Distributions in Excess of Shareholder Basis

By Jason Watson, CPA
Posted Sunday, October 29, 2023

We broached this little devil in a the previous section, but we want to expand on it. If you buy Google stock for $100 and later sell it for $150, you have a $50 gain. Easy. The first $100 represents a return of your capital and the next $50 represents your gain. Done. How does this to relate to S corporations?

If you inject $5,000 into your business, your business earns $100,000 and your business checking account has $105,000, you have $105,000 in shareholder basis. You can take all $105,000 out without trouble.

There are at least four scenarios where this breaks down, and we’ll review each one.

Depreciation

Please forgive us for reiterating this little issue, and to make matters worse we use a different data set for the example.

Depreciation bites people all the time, and bites hard! Same situation as above. $100,000 in net business income (profit) but you also financed a brand-new Ford F150 pickup truck for $60,000, and used 60% bonus depreciation to deduct it (for the 2024 tax year). Therefore, you have $105,000 in the business checking account and $64,000 in net ordinary business income after expenses and deductions (you had $100,000 in initial profit but deducted $36,000 in truck depreciation).

Your shareholder basis is $5,000 (original injection of cash) plus $64,000 in net business income, or $69,000. If you take out $100,000 as a shareholder distribution, you have $31,000 of the $100,000 exceeding your shareholder basis and that portion will be taxed as a capital gain on your individual tax return. Yuck!

How do you fix this? Easy. You can either not take the cash out in the form of a shareholder distribution, or don’t use bonus depreciation on the new truck and pay more immediate income taxes. Wow. Not desirable at all!

You could use another depreciation method that spreads the deduction across several tax years. Sure, you will pay more income taxes in the year of purchase, but you won’t have the capital gain on the excess distributions. Moreover, you have a nice depreciation deduction in the future to offset hopefully increasing incomes (and associated tax rates).

Loans

This one can bite too! WCG has a client who is a very successful Amazon reseller. To add to the excitement, Amazon offered a low-cost $250,000 loan to the business presumably with the hopes that the business would buy more stuff to sell on Amazon. The business didn’t. The sole shareholder took the loan proceeds plus some extra cash out of the business as a shareholder distribution. Let’s breakdown what happened using our basic example above.

You inject $5,000 into your business and the business earned $100,000 in net ordinary business income after expenses and deductions. The business also took on a $250,000 Amazon loan and received cash. Therefore, your business checking account reads $355,000 but your shareholder basis is only $105,000. You can only take a $105,000 distribution leaving $250,000 behind without triggering a distribution in excess of shareholder basis. Another yuck!

When cash loans like above happen and the shareholder has a distribution in excess of his or her basis, we advise the client to return the cash to the business.

Recall that a business loan made directly to an S corporation from an external lender does not create shareholder basis even if the shareholder personally guarantees the loan. This is contrary to a partnership where each partner personally guarantees the loan, and adds to his or her partner basis. However, a shareholder who lends money directly to the S corporation does add to his or her basis (we typically suggest not making this is a loan, but rather a capital injection from the shareholder).

Business debt and capitalization must be handled carefully.

Payables

Along the same lines of loans are payables. Let’s say you record a $25,000 employer 401k match expense on December 31, but you haven’t sent the check yet. This would be recorded as a debit to 401k Company Contribution as an expense and a credit to a 401k Payable liability account. Additionally, this payable isn’t due until March 15 the following year, so you have some extra cash in your business checking account that is earmarked for the 401k payment. But it’s Christmas, and baby needs new shoes, so you pull this $25,000 as a shareholder distribution knowing that you’ll earn enough between January 1 and March 15 to make the 401k payment.

This distribution could exceed your shareholder basis as well. How? You reduced the amount of business profits by recording the 401k Company Contribution expense, but didn’t use cash to do so. You used a payable or an IOU if you will, freeing up some cash albeit temporarily. This cash-less reduction of business profits combined with a distribution can be bad.

Credit cards can create this little fiasco too and are very similar to the 401k example above. The IRS allows you to recognize the expenses as soon as you are liable for the payment (swipe the credit card, and boom you are liable). This is true even in a cash-based accounting system. Therefore, if you rack up a bunch of deductible business expenses in December with your credit card, you will have a gaggle of debits (expenses) and a Credit Card Payable as the corresponding liability (credit) on your balance sheet.

This in turn reduces your net business income (profits) but creates an artificial sense in available cash (since you haven’t paid the credit card bill yet). Here is what we mean-

Starting Shareholder Basis on Jan 1	5,000
Net Income Before Credit Card	100,000
Expenses Paid with Credit Card	25,000
Net Income (profit) on K-1	75,000
Available Cash in Business on Dec 31	100,000
Ending Shareholder Basis	80,000

If you take $90,000 out as a shareholder distribution on December 31, you will have exceeded your shareholder basis by $10,000.

What can be done here? Wait until January 1 to take the money out rather than December 31. Show the cash on the books for the ending cash number which is a part of your business entity tax return, wait 24 hours, and then do the money-grab.

Bad Basis Data

Most tax software will maintain shareholder basis using worksheets and other supporting documentation within the tax return. This information is typically not filed with the IRS or state, but it is a part of the tax return documents. Cool, right? If you switch tax professionals, your new person can easily take this data and enter it into the tax software to preserve your shareholder basis data. More cool.

This sounds great until it isn’t. Let’s say you’ve been in business for 20 years, and for some reason or another you’ve had four different tax professionals over the years. What if in year 4, a tax professional messed something up which caused your shareholder basis to get slightly out of whack; nothing huge, but certainly wrong. Your next tax professional simply took last year’s worksheets… did a quick sanity check… and plopped a number in as your shareholder basis that was too low. Ten years later, you are pulling some money out as a distribution and get hit with long-term capital gains.

Everyone is scratching their chin asking What happened here?

What makes matters worse is that a lazy tax professional who doesn’t want to dig into the numbers or have an awkward conversation with the business owner might create a shareholder loan to avoid the capital gain conundrum. In other words, he or she will take the portion of the shareholder distribution that exceeds the basis and call it a loan to the shareholder. Great, now we’ve taken a dumpster fire and threw a 55-gallon drum of gas on it. The IRS cannot stand shareholder loans since they are usually disguised distributions.

Lazy might be a strong word. And why are dumpster fires considered bad? They are safely contained in a thick metal box, no? We should say that someone is a camp fire in high winds. We digress…

What can be done? We usually advise pumping the brakes on the current year’s tax return and re-building the shareholder basis data from business inception. WCG just recently did this for a client who owned a bunch of Arby’s over several years; the shareholder basis on the worksheet from the previous CPA was understated by over $240,000. Yeah, a big number.

The lesson here is to be careful on seeing a bunch of cash and thinking you can do a money-grab without pain. Better yet! The lesson is to engage a team of wonderful Certified Public Accountants and business consultants to keep you out of trouble. We can fix things during the year. After the year is over, it might be hard to put toothpaste back in the tube.

Tax Planning Opportunity

But wait! There’s more. There might be a tax planning trick to welcome this capital gain on distributions in excess of shareholder basis. Huh? Well, the capital gain is considered long-term and as such has favorable tax rates versus ordinary income tax rates. In other words, if you are going to pay taxes on the income your business earns anyway, do you want to do it at ordinary income tax rates or capital gain tax rates?

You might have long-term capital losses that are quite large and might take a long time to recoup. For example, and for whatever reason, you have $100,000 in capital losses that are being carried forward. In addition, you don’t see yourself using these losses anytime soon. Under current tax law, you can only deduct $3,000 per year so quick math suggests needing 34 years to fully deduct these capital losses. Sounds like a long time, right? As such, having a shareholder distribution in excess of your basis which in turn causes a capital gain just to be absorbed by these losses doesn’t seem so bad.

We are saying this in the abstract, but there could also be tax planning opportunities when allowing this capital gain to occur.