With the new IRS rules for maintaining accurate tax basis calculations and reporting tax basis on S Corp returns, shareholders may be in for a surprise if any of the following occurs in a tax year:
· A loss is reported on the Schedule K-1
· A distribution is received
· Stock is disposed of
· A loan repayment is made from an S corporation
Shareholders are responsible for calculating any adjustment to their tax basis and attaching an accurate tax basis schedule to their individual tax returns. Companies are not required to do this on behalf of shareholders. As part of your individual risk management and tax planning strategy, it’s important to have an accurate calculation and adjust it annually if necessary. Keep in mind that an accurate calculation is cumulative from the original date of the S Corp election. Seeking assistance from a knowledgeable CPA is recommended.
Starting in tax year 2021, the IRS introduced Form 7203 to figure shareholder stock and debt basis. This form can help shareholders determine the resultant basis after losses, gains, deductions and/or loan repayments. See instructions on the IRS website, for more information.
Basis is a metric for measuring the amount of an individual’s investment in an entity in the eyes of the IRS. Tax basis can increase or decrease as certain income is recognized, excess distributions are made or when nondeductible expenses and certain losses occur. Here are a few examples of when a change in stock basis may result in a tax impact to the shareholder.
Tax-free distributions to S Corp shareholders are only tax free to the extent that they do not exceed the shareholder’s stock basis.
On the personal tax return of shareholders, distributions exceeding the stock basis will generally be taxed as long-term capital gains. The current long-term capital gains tax rate is 15%.
When you sell all or a portion of your stock in a company, you may need to recognize a capital gain or loss on the sale of your shares. The sale does not include any suspended losses due to basis limitations.
If you received a loan repayment from the S Corp, you must include any calculated ordinary income/capital gain on your individual return.
Penalties for Over-Reporting & Under-Reporting
Over-reporting or under-reporting taxable income due to an inaccurate tax basis can lead to additional tax and/or penalties. Sec. 6662 of the Internal Revenue Code imposes an accuracy penalty. The penalty for under-reporting and over-reporting is calculated as a flat 20% of the net understatement of tax.
If you under-reported taxable income, you may be subject to penalties based on the amount of understatement, as determined by the IRS, included on your return. The first potentially applicable penalty is a failure to pay penalty.
Failing to make payments results in a penalty of 0.5% per month, up to a maximum of 25% of the amount due (subject to the lower of $100 or tax due minimum.)
A substantial valuation misstatement carries a 20% penalty, while a gross misstatement is subject to a 40% penalty. An overstatement of your basis of more than 200% is considered a gross misstatement.
These fees add up, so you can see the importance of correctly calculating tax basis each year per the new IRS rules.
If you have any questions or comments regarding your risk management or tax planning strategies for adjusted tax basis, contact our experienced tax team at WhippleWood CPAs.