Every profession has them. Names, words, jargon or acronyms that only people in the profession use. The words are designed for insiders to communicate with insiders. The mere mention of the words keeps outsiders at bay.
Tax accounting has more than a few. Amortization, bonus deprecation, MACRS, any phrase containing the word “section” and of course, the word “basis”.
The insider jargon makes accounting all but impossible to understand for the business owner. Since accounting is ultimately about business, it is critical for the business person to know what some of these phrases are.
What is basis in my s-corporation?
If you are asking this question it is likely your accountant told you that you don’t have enough of it and your taxes are impacted because of it.
In a very basic comparison let’s think of basis as your wager, or how much “skin” you have in the game. When placing a wager, money is bet (put at risk) for you to gain more money. What is wagered can then be lost. Winning increases how much can be lost and taking money off the table reduces it. In its most basic form, this is how basis works.
Who cares if I have basis?
In a good year, it won’t matter, but in a bad year basis will allow you to deduct your losses thereby reducing your taxable income.
The IRS uses the concept of basis to determine how to deduct loses. You are only able to deduct from your taxes the amount you have in the investment. The more “skin”, the more you are allowed to lose and deduct from your taxable income.
The strategy here is simple, to reduce your taxes, you need to make sure you have basis to deduct. This may require planning so let’s look at what increases and what decreases basis.
How do I increase basis?
That seems simple enough so let’s look at a few ways of increasing basis.
- Invest in your company by contributing capital (equity).
- Make more profit. Net income will increase your basis because you are earning more to potentially lose.
- Lend money to the corporation. Since the shareholder is increasing the amount she can lose by lending to the corporation, the IRS allows this to count as basis and therefore deductible.
How is it reduced?
Just like increasing your basis, you reduce basis primarily in three ways:
- Losing money
- Paying back the shareholder loan, or
- Taking money out of the corporation via a shareholder’s distribution
As you may know, much of what an accountant will do to reduce income taxes is to monkey with depreciation. Between bonus depreciation and section 179, your tax accountant is often solely focused on reducing taxable income by any strategy possible including depreciation. But you must be careful with this one, if you increase depreciation, you decrease taxable income and therefore basis.
(At this point if you’re still with me, pat yourself on the back.)
All of this hits home when one of two events happen;
- You don’t have enough basis to deduct your losses or,
- Distributions to the owner are in excess of basis.
If you have the first option take place the loss simply carries forward until you do have basis to deduct, however, if distributions exceed basis this is a taxable event and they are taxed as capital gains.
Just to make sure you read that correctly, too many distributions make them taxable. (If you’ve been told distributions are not taxable, in this case they are.)
While there are a few ways to manage this, the important thing is to monitor profits and distributions and make adjustments before the end of the year.
Basis can be a very complex topic that can impact the taxes from your corporation, but it is mostly about managing the “chips on the table.” There are strategies to increase and decrease your basis. You as an owner need to know what the term means and what impacts the number so you can manage your s-corporation effectively.