis for an S corporation shareholder.
Step 1: Initial capital contribution
Say you start your S corporation by contributing $50,000 in cash. This $50,000 becomes your initial basis in the business.
- Initial basis: $50,000
Step 2: Contributing property to the company
Next, you contribute a piece of equipment to the company. The fair market value of the equipment is $30,000, but it comes with a $15,000 equipment loan that the company assumes.
- New basis: $50,000 + ($30,000 – $15,000) = $65,000
Step 3: The business earns income
Over the course of your first year in business, the S corporation earns $40,000 in ordinary income. Since S corporations are pass-through entities, that income passes through to you and increases your stock basis.
- New basis: $65,000 + $40,000 = $105,000
Step 4: Distributions
Now, let’s say you decide to take a $20,000 distribution from the business. S corporation distributions reduce your basis, but they’re generally not taxable unless they exceed your basis.
- New basis: $105,000 – $20,000 = $95,000
At the end of the year, your S corporation basis is $95,000.
Deducting losses to the extent of basis on business taxes
Here’s where basis becomes super important: you can only deduct business losses up to your basis. If you’re thinking, “Wait, I thought I could deduct all my losses,” it’s not that simple.
Let’s say you have a basis of $50,000 in your business and the business suffers a $60,000 loss. You can only deduct $50,000 of that loss in the current year because that’s your basis. The remaining $10,000 has to wait until you either increase your basis or carry the loss forward to future years.
This is why keeping track of your basis is critical—especially if your business is losing money. You don’t want to get hit with losses that you can’t deduct simply because you weren’t aware of your basis limitation.
Debt basis: S Corporation vs. Partnership
Now, if your business is an S-corporation or a partnership, you have another layer of complexity—debt basis.
S Corporation basis includes loans the shareholder personally guarantees or lends directly to the business. This debt basis allows you to deduct losses to the extent of the debt. But, if you don’t have debt basis or it runs out, you’re stuck with losses you can’t deduct until you build it back up.
For partnerships, it’s a little different. Partners get to include their share of the partnership’s debt in their basis. This means they can deduct losses based on the amount of debt on the partnership’s books. This feature provides a little more flexibility compared to S-corporations.
The key takeaway? How you calculate shareholder basis differs depending on how you structure your business. That’s why it’s important to work with an advisor who understands stock and debt basis for pass-through entities.
What about C corporation shareholder basis?
C corporation shareholders generally don’t have to be as concerned about basis. That’s because stock basis for a C corporation shareholder equals what they paid for the stock. If the company earns revenue and invests is back into the business, the C corporation shareholder’s basis is the same as when they first invested, minus any non-dividend distributions they receive from the corporation.
It doesn’t change from year to year like S corporation and partnership basis does.
Are you monitoring your basis?
Monitoring your basis isn’t just a “nice-to-do” thing—it’s essential. If you’re running losses or financing your business with debt, tracking your basis could save you from an IRS audit or an unexpected tax bill.
Imagine you’re in the startup phase of your business. You’re reinvesting revenue into the business, focused on building your client base.
You’re been running at a loss for a couple of years, but you’re not worried about it as you know it’s an investment in future growth. As the owner of a pass-through business, you think you can deduct those losses to offset other income on your individual tax return.
However, when you file your return, you find out your basis is zero or negative—meaning no deduction for you! Worse still, you took distributions in excess of your basis. What you thought was tax-exempt income is actually taxed as capital gains on your personal tax return.
Staying on top of your basis calculation is important as it can help you avoid:
- Losses you can’t deduct
- Unintended taxable income
It’s usually pretty easy to calculate and update basis at the end of each taxable year. However, if you overlook basis calculations for several years and then need to catch up on several years’ worth of calculations, it can be a big, messy headache.
So, do yourself a favor and keep an eye on your basis (or worth with a tax advisor who will keep an eye on it for you)—especially if you’re debt-financed or dealing with losses. Trust me, your future self will thank you!
Need more help with your business’ basis?
Basis may not be the most exciting part of business taxes (we get it, it’s no thrill ride), but it’s definitely something you want to pay attention to. By understanding how your basis changes, keeping track of losses and distributions, and knowing the rules around debt basis for your business type, you can avoid unpleasant surprises when tax season rolls around. If you’d like help monitoring your company’s basis, please reach out, we’d love to help.
Now that you’ve got the basics down, your next step is simple: keep tabs on your basis!