With so many small businesses struggling to survive the pandemic, the last thing any S-Corporation or shareholder wants to have to deal with is a big tax bill. One way to possibly avoid additional financial hardship on businesses is to plan ahead by reducing or avoiding gains on excess distributions and shareholder loan repayments. The tax on excess distributions and shareholder loan repayments can hit business owners hard, even if their revenue is zero for the tax year. In addition, those that took the PPP (Paycheck Protection Program) loan could see an additional set of issues.
How is shareholder basis calculated in an S-Corp?
Shareholder basis in an S-Corp increases when shareholders put money into the company through capital contributions and loans, plus any income the company earns. Shareholder basis is reduced by losses and money paid back to the shareholder. Shareholders can take losses as long as they have basis in the company. For example, if John Smith opens an S-Corp 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, when John has adequate basis to take them.
Why do shareholders get taxed on excess distributions and shareholder loan repayments?
The reason shareholders get hit with taxes on excess distributions is that basis in a company cannot drop below zero. If John Smith contributes $20,000 to his S-Corp in year 1, takes losses of $20,000 in year 2, and then repays himself his original $20,000 contribution in year 3, he will have to pay taxes on $20,000 in excess distributions in year 3. Shareholder loan repayments can be even worse for the shareholder because gains are prorated. 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.
Frequently, when taxes on excess distributions come up, it happens because the shareholder is borrowing money to fund losses or personal distributions and shareholder loan repayments. Bank loans do not provide shareholders with basis, even if shareholders 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-Corp. If a shareholder owns two S-Corps and loans money from one to the other, that still does not increase the shareholder’s 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 (such as has been the case for many PPP recipients). He may end up being taxed on the salary while being unable 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.
Will PPP recipients end up owing tax on excess distributions and shareholder loan repayments?
The PPP loan was intended to offer businesses a lifeline through the pandemic, but there’s a potential snare that could pop up on shareholders’ tax returns. If the shareholder’s basis was zero at the beginning of the year, and there has been no contribution to capital and no income, the business cannot claim a loss. The latest COVID relief bill explains that “no basis increase shall be denied by reason of the exclusion from gross income,” which means that a shareholder can and should increase his or her basis via the forgiven PPP proceeds. Of course, the big question is when? If the loan is not forgiven in the same tax year, this could result in tax implications. This can be tricky to work through and is something to discuss with your CPA.
How can I avoid gains on excess distributions and shareholder loan repayments?
Truthfully, the best way to avoid gains on excess distributions and shareholder loan repayments 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 to avoid an excess distribution or gain on shareholder loan repayment 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 shareholder 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.
If you have concerns about gains on excess distributions, gains on shareholder loan repayments, or other tax matters, please contact us to schedule a consultation.