In the United States, the debate on taxes consistently revolves around the question of whether the rich should be taxed more. However, there are many tax rules on the books that do the exact opposite. What would you think of a tax that often effects small business owners who have lost so much money they are using business loans to avoid personal bankruptcy? What about property investors who are already underwater on their properties and need money to feed their families while they struggle to find ways to sell their properties? The tax on excess distributions and shareholder loan repayments in excess of basis is exactly that. This hidden tax can can hit business owners who are barely hanging on even if they don’t make a dollar in revenue for the tax year. Avoiding gains on excess distributions takes planning, which may seem unaffordable until you consider the consequences.
Basis in an S Corporation consists of money that shareholders put into the company through capital contributions and loans plus company income. It is reduced by losses and money paid back to the shareholder. Shareholders can take losses as long as they have basis in the S Corp. For example, if John Smith opens an S Corporation and contributes $20,000 to it, he can take up to $20,000 in losses. Losses in excess of basis are suspended and carried forward to following years.
The reason shareholders get hit with taxes on excess distributions and loan repayments is that basis in a company cannot drop below zero. If John Smith contributes $20,000 to his S Corporation in 2010, takes losses of $20,000 in 2011, and then repays himself his original $20,000 contribution in 2012, he will have to pay taxes on $20,000 in excess distributions in 2012. Loans can be even worse for the shareholder because gains are pro-rated. In other words, if Smith loans $20,000 to his company, takes $5,000 in losses and then repays $10,000 of the loan, he will still have to pay taxes on $2,500 of that repayment even though he has more than enough loan basis left over to cover the $10,000 repayment. If you are completely lost at this point, that puts you in the same boat as most business owners this hidden tax strikes.
Oftentimes the reason taxpayers get caught with basis issues is that they are borrowing from the bank in order to fund losses or personal distributions and loan repayments. Bank loans do not provide shareholders with basis, even if they personally guarantee the loans. The only way that a bank loan can provide basis for a shareholder is if the shareholder borrows the money from the bank personally and then loans it to the S Corporation. If a shareholder owns two S Corporations and loans money from one to the other, that still does not provide basis.
Suspended losses can also result in negative tax consequences for shareholders. Suppose that Smith is borrowing from the bank in order to pay himself a salary. He may end up being taxed on the salary while not being able to take suspended flow through losses to offset the salary. This would be another situation where the owner is losing money but still paying a high tax bill.
There are ways to avoid or reduce gains on excess distributions. The best way is to plan ahead with your accountant. Knowing what your basis situation is before year end can help you plan ahead and see if you need to move money before year end to avoid an excess distribution situation. If you make loans to the company, make sure you put the loans in writing. This simple step means the difference between gains on excess loan repayments being taxed as ordinary income or capital gains.
One final warning: talk to your accountant before transferring real or personal property out of an S Corporation. Excess distributions don’t have to be cash and often arise out of transfers of real property. Happy Easter!