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Jeremy Wells: As corporations blend the tax and accounting rules of corporations with pass through entities like partnerships and sole proprietorships. And sometimes that leads to some awkward and interesting combinations of very different [00:00:30] sets of rules. The blending makes it to where we have to track different kinds of amounts and different kinds of features. Some of those have their roots in the corporate background of an S corporation, but they've either been adapted or recreated in a pass through way of thinking about how that entity and its [00:01:00] shareholders are going to be taxed. So we have to have ways of blending the various accounting and tax treatments that are involved in this relatively unique entity that we call an S corporation, in order to ensure that we have the proper tax treatment and reporting. Because after all, an S corporation really is just a figment of tax [00:01:30] law. Federal tax law. There is no real s corporation in terms of the every day business activity of that entity. Right. The founders will register an entity at the state level. That entity will have some reporting requirements, some economic rights in that state. There will be some sort of federal tax treatment of that. But this concept [00:02:00] of an S corporation exists solely within subchapter S of the Federal Internal Revenue Code. And yes, states have, for the most part, have acquiesced and adopted S corporations. But really most states continue to treat the S corporation either as a corporation or as a pass through entity, or they just kind of take this hybrid corporate and pass [00:02:30] through approach the way federal tax law does.
Jeremy Wells: When we have s corporations that are this hybrid entity type, they have some aspects of being a corporation, some aspects of being a pass through entity. Then we have to adjust the way we think about accounting for various items for that corporation. And the way we do this is through what I refer to as these three key amounts or ledgers [00:03:00] actually, uh, for an S corporation retained earnings, the accumulated adjustments account or triple A and then shareholder stock basis. And really it's understanding how each of these three ledgers operates and then understanding the subtle differences among the three of them that is really required to truly appreciate the [00:03:30] relative complexity of an S corporation. It, an S corporation can be fairly simple, but if you're not aware of how these three different ledgers operate, and especially how they differentiate from each other, then it can become pretty complex. And it can you can actually be, uh, making some, uh, incorrect assertions about what could happen with the corporation, and especially what could happen to the shareholders in terms of the tax [00:04:00] treatment of some of the items of income that are flowing through that entity. I've seen lots of tax professionals and also their clients and S Corporation shareholders get really confused about how these three different ledgers retained earnings triple A and stock basis are are actually different from each other.
Jeremy Wells: And how changes to 1st May not necessarily translate into changes or the [00:04:30] same change in the other two. And then also which one of those is going to matter when it comes to things like understanding the taxation of the pass through from an S corporation to its shareholders. So in this episode, we're going to look at some working definitions for those three key amounts or ledgers as I call them. And then we're going to look at a simplified comparison of their calculations to see how those differences [00:05:00] play out. So in general, the way to think about these three measures is three different questions. And each one answers a different question. So retained earnings answers the question of what happened over time with that corporation. Triple A determines what kind meaning, what kind of transactions happened, and what kind of effects are those going to have on the corporation and on the shareholders. [00:05:30] And then basis is going to determine how much specifically how much in terms of limitations on what that shareholder may or may not be able to deduct on their own tax return, or if any of those cash payments that they get from that's corporation in terms of distributions are going to be taxable or not. So upon completion of this course, you're going to be [00:06:00] able to first define S Corporation retained earnings accumulated adjustments account and shareholder basis. We're going to work on what those three different concepts are and what they mean.
Jeremy Wells: We're going to differentiate among them. And then we're going to look at specifically basis for a little bit using form 7203, which is a form we've had for a few years now to report S corporation shareholder stock and debt basis. We're specifically going to focus on stock basis. But [00:06:30] debt basis is a related concept that factors into that as well. Retained earnings shows accumulated profits over time. That's the easiest way that I can come up with to think about what retained earnings are. And back to the point about S corporations being this blend this hybrid of corporate and pass through models. Pass through entities don't have retained earnings. If it's a partnership, [00:07:00] you talk about the individual partners capital accounts. And so the partnership has the combined capital account. But that's split up among all of the different partners. And a sole proprietorship is similar. You just have the net value of that owner's capital in the business. When you have a corporation, you have retained earnings, which is again that accumulated undistributed profits over time. An [00:07:30] S corporation, at least in terms of the balance sheet, also has this this ledger or this amount at the end of each accounting period, which is usually a calendar year for most taxpayers, although you might have a corporation and sometimes an S corporation that operates on a fiscal year. It's a little more rare with S corporations due to the way the, uh, [00:08:00] use of a tax year works with S corporations.
Jeremy Wells: But in general, when you get to the end of the accounting period, the net income from that period closes out, uh, or essentially transfers and zeros out into retained earnings. The, the prior year's retained earnings or the prior periods retained earnings. And then distributions also close [00:08:30] out to retained earnings at the end of each period. So retained earnings. Thus is just the cumulative net income that a company holds rather than distributes out to its shareholders. Retained earnings can take any value. Positive or negative. Negative. Retained earnings. If you think about that as already distributed [00:09:00] future profits. Another way to think about it is that the business has either, uh, distributed more than it has in accumulated profits. And so actually, it needs to make some more profit in the future to cover those distributions that it's already given to its owners. Or in the case of no distributions, it might just be accumulated losses over time. In fact, there are some [00:09:30] GAAP accounting rules, generally accepted accounting principles, US GAAP that say if the corporation has net losses over time, in other words, negative retained earnings, that we should actually call that accumulated losses instead of retained earnings. But in general, I'm just going to use retained earnings to mean both. Whether we're we actually have positive retained earnings or negative retained earnings. But this is key to [00:10:00] understand retained earnings is absolutely can be negative.
Jeremy Wells: And in fact there are no restrictions on just how negative retained earnings can go. Uh a corporation could theoretically, uh, have losses and have distributions in excess of its accumulated net income over time such that retained earnings really has no floor. Retained earnings can be any virtually [00:10:30] negative amount. And likewise it can it doesn't have any ceiling. It can be virtually any positive amount. But what differentiates retained earnings from triple A and from basis is that there is no floor to retained earnings. Retained earnings can be as negative as you know really as possible. Retained earnings is a book not a tax balance sheet. Number and [00:11:00] differences in retained earnings over time can clue us in to some changes that have occurred, whether reported or unreported over time. So it likely does not tie directly to the amounts in the schedule M2, which we'll talk about here in a minute. One of the amounts in M2 [00:11:30] is that Accumulated adjustments account or triple A and schedule M2 is part of the form 1120 S, the S corporation return form 1120 S doesn't provide directly in the form itself a reconciliation Of retained earnings now on a form 1120 for a C corporation, there is, as part of that form, a reconciliation of retained earnings. That reconciliation starts with the prior year retained earnings. It [00:12:00] includes a line for each for a summary of each kind of adjustment. So net income or loss dividends, different things like that.
Jeremy Wells: And you wind up with what should be ending retained earnings. And that amount should match what you actually see in the balance sheet or the schedule L per books in the tax return that doesn't exist in form 1120 S. So what we wind up with a lot of times in tax software is [00:12:30] an actual, uh, worksheet that is provided by the tax software that does this reconciliation for us. What this means for, uh, the preparer of an 1120 S and especially for the IRS, is that it's important to look at the changes in retained earnings year over year and be able to explain those changes [00:13:00] in full. The IRS recognizes that there is no reconciliation of retained earnings on the 1120 s, and so its internal guidance instructs examiners to review retained earnings and to ask the returns prepare in an examination about any unexplained differences, especially if there are increases in retained earnings. Why increases? Because what would an increase an unexplained [00:13:30] increase to retained earnings possibly indicate unreported income? So if retained earnings increased more than we expected it to based on everything else happening on the 1120 s that could be explained in only so many ways. And the really the most likely of those ways is income and therefore unreported income. So in [00:14:00] IRM uh, excuse me, the Internal Revenue manual IRM4 point 10.3, which is titled examination techniques. There is guidance for examiners on business return examinations, including proprietorships, partnerships and corporations.
Jeremy Wells: I recommend looking through this section of the IRM if you work with small businesses and especially if you prepare forms ten, 65, 1120 or 1120 S. [00:14:30] Within that, there is this guidance on two examiners to review retained earnings and to use retained earnings as a way to try to find potentially unreported income. That's specifically in item 4.1, 10.3 .8.2.2. Item citations are a bit weird. It's that decimal system. But within that 4.2 excuse me, 4.1 10.3 is [00:15:00] where we get a lot of this guidance on how IRS examiners should review these entity returns. That can be helpful if you're preparing these kinds of returns. Okay, let's look at triple A now the Accumulated Adjustments account. This is probably one of the most misunderstood concepts of the the S corporation as a whole. I would say it's probably even more misunderstood [00:15:30] than the concept of reasonable compensation, although that's a that's a pretty close, uh, tie, pretty close comparison, probably, but I've seen a lot of misinterpretations of what triple A actually is. Triple A displays the undistributed pass through profits of an S corporation. That's that's the best way I can come up with to think about it. It is a corporate [00:16:00] level measure, and it is a reflection of a couple of things that are unique to s corporations. First of all, again, back to the point I opened this episode with. It is a reflection of the fact that an S corporation is a hybrid of the corporate and pass through concepts of taxation.
Jeremy Wells: The second thing [00:16:30] that it reflects is the actual history of the concept of the S corporation, the S corporation as a concept existed prior to the evolution of what has become the most common kind of pass through treated entity that we have in small business in the [00:17:00] US today. And that's the limited liability company. Subchapter S was added to the Internal Revenue Code in the late 1950s, and we didn't start getting LLCs. We get the first LLC law in Wyoming about two decades later. So before we had LLCs that could then elect to become S corporations, we had actual state law corporations, which by default are treated as C corporations. [00:17:30] So most of the first S corporations were C corporations first, not lwcs they were C corporations that made the s election. There had to be some way of being able to differentiate the accumulated earnings of the C corporation from the S Corporation. Why? Because [00:18:00] the distributions paid from the S Corporation's profits are generally tax free distributions, whereas the dividends paid from C Corporation earnings are taxable as dividends. Now, we don't actually get triple A until a few decades after we get subchapter S, but the reason we have triple A added to this concept of the S corporation [00:18:30] is because there was an acknowledgment that these two ledgers. Again, this is why I go back to calling retained earnings and triple A and then later on basis A ledger because it is this ongoing tracking of an adjusted amount.
Jeremy Wells: Right. And that's essentially what a ledger is in accounting. So if we think of retained earnings as this ongoing accumulated undistributed profits. Triple A is the portion [00:19:00] of that attributable to the S corporation. So the accumulated adjustments account reflects the cumulative undistributed pass through income of an S corporation. And this is necessary because an S corporation may have existed as a C corporation prior to making the S election. And that means that retained earnings could include both C corporate earnings and pass [00:19:30] through s corporate profits. Triple A ensures that the s corporate earnings are distributed before any C corporate earnings and profits are treated as dividends. And this is essentially the the ordering rules that we get in subchapter S and then the related regulations that when a when an S corporation that has C corporation earnings makes [00:20:00] a distribution first, the S corporation is going to distribute its S corporation earnings because those are going to be tax free distributions to the shareholders once it has exhausted the S Corporation's earnings. In other words triple A then and only then does it begin to distribute those taxed C corporation dividends. Now there is an election to [00:20:30] distribute C Corporation uh, accumulated earnings and profits are what's known as A, E and P before the S corporation earnings. It's possible to make that election, but without that election the S corporation distributions from triple A are distributed first.
Jeremy Wells: But that is a corporate measure. Triple A actually doesn't tell us anything about how those distributions are [00:21:00] treated at the shareholder level. Those S corporation distributions are treated at the shareholder level. All it tells us is whether the corporation is distributing S corporation pass through profits, or if it's distributing C Corporation taxable dividends. Triple A has its authoritative basis in IRC section 1368 E, and then in [00:21:30] regulation section 1968. Two. That's where we get this definition of triple A, and then how triple A is actually calculated and recorded. Now triple A differs from retained earnings in two key ways. They are very similarly calculated, except that first distributions do not reduce triple [00:22:00] A below zero. In other words, if triple A is a positive amount. But distributions are more than the amount of triple A before accounting for those distributions, then triple A does not go below zero. Also, if triple A is already negative and triple A can be negative. But if [00:22:30] triple A is already negative, then distributions don't reduce triple a any further. So the only way distributions affect triple A is if triple A is positive, and only to the extent that those distributions don't reduce triple A below zero. So that's the first way that triple A differs from retained earnings. Retained earnings can be any amount negative or positive. There's no restriction on how negative retained earnings can go. The [00:23:00] second way that they differ is that tax exempt income increases retained earnings.
Jeremy Wells: But it does not increase triple A. Why not? Because triple A reflects the undistributed pass through taxable income that the S corporation has earned over time. The accumulated Undistributed [00:23:30] pass through income tax exempt income. Bypasses triple A because it's never going to be taxed if it passes through to the shareholder. The shareholder won't pay federal tax on it. So it does not increase triple A. It does, however increase what's known as the other adjustments account or OAH. And that is also tracked in schedule M-2. But [00:24:00] that is a separate ledger from triple A. Any expenses related to earning tax exempt income also reduce the other adjustments account OAH they don't reduce triple A. So anything having to do with tax exempt income or the expenses related to tax exempt income, those those all go into other adjustments account which is also in schedule M2. [00:24:30] But schedule M2 is more than just triple A. Now, if you were working with small business owners during the Covid 19 pandemic, and those business owners got some of that pandemic relief in terms of either the Paycheck Protection Program loans that were then forgiven for many taxpayers, or if they received the $1,000 [00:25:00] per employee. That was the tax free grant that preceded the, uh, those SBA idols, the the loans that the SBA gave to small businesses. Both of those cases, the Paycheck Protection Program, loan forgiveness, and then those grants that preceded the idols, Those were tax exempt [00:25:30] income.
Jeremy Wells: So those amounts increased. The other adjustments account, those amounts will theoretically be there in the schedule M2 forever, either until there are expenses related to tax exempt income that zero out those amounts, or until the S corporation exhausts its triple A and then can start distributing from [00:26:00] that. Now tax exempt income. And those related expenses, like I said, are tracked in the other adjustments account that's also tracked in the schedule M2. And that all comes from regulation section 1.1682 A three and then triple I. Also back to the Internal Revenue manual IRM4 .1.3.8.2.2 says that the purpose of the schedule M2 is [00:26:30] to track the income losses and separately stated items that should have been reported on the shareholder's tax returns. So when we're thinking about the M2, what we're thinking about is, at the corporate level, the accumulated amounts that should have been separately reported on the shareholder's tax returns. Note that [00:27:00] that is different from what we're about to talk about, which is the individual shareholders actual basis. Uh and so this is triple A. It's critical to keep in mind that triple A and the M2 these are corporate amounts. And they don't actually tell us anything specific about the treatment of these items on the shareholders individual returns now basis [00:27:30] especially and particularly here stock basis debt basis is a separate issue that I want to save potentially for a future episode. Although really the only thing you need to know about debt basis.
Jeremy Wells: Um, it for purposes of, uh, you know, this episode really is that the main thing with debt basis is that it has to be a [00:28:00] bona fide debt from the shareholder to the S corporation, and that the S corporation owes the money back to the shareholder, a personal guarantee by the shareholder on debt, that is financed directly to the S Corporation by a third party does not [00:28:30] affect a shareholders debt basis. That is confusing. The way partnerships work with the way s corporations work and when it comes to the treatment of debt with respect to an individual shareholders basis, partnerships and S corporations are completely different things. There is no basis for a shareholder for debt that the corporation owes to [00:29:00] a third party. The only way a shareholder has debt basis is if the corporation owes that debt directly back to the shareholder. Personal guarantees do not count. Okay, back to stock basis, which is what we're actually talking about here. So this is the third ledger that I'm calling them for S corporations. The first one was retained earnings which was the accumulated undistributed [00:29:30] profits, triple A which is the accumulated undistributed pass through profits of the S corporation. And now we have stock basis stock basis tracks limitations on the specific shareholders deductions and distributions. This is the only one of these three ledgers that is [00:30:00] specific to a shareholder. Retained earnings and triple A are both maintained at the corporate level.
Jeremy Wells: They tell us about the corporation as a whole. They don't tell us anything about any particular shareholder. I will sometimes hear practitioners talk about triple A and the schedule M2, as if it tells us anything about the tax treatment of distributions or losses for any particular shareholder. [00:30:30] And even in the case of a single shareholder, an S corporation with one shareholder that earns 100, that owns 100% of the stock. Triple A still does not tell us anything about the actual tax treatment of losses and distributions for that individual shareholder, and I'm going to get into an example here in a few minutes. That's going to explain how and why that is the case. Only stock basis and to an extent debt basis. But focusing [00:31:00] here on stock basis only stock basis tells us about the individual shareholders limitations on losses and distributions. So stock basis plus debt basis limits the aggregate amount of losses and deductions that a shareholder can deduct in the current year. And then it also tells us the amount of nontaxable distributions a shareholder can take. Any deductions [00:31:30] and losses in excess of basis will carry over into the next tax year, and the shareholder treats them as if they are incurred in that following tax year. The other way that this gets explained is that those losses in excess of basis are carried over, and then deductions in excess of basis are carried over indefinitely.
Jeremy Wells: Way that the regulations actually explain this is [00:32:00] that those amounts carry over into the next year and are treated as if incurred in that following year. And then if in the following year, there are more losses or not. All of the losses are used against income and gains in that year. Then the remaining amount of loss or deduction. Carries over to the next year, and so on and so on. That essentially [00:32:30] could go on forever. And that's why a lot of times we do talk about. Those deductions or losses carrying over indefinitely. But really, the way the regulations describe them, they're carried over into the following year. And then also any distributions that are paid out to a shareholder in excess of basis are treated as a capital gain. This is something that I [00:33:00] often, often, often see not handled correctly, which is a polite way of putting it. Distributions in excess of basis are treated as capital gain income to the shareholder. What is incorrect. But what I see quite often is that those amounts in excess of basis are treated as if they were loaned to the shareholder. I [00:33:30] see a lot of 1120 S's that have amounts in loans to shareholder that either don't change or if they do change, they go up each year and there is no actual paperwork. There is no attempt to repay. There is definitely no interest income reported on the 1120 S. Year after year after year.
Jeremy Wells: In other words, these are not bonafide loans to [00:34:00] the shareholder. This is not bona fide debt. What this is instead, is an attempt to avoid the taxation of these distributions in excess of basis. Because instead of reporting those distributions in excess of basis. At some point somebody said, let's just hide this on the balance sheet as a loan to shareholder and treat them as if the corporation [00:34:30] just loaned those amounts to the shareholder. That's not what happened. What happened is the shareholder received distributions from the corporation in excess of basis. And by definition that is capital gain income to that shareholder. Both the IRS and the courts have consistently struck down claims that transactions were loans [00:35:00] when there was no clear debtor creditor relationship. In other words, there is a statutory definition and a regulatory definition of bona fide debt, and most, if not all, of these transactions that attempt to reclassify distributions to shareholders as shareholder loans, they just don't meet that definition. They don't meet that definition of bona fide debt. If you see a return [00:35:30] on 1120 S, uh, whether you or somebody else has prepared that return that has loans to shareholders, question those, ask if there's any paperwork, any documentation of those loans. Ask if there's been any attempt to repay them. Ask if there has been any interest income reported or look for that on the 1120 s. And if none of those are true, then it's likely that those amounts were just distributions in excess that [00:36:00] were instead reported as loans to shareholders improperly.
Jeremy Wells: By the way, the treatment of losses in excess of basis is IRC 1366 d, and then the distributions in excess of basis is section 1368. One of the main differences between stock basis and triple A and retained earnings [00:36:30] is capital contributions. So when a shareholder contributes capital to the corporation that increases that shareholder's basis. However, that amount is not going to be reflected in either triple A or retained earnings. This is another error I see on 1120 S um more frequently than should happen. Actually capital contributions don't affect triple A. What is triple A? It [00:37:00] is the accumulated undistributed earnings pass through of an S corporation pass through earnings of an S corporation. Capital contributions don't increase that amount. Capital contributions are not pass through income earned by an S corporation. They're also not part of retained earnings which retained earnings is similarly the accumulated undistributed [00:37:30] earnings of a corporation. So at no point should capital contributions be included in the calculation of triple A or retained earnings. Rather, those amounts are just reported directly in capital stock, which is line 22 or additional paid in capital, which is line 23 of schedule L, which is the balance sheet per books in the 1120 S. That's where those capital contributions go. They go directly to the balance sheet. [00:38:00] They do not go into triple A, they do not go into retained earnings. They do increase shareholder stock basis.
Jeremy Wells: So if you are preparing the 1120 s, it's not up to the corporation technically to track individual shareholder basis, although most tax softwares that I've used allow the whoever's preparing the 1120 s to track shareholder basis. We usually do that [00:38:30] for the S corporation tax returns that we prepare. And so if we see that capital contribution come in we're going to find out which shareholder contributed it. And we're going to increase that. Uh our record, the corporation's record of that shareholders, uh, basis by the amount of that contribution. And then we're going to add that amount to the balance sheet. If it's, if it's an initial contribution or if it's a new shareholder, then we'll call it capital [00:39:00] stock sometimes, or at least a portion of it. Capital stock. Uh, generally though, we're going to increase additional paid in capital, whichever one of those actually makes good accounting sense. If we're preparing the 1040, it gets a little trickier, especially if we don't know anything about the S corporation, the 1120 S other than the K one, because unless the 1120 S prepare [00:39:30] puts a note on the k one inside that k one package, that indicates that there was a capital contribution, then there's nothing on the k one that specifically indicates that contribution. So it's entirely possible that that just gets lost or missed. So if you work with S Corporation shareholders but you don't prepare the 1120 S and the K one, you need to be asking every year, did [00:40:00] you make any contributions to this S corporation.
Jeremy Wells: Otherwise you're going to understate their stock basis. And speaking of stock basis along with debt basis goes on the new form 7203. We've only had this form for a few years now. Before that, I believe before about 2021 or so. The tracking S corporation basis stock basis was a worksheet [00:40:30] that printed with the tax returns. Now it's a specific form, an IRS form 7203 S Corporation shareholder stock and debt basis limitations. There are a set of specific events that will trigger a requirement to prepare and file form 7203. One of them is if the shareholder takes any distributions. Another is if the shareholder is reporting any losses from. That's corporation. We generally always prepare [00:41:00] 7203 and include it with the return, because we want to track basis every year. We don't want to skip any years where it's not clear what the shareholder's basis is, so that 7203 is included and attached to the shareholders return. Now again, if you're working with the shareholder and not the S corporation, you may notice that the corporation's version of the 7203 can be included. [00:41:30] And now it often is included in the K one package that the shareholder receives. That is not the official 7203. That version does not get filed with IRS form 7203 is filed at the shareholder level, not at the corporate level. So it's still up to the shareholder.
Jeremy Wells: And if you're preparing the shareholders return you to verify the amounts in the calculation happening on that form 7203. It's entirely possible [00:42:00] that the preparer of the 1120 S made an error, for example, not recording a capital contribution for that specific shareholder. They may have added it to the balance sheet, but they didn't know which shareholder it went to, or they just simply forgot to apply it to that specific shareholder. And so again, basis would be underreported. So you need to make sure that your specific clients for 7203 make sense based on [00:42:30] what you know about that shareholder. Part one of form 7203 calculates stock basis. Part two calculates debt basis and any gain on repayment of that debt. And part three is critical that determines the allowable loss and deduction items and carryover amounts. So if there are any losses, if there are any separately stated deductions such as charitable contributions, and if there are any [00:43:00] carryovers from prior years, those are all going to be part of the calculation in part three. So if you're reviewing an incoming client tax return and that client is an S corporation shareholder, it's important that you look at the form 7203, especially part three, and check if there are any carryovers. You don't want to miss those. It's important that you get those preformed [00:43:30] into your tax software so that you're accurately calculating that client's basis. Now there's an order of operations for calculating basis that is determined by a mix of statutory and regulatory law.
Jeremy Wells: This all comes from IRC section 1367 and then the associated regulation 1.113671 F. Each shareholder adjusts her basis at the close of each [00:44:00] taxable year or upon disposition of her stock, whichever comes earlier in the following order. So first you increase basis by the sum of items of income and gain both separately and non separately. Stated before that you're going to take the prior year's basis, carry that over and then you're going to increase that by any stock contributions. Right. Uh capital contributions. Then you're going to increase by the sum of items of income and gain. Then you're going to decrease [00:44:30] basis but not below zero by distributions. Then nondeductible non capital expenses. These are going to be things like entertainment, the nondeductible half of meals expense, any kind of penalties anything that is non deductible but also non capital or non depreciable by the business. And then after that separately and non separately stated losses and deductions. Now [00:45:00] there's an election to reverse the order of the Nondeductible non-capital expenses and the separately and non separately stated expenses and losses. So nondeductible non-capital expenses in excess of basis normally don't carry over. However, a shareholder can elect to allow separately and non separately stated items of loss or deduction to reduce basis prior to [00:45:30] nondeductible non-capital expenses and carry over those nondeductible non-capital expenses. Now that election is permanent and once made, the only way to not have that election in place year after year is for the shareholder to receive permission directly from the IRS.
Jeremy Wells: This is regulation 1.1671 G. Now without that election suspended [00:46:00] Nondeductible non-capital expenses don't carry over. Generally, this is actually good for a shareholder, right? Because you want to maintain as high a basis as possible for the future to offset, uh, any sort of gains for from something like selling your stock in the S corporation. Right. However, if it's a business that routinely has significant [00:46:30] nondeductible non-capital expenses, then it might make sense to preserve that deductible loss carryovers via that election. What kind of business would this be particularly advantageous for? Possibly a cannabis based business that has a lot of nondeductible non-capital expenses due to IRC section 280, capital E? Now, [00:47:00] if you're not familiar with that, go back and listen to episode 22. That episode is on Cost of Goods Sold. But I specifically talk about cannabis based businesses quite a bit in that episode, because that's a great example of where section 280 cap E makes the operating expenses, not the cost of goods sold, but the operating expenses of those businesses. Nondeductible. And in these cases, you might have a situation where it benefits [00:47:30] the taxpayer to make that election under regulation. Section 1.1671 G excess losses. You have to be careful with those over time with an S corporation because upon the termination of an S corporation, a shareholder treats suspended losses as incurred on the last day of the post-termination transition period during that period, the shareholder [00:48:00] can acquire additional basis via contributions so the shareholder can put more money into the S corporation.
Jeremy Wells: Now, why would you want to do that? Because those suspended losses are permanently disallowed upon termination. There is no way to roll those over. They're not like passive activity losses, where you can take them in full against the activity on, uh, disposal. There's no way to do that. Those losses in excess of basis are [00:48:30] permanently disallowed upon termination. So any remaining losses are just lost forever. You might want to put more cash into the business in order to increase basis to be able to take those suspended losses if possible by the shareholder, that is from IRC section 1366D3A let's look at an example real quick to understand what's happening here. Now [00:49:00] doing math over audio like this is going to be difficult, but I'll try to work through the numbers in a way that makes sense. Jessica registers lighthouse LLC with herself as the sole member. So we're talking about a 100% shareholder here. On January 2nd, 20 x one. So just year one on that date, she opens a checking account in the name of lighthouse LLC and funds it with $1,000 of her savings. She also timely and correctly files [00:49:30] form 2553 uh, and that's the s election. So this is going to be an S corporation, uh, as of the date that the LLC, which was registered at the end of year one, lighthouse LLC has non separately computed income.
Jeremy Wells: So this would just be normal box one of the K one of $84,000 municipal bond interest income comes can be tax exempt income of $500 and nondeductible meals and entertainment [00:50:00] expense totaling $4,000. Jessica also received cash distributions totaling $35,000. So let's look at what happens here. The $84,000 of ordinary income non separately stated income is going to increase retained earnings triple A and basis. The $1,000 that she contributes into the savings account from her savings into [00:50:30] the business checking account. That is also going to increase her stock basis. She essentially bought $1,000 worth of stock in her new S corporation that does not affect retained earnings in triple A. So from the very first day of an S corporation, we already have a difference here between retained earnings triple A and then basis. Now the $500 of Nontaxable interest does not increase triple A because [00:51:00] triple A is only for the pass through the taxable S corporation income. It does increase retained earnings and it does increase her basis. The $4,000 of Nondeductible expenses decrease retained earnings, decrease, triple A and decrease her basis. And then the $35,000 of distribution also decrease all three. So she winds up with retained earnings of $45,500, triple A of $45,000 and [00:51:30] basis of $46,000. $46,500. So already we have three different amounts for these three different ledgers. I have seen tax professionals get very confused when retained earnings and triple A are different numbers.
Jeremy Wells: And I've seen them get confused when triple A and basis for a solo shareholder are different. But what I'm trying to show you with this example, fairly simple, is that just right off [00:52:00] the bat, there is nothing locking these three ledgers together. There's nothing forcing them to be the same number. Now, if the capital contribution hadn't been made, then basis and retained earnings would be the same. If there hadn't been the $500 of tax exempt income, then potentially all three could be the same. And there are situations because those are kind of, you know, odd things in small business. S corporation land where, you know, a lot of times [00:52:30] all three amounts are the same and they stay the same. It doesn't have to be that way though. Now, I run through a couple more years of this example in the article that I posted to my website, J dot tax. If you go to that and you look at the article that I posted in late March. Then you'll see the example spread out over the next couple of years as well, and you'll see how these different [00:53:00] items can affect retained earnings, triple A and basis differently. What I wanted to show you here or tell you about here is that it's very easy for these three different ledgers to take on different amounts, and that's actually correct. It's not necessarily incorrect if you have different amounts.
Jeremy Wells: If you do have different amounts, you need to understand why. And it's important to understand the different influences that these different kinds of effects have on these [00:53:30] three different ledgers. But I do see a lot of practitioners get confused when those three don't stay in lockstep with each other. And there's a reason for that. They're measuring three different things. They answer three different questions, as I said before, and that's the first key takeaway from this episode. Retained earnings shows what happened over the entire life of that entity, uh, at least as a corporation. If it if it had a non-corporate, uh, period before, uh, then [00:54:00] there won't be retained earnings from that period. But as a corporation retained earnings shows what happened. Triple A shows us what kind of things happened in terms of distributions in terms of S corporation pass through income. And then basis determines how much meaning how much of those limitations there are on what the shareholder can deduct and how much of those distributions are in fact tax free for that shareholder. Now, of [00:54:30] the three, only basis determines whether a shareholder has taxable distributions or suspended losses in excess of basis. And that's key to remember if you're trying to understand the effect that an S corporation has on an individual shareholder, you're not going to know that looking at the 1120 s meaning looking at either retained earnings or even the triple A, you have to look at the shareholder's basis.
Jeremy Wells: And for that you're going to need form 7203. And then finally S Corporation shareholders [00:55:00] should know their basis. And on top of that they should perform mid-year tax projections. Now basis is calculated at the end of the tax year or upon disposal of the stock, whichever happens first. But if you're dealing with an S corporation shareholder that has no foreseeable termination of the S election or foreseeable exit from the corporation, then you need to project out what that shareholder's basis will be [00:55:30] at the end of the year. So you can answer questions like, will any of those distributions be in excess of basis and therefore taxable? Well, any of those deductions and losses be suspended because they're in excess of basis. So we need to constantly be making sure that the shareholder is aware of those limitations and doesn't run into an issue where they have some sort of tax complexity due [00:56:00] to basis limitations, or if they are going to have those complexities that they're prepared for them ahead of time. So now if you found this this episode valuable, then please let me know by leaving a comment and liking the episode in your podcast application of choice or on YouTube at. And for the next episode, we're going to look at S Corporation stock sales. So this episode set up thinking about stock bases. What happens [00:56:30] when a shareholder actually sells the stock in the corporation? How is that going to affect that shareholder? Tune in to the next episode to find out.