Understanding Basis for S Corps: Avoiding Extra TaxesSep 02, 2022
Many business owners have heard about the S Corporation as a tax savings strategy. An S Corp allows you to pay less in self-employment taxes as compared to an LLC or sole proprietorship. As the owner of an S Corp, you can pay yourself a reasonable salary through payroll and then take distributions that are not subject to self-employment tax. What most business owners do not realize, however, is that there is a limit to these distributions and you could wind up paying additional taxes if you are not careful.
In order to understand the limit, you first need to know what basis is. Basis is essentially how much you own in the S Corporation. It can increase through things like profits of the business or contributions from shareholders. But it can also decrease when there are distributions from the business or losses incurred by the business. Your basis carries over year over year. So, if you end the year with a $100,000 basis in the S Corp, you begin the next year with that basis and continue increasing and decreasing based on your activities.
How do we calculate basis? For most people, their basis in the S Corp is equal to the amount they paid for their shares plus any money they have put into the business through loans or contributions. For example, if you paid $50,000 for your shares and you have loaned the business an additional $20,000, then your basis would be $70,000. Similarly, your basis goes down if you take money out. So, if you have a basis of $70,000 and you take a distribution of $30,000, your new basis would be $40,000.
Basis is not the same thing as cash in the bank. Your basis can fluctuate from non-cash activities like debt, so how much cash you have in the bank is not a direct indicator of your basis. You can also have a negative basis without having a $0 cash balance.
So, why is basis important? Even though you save self-employment taxes on the portion of your profits that are distributions (non-salary,) if you distribute beyond your basis and send yourself into a negative basis, you will need to pay capital gains tax on the excess distributions. This eliminates the whole benefit of the S Corp for those dollars earned.
You can find your basis on your S Corp tax return. You also want to set up a way to calculate and track your basis on an ongoing basis year-round to make sure you are not at risk for over-distributing.
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