Capital, Income, and Expenses
S-Corporations need to maintain accurate and meticulous records of income, expenses, and capital investments. Overall, the S-Corporation reports total income and expenses at the company level, and passes-through a share of net profit or loss to individual shareholders. The S-Corporation needs to maintain excellent records regarding each shareholder's investment of cash or property. These records are crucial for establishing each shareholder's percentage of ownership in the company.
Accounting for Income and Expenses
Generally, S-Corporation accounting is the same as C-Corporation accounting. Income and expenses are reported at the corporate level, and the nature of various types of income and expense are identified at the corporate level as well. S-Corporations can choose an accounting method best suited to report the income and expenses of the company. S-Corporations are not required to use the accrual method of accounting; they may choose the cash method or a hybrid method of accounting if those methods of accounting.
Income and expense items retain their character when they are passed-through to S-corporation shareholders. Long-term capital gains, for example, earned by the S-corporation are passed through as long-term capital gains to shareholders. S-Corporations therefore need to identify types of income and types of expenses for the benefit of their shareholders.
Accounting for Shareholder Capital
The biggest problem by far is accounting for the capital accounts of each and every single shareholder. The company must maintain meticulous records of each shareholder's equity investments of cash and property, as well as any loans that each shareholder advances to the company.
Unlike limited partnerships and limited liability companies, shareholders of S-corporations must divide the corporation's net income in strict proportion to their share of ownership. If a shareholder has contributed exactly one-third of the company's capital, then exactly one-third of the company's net profit or loss must be allocated to that shareholder.
The capital accounts come into play in two crucial parts of an S-Corporation's financial and tax reporting. First, the capital accounts are reported on the company's balance sheets as shareholder equity and loans from shareholders. Second, each shareholder's capital account can be summarized on Form 1120S Schedule K-1. Insufficient capital investments can cause shareholders to fail to meet the At-Risk rules for losses and can cause business losses to become non-deductible.
Investing Cash and Property
Shareholders can invest cash or property to an S-Corporation. A shareholder might contribute a computer, desk, reference books, and software programs to her newly formed S-Corporation in addition to her cash investment. The value of the shareholder's property is the lower of (a) the fair market value of the property, or (b) the shareholder's adjusted basis in the property.
(More information: Donating Property to an S-Corporation.)
Shareholder Basis, Adjusted Basis, and Loan Basis
A shareholder's capital account needs to reflect the shareholder's investments and current basis in the S-Corporation's equity or liabilities. A shareholder is invested in the S-Corporation to the extent that a shareholder has made an equity investment or advanced a loan to the company.
Shareholder's Equity is reflected in the shareholder's capital account. This account should show the dollar amount of cash investments, and value of property donated to the company. A shareholder who contributed cash of $10,000, a computer worth $2,000, and software worth $400 would have a capital account showing a total investment of $12,400.
The capital account is adjusted from time to time to reflect additional equity investments.
Additionally, the capital account is adjusted at the end of the year to reflect each shareholder's pro-rata share of income and expenses.
The adjusted basis of a shareholder's stock is calculated as follows:
- Adjusted basis at the beginning of the year
- + Share of all income items that are separately stated, including tax-exempt income
- + Share of all non-separately stated income items
- + Share of deduction for excess depletion of oil & gas properties
- - Distribution of cash or property to the shareholder that was not included in the shareholder's wages
- - Share of all loss and deduction items that are separately stated, including Section 179 deductions and capital losses
- - Share of all non-separately stated losses
- - Share of non-deductible expenses, such as the non-deductible portion of meals & entertainment expense or non-deductible fines and penalties
- - Share of depletion for oil & gas properties not in excess of the property's basis.
- = Adjusted basis in S-Corporation stock at the end of the year
Next: Accounting for Loan Basis, Negative Basis, Restoring Basis, At Risk Rules, & Passive Activity Losses.
Loan BasisShareholder may advance money to the S-Corporation as a loan. A common example is a shareholder that pays for company expenses using his personal credit card, and submits an expense report to the company for repayment. Loans to the company may be short-term loans (to be repaid in one year or less) or long-term loans (to be repaid in more than one year). Shareholder's making loans to their S-Corporation may take a tax deduction in the current year for losses in excess of their stock basis, but only to the extent they have loan basis.
Loan basis, and adjusted loan basis, is calculated as follows:
- Initial amount loaned to the company
- + Additional amounts loaned to the company
- + Deferred interest that is capitalized (added to the loan) instead being repaid
- - Amount of loan principal repaid
- - Amount of loan principal forgiven by the shareholder
- - Amount of loan principal converted to stock
- - Share of net loss in excess of shareholder's adjusted stock basis
- = Adjusted basis in S-Corporation debt at the end of the year.
Negative Basis and Suspended LossesAdjusted basis cannot be below zero. However, using the formula above for calculating adjusted basis will often result in a negative number. Here are the rules for handling "negative basis" of S-Corporation stock:
- Shareholder's stock basis is reduced, but not below zero,
- Then Shareholder's loan basis is reduced, but not below zero.
Any excess "negative basis" is treated as a non-deductible loss. This excess loss is a "suspended loss" and carries over to future years indefinitely.
The suspended loss may be deducted in any future tax year during which the shareholder has restored her loan basis or stock basis.
If the shareholder had both an equity investment and advanced a loan to the company, then in following years the shareholder must restore her loan basis before restoring her stock basis.
Restoring BasisShareholders may restore their stock basis or loan basis in several ways. The easiest way to restore basis is to make additional cash investments (to restore stock basis) or to advance additional cash loans (to restore loan basis).
Adjusted stock basis and loan basis should be calculated tentatively just before the end of the year. This will give shareholders sufficient time to make additional loans or equity investments to ensure that any losses are fully tax-deductible.
At-Risk RulesEach shareholder has an amount at risk. This is the amount of money the shareholder stands to lose from her investments or loans to the company. A shareholder's amount at risk is calculated as follows:
- Adjusted Stock Basis
- + Adjusted Loan Basis
- = Amount At Risk.
Any loss in excess of the amount at risk is a "suspended loss" and follows the rules for suspended losses outlined above.
Each shareholder's stock basis and loan basis will be adjusted for her pro-rata share of losses even if those losses are suspended because of the at-risk rules. It is therefore very important for the S-Corporation and its shareholders to track adjusted stock basis and adjusted loan basis accurately and meticulously.
Passive Activity LossesS-Corporation shareholders are subject to the passive activity rules. These rules govern to what extent an S-Corporation loss is currently deductible by a shareholder.
If the S-Corporation is engaged in the rental property business, then shareholders must meet the stringent "active participation" tests for real estate professionals in order to deduct rental losses in full. If a shareholder cannot meet the active participation tests for real estate professionals, then S-Corporation rental losses are deductible only to the extent the shareholder has passive activity income.
If the S-Corporation is engaged in any business but the shareholder does not actively participate in the S-Corporation's business, then S-Corporation losses are deductible only to the extent the shareholder has passive activity income.
Passive activity income includes passive income from S-Corporations, partnerships, trusts, interest, dividends, and other investment income.
Previous: Accounting for Income, Expenses, Shareholder Equity, Converted Property, Adjusted Stock Basis.