As a shareholder in an S corporation, you need to understand your tax basis—especially if you want to deduct business losses on your individual tax return. Many medical professionals operating through S-Corps assume their accountant will handle all the details, but overlooking tax basis can lead to missed deductions and unintended tax consequences.
In this guide, we explain what tax basis is, why it matters, how to calculate it, and how to use this knowledge to protect your tax position.
What is tax basis?
Your tax basis in an S-Corporation is your investment in the company for tax purposes.
Unlike a C corporation, an S corporation is a pass-through entity, meaning that its income, losses, and other tax items flow through to its shareholders. Your basis determines how much loss you’re allowed to deduct on your personal tax return and whether distributions from the company are taxable.
In other words, as an S-Corp shareholder, you can’t automatically deduct business losses. You must first have sufficient tax basis to do so.
Why does basis matter?
A typical tax strategy among S-Corp business owners is to generate tax losses by taking advantage of deductions from shareholder wages, the home office deduction, retirement plan contributions, and other business expenses. This allows shareholders to deduct losses on their individual tax returns, even though they’re receiving financial benefits from the company.
The problem is, the IRS limits the amount of loss you can deduct from your S-Corporation to the amount of your tax basis. So, if you try to deduct a loss greater than your basis, the IRS will disallow that deduction, at least for the current year. Instead, you’ll have to carry the loss forward until you have enough basis in a future year to absorb it.
Without proper planning, you could find yourself unable to deduct those losses in the year you incur them. Fortunately, there are ways around the limitation if you’re aware of your basis.
The first step is understanding what goes into that number.
How do you calculate tax basis?
Your tax basis isn’t a fixed number. It fluctuates throughout the business’s life cycle. Here’s a simplified overview of how it works:
Your basis increases when you:
- Contribute money or property to the business
- Report your share of S-Corp income
- Loan money personally to the S-Corp (must be a direct shareholder loan)
Your basis decreases when you:
- Take distributions or draws from the business
- Report your share of S-Corp losses or deductions
- Have the company repay you for previous loans
Here’s the formula for calculating your basis:
Beginning basis
+ Additional capital contributions
+ Your share of S-Corp income
– Distributions
– Your share of S-Corp losses and deductions
= Ending basis
Suppose this is your first year in business, or you’re a new shareholder in an existing business. In that case, your beginning basis is the capital contribution you made in exchange for stock ownership in the company.
Keep in mind that there is no such thing as a “negative basis.” If decreases exceed your adjusted basis amount, the excess loss is suspended and carried over to the next tax year.
An example of year-end planning to secure deductions
Let’s consider a common year-end scenario for medical professionals running an S-Corp:
Your S-Corp is running a loss for the year due to legitimate deductions like wages, payroll taxes, business use of your home, etc. You also plan to deduct a retirement plan contribution, but the contribution itself will be made in the following year before you file your tax return.
The problem:
If you don’t have enough basis as of December 31st, you won’t be able to deduct the entire loss in the current tax year, even if you make the retirement contribution later.
The solution:
Move money from your personal checking account to your business checking account before year-end (by December 27th to ensure the funds clear) as an owner contribution for the estimated retirement contribution later in the following year. This creates a tax basis to support the deduction.
You leave the money in your business account through December 31st. You can either move the funds back to your personal account in early January or leave it in your business account until you’re ready to make your retirement contribution by March 15th (or September 15th if you extend the S-Corporation’s tax return).
This approach temporarily increases your tax basis at year-end so you can deduct the loss in the current year. It’s important to note that you won’t actually lose the deduction if you don’t make the transfer by December 31st. But you won’t be able to take the deduction in the intended year if you do not have enough basis. You’ll have to wait until next year when you presumably have the necessary basis in the S-Corp to take the loss.
Risks of not tracking basis
Many S-Corp owners assume the S-Corp itself or their tax advisor is handling basis calculations. Some do, but it’s a risky assumption to make.
In fact, the IRS makes it clear that it’s the shareholder’s responsibility to track their own basis:
“It is not the corporation’s responsibility to track a shareholder’s stock and debt basis, but rather it is the shareholder’s responsibility.”
Failing to track basis can result in several consequences:
- Disallowed loss deductions until you restore basis
- Taxable distributions if you take money out of the company with insufficient basis
- Errors in reporting income and losses to the IRS, increasing your audit risk
While the IRS has placed increased emphasis on basis tracking in recent years, it doesn’t require S corporations or individual shareholders to report on their basis annually. You only need to attach Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, to your individual tax return if you:
- Deduct an S-Corp loss
- Received a non-dividend distribution from the S-Corp
- Disposed of S-Corp stock
- Received a loan payment from the S-Corp
The Schedule K-1 you receive from the S-Corp each year doesn’t necessarily show your current-year taxable distributions because the taxable amount depends on your basis.
So, if your tax preparer doesn’t maintain a basis schedule, you’ll have to reconstruct your basis from the day your initial investment in the S-Corporation began. Depending on how long you’ve owned the shares, it can be time-consuming (and potentially expensive) to go back through several years of income, losses, capital contributions, distributions, and shareholder loans to come up with an accurate, up-to-date number when needed.
It’s better to calculate basis on a rolling schedule because if a shareholder leaves your organization, you have to take a large distribution, or the business closes, it’s likely not an ideal time to get into the complicated and tedious tax calculations. So do yourself a favor and stay on top of your basis (or hire someone to stay on top of it for you).
S-Corp basis best practices
Rather than waiting until you get a dreaded IRS notice, here are a few best practices we recommend for staying compliant and making the most of your S-Corp tax benefits:
- Maintain clear records. Track all money and property contributed to or withdrawn from the business. Keep documentation for any shareholder loans, and remember, written agreements are always best.
- Review basis annually. Prior to year-end, ask your accountant for a tax planning strategy that includes a basis calculation. Make sure you have enough basis to support planned deductions and distributions.
- Consider transferring funds to increase your basis prior to year-end. If you don’t have sufficient basis in the company to deduct losses, consider transferring funds from your personal account to the business before December 31 to increase your basis for that year. It’s a good idea to make the transfer a few days ahead of year-end to ensure the funds clear by year-end, since bank processing delays can affect timing.
- Don’t assume loans create basis. Basis from debt only applies if the shareholder is the lender. Loans from a third party do not increase basis. For example, if the S-Corporation takes out a bank loan, this doesn’t increase shareholder basis, even if the shareholder personally guarantees the loan.
- Work with a tax professional. Basis calculations are complex and easy to get wrong. Work with a qualified tax advisor who understands S-Corporations and can provide proactive planning as you approach year-end. At Cerebral Tax Advisors, we handle basis calculations and inform our clients of the amount they should transfer from their personal accounts to the business as part of our standard year-end tax planning routine.
Don’t let basis be an afterthought
Tax basis is a foundational concept in S-Corporation tax planning, but it’s one that often gets overlooked until it’s too late to act. For medical professionals and other high-income earners operating through S-Corporations, understanding and proactively managing your tax basis can help you maximize deductions, reduce taxable income, and avoid surprises when filing your individual tax return.
If you’re unsure about your current basis or how it affects your year-end tax strategy, now is the time to reach out. Schedule a free Tax Discovery Session with Cerebral Tax Advisors to review your current basis and ensure your year-end moves align with your overall tax strategy.