811 / How is an S corporation shareholder’s basis in the S corporation stock calculated?

The basis of each shareholder’s stock is increased by his share of items of separately stated income (including tax-exempt income), by his share of any nonseparately computed income, and by any excess of deductions for depletion over basis in property subject to depletion.¹ An S corporation shareholder may not increase his basis due to excluded discharge of indebtedness income.² The basis of each shareholder’s stock is decreased (not below zero) by (1) items of distributions from the corporation that are not includable in the income of the shareholder, (2) separately stated loss and deductions and nonseparately computed loss, (3) any expense of the corporation not deductible in computing taxable income and not properly chargeable to capital account, and (4) any depletion deduction with respect to oil and gas property to the extent that the deduction does not exceed the shareholder’s proportionate share of the property’s adjusted basis.

S corporation stock plus his basis in any indebtedness of the corporation to him.⁵ Such disallowed deductions and losses may be carried over.⁶ In other words, the shareholder may not deduct in any tax year more than he has “at risk” in the corporation.

Generally, earnings of an S corporation are not treated as earnings and profits. A corporation may have accumulated earnings and profits for any year in which a valid election was not in effect or as the result of a corporate acquisition in which there is a carryover of earnings and profits under IRC Section 381.⁷ Corporations that were S corporations before 1983 but were not S corporations in the first tax year after 1996 are able to eliminate earnings and profits that were accumulated before 1983 in their first tax year beginning after May 25, 2007.⁸

A distribution from an S corporation that does not have accumulated earnings and profits lowers the shareholder’s basis in the corporation’s stock.⁹ Any excess is generally treated as gain.¹⁰

If the S corporation does have earnings and profits, distributions are treated as distributions by a corporation without earnings and profits, to the extent of the shareholder’s share of an accumulated adjustment account (i.e., post-1982 gross receipts less deductible expenses, which have not been distributed). Any excess distribution is treated under the usual corporate rules. That is, it is a dividend up to the amount of the accumulated earnings and profits. Any excess is applied to reduce the shareholder’s basis. Finally, any remainder is treated as a gain.¹¹ However, in any tax year, shareholders receiving the distribution may, if all agree, elect to have all distributions in the year treated first as dividends to the extent of earnings and profits and then as return of investment to the extent of adjusted basis and any excess as capital gain.¹² If the IRC Section 1368(e)(3) election is made, it will apply to all distributions made in the tax year.¹³

Certain distributions from an S corporation in redemption of stock receive sale/exchange treatment. (Generally, only gain or loss, if any, is recognized in a sale.) In general, redemptions that qualify for “exchange” treatment include redemptions not essentially equivalent to a dividend, substantially disproportionate redemptions of stock, complete redemptions of stock, certain partial liquidations, and redemptions of stock to pay estate taxes.¹⁴

If the S corporation distributes appreciated property to a shareholder, gain will be recognized to the corporation as if the property was sold at fair market value, and the gain will pass through to shareholders like any other gain.¹⁵

The rules discussed above generally apply in tax years beginning after 1982. Nonetheless, certain casualty insurance companies and certain corporations with oil and gas production will continue to be taxed under the rules applicable to Subchapter S corporations prior to these rules.¹⁶