What's Your Tax Basis? Does it Matter?
I've often said that I consider TAX a four-letter word. So I was most pleased when CPA Karen deLaubenfels accepted my invitation to make a guest post on this very subject.
>>>>>>>>>> So, without further ado, KAREN DELAUBENFELS on TAX:....
A business tax issue that is somewhat neglected is owner tax basis, which is, roughly speaking, the owner’s stake in the business. Tax basis of business ownership is a topic of interest regardless of entity choice because it can affect the amount (and whether) you may owe the government for taxes. However, we focus here on the tax basis of a corporate shareholder.
Many entities aside from actual corporations, such as LLCs, may wish to be taxed as a corporation under the “check-the-box” regulations, which allow the non-corporate entity to choose whether to be taxed as a “flow-through” partnership/sole proprietorship or a C (regular) corporation. The C corporation can then elect to be taxed as a “flow-through” S corporation, as Teri Rasmussen mentions in her article, "Taking the Plunge - How to Choose the Right Business Entity for Your Business." In a “flow-through” entity, the owners are taxed on their share of the company’s income, regardless of whether they receive any actual distributions of cash or property. Many of these non-corporate entities choose to be taxed as S corporations to maintain the flow-through aspect of the business, while avoiding possible ambiguity about whether owners may be treated as employees, allowing for withholding and tax-free fringe benefits available only to employees. Regardless of the entity choice, though, basis is a key player in determining taxability of any distributions to owners.
Each business owner has a tax basis in that ownership, unique to that individual. This basis is often, roughly speaking, the owner’s investment, plus earnings of the business, minus distributions to the owners and losses of the business, although the calculation differs somewhat depending on the type of business entity. We’ll focus on an entity that comprises 61.9% of the total number of corporations in the U.S. according to 2003 IRS statistics: the S corporation.
So what happens when the owner of an S corporation takes a distribution of cash or property? The short answer is that it’s generally not taxable, since the owner has already been taxed on the flow-through income; however, the exceptions to this general situation can have serious tax consequences for the business owner, and deserve a look.
An S corporation has a different set-up than other business entities, and is distinct even from other flow-through entities. The owner’s basis in shares of stock generally begins as just their cost, as with any other corporate shares; however, whereas the C corporation owner’s stock basis doesn’t change, the S corporation shareholder’s basis in the shares is a moving target, changing with corporate earnings and the owner’s contributions and distributions. In addition, if the owner makes any loans to the S corporation, there’s an additional quirk of the S corporation, loan basis. Although loan basis is beyond the scope of this post, it should be noted that it can affect the deductibility of corporate flow-through losses, and is thus worthy of consideration by the S corporation shareholder as well.
Whether a distribution to the shareholder is taxable or not depends on whether the corporation has sufficient AAA, PTI, AEP, and OAA, and then on whether the shareholder has any tax basis in his/her shares.
This jumble of letters deserves some explanation.
- AAA (the Accumulated Adjustments Account) tracks the corporation’s contributions, taxable earnings/losses, and distributions. A positive balance in this account represents corporate earnings that have been taxed as flow-through income, but not yet distributed to owners.
- PTI (Previously Taxed Income) is an “old-school” analog of AAA, which is only (possibly) relevant for S corporations that were in existence before 1983.
- AEP (Accumulated Earnings and Profits) is only (possibly) relevant for S corporations that were formerly C corporations. AEP is a topic in itself, and deserves its own separate discussion. For now, let’s note that any distributions from AEP are taxable as corporate dividends.
- Finally, OAA (the Other Adjustments Account) tracks the corporation’s non-taxable items affecting shareholder basis. This would include such items as tax-exempt municipal bond interest and “key person” life insurance proceeds, along with their associated non-deductible expenses.
Every time a cash or property distribution is made to shareholders, it reduces the balances in these accounts, in the order given above. As long as distributions do not use up AAA and PTI, they are not taxable. If AAA and PTI are gone, any distributions are next deemed to come from AEP, and are taxable as regular corporation dividends, subject to lower tax rates at present. When AEP is gone, distributions are deemed to come from OAA, and are again not taxable.
Next, though, we have the situation to watch out for, as it’s generally avoidable with good tax planning: If AAA, PTI, AEP, and OAA are consumed, the distributions are a return of the shareholder’s capital, lowering his basis in his shares. Once basis is used up by distributions, any additional distributions are taxable gain to the shareholder.
Do you need to know your AAA, PTI, AEP, and OAA? If your corporation has ever been a C corporation, you need to look at all four. If not, you need at least AAA; if you sell your ownership interest, your taxable gain may be reduced by your share of any positive balance in the AAA account.
Do you need to know your tax basis in your corporate ownership? Absolutely. How else will you know whether your distributions have crossed the line from tax-free to taxable gain?
Karen L. deLaubenfels, CPA offers accounting advice, including a full line of tax consulting and preparation service, to clients in Central Ohio. She also offers Quickbooks consulting and bookeeping services. For more information, you can visit her website at www.karendcpa.com,
