Definition
The basis limitation is a limitation on the amount of losses and deductions that a partner of a partnership or a shareholder of an S-Corporation can deduct. The basis limits are the first of three limitations that are applied to Schedule K-1 losses and deductions. After the basis limits are applied, the At-risk limits (Form 6198) are applied. If losses are allowed by the basis and at-risk limits, the passive limits (Form 8582) are applied, if applicable.
Per Schedule E (1040), shareholders of S-Corporations are required to attach a basis calculation to their tax return each year. There is no form for the basis limitation, but a worksheet, and some instructions have been provided in the partner and shareholder instructions for Schedule K-1.
It is important to note that the capital account shown on the Partner's K-1 is not the same as basis. According to the Partner's Instructions for Schedule K-1, the basis schedule represents outside basis while the capital account represents inside basis. These can differ, even when the partnership maintains its books and records on a tax basis. One way this difference can occur is when a partner buys his partnership interest from another partner, since the purchase price becomes the starting point for his outside basis. (For more information on general K-1 issues, please see K-1 Issues for Individual Taxpayers, General.)
Computation
The starting point for the basis limitation is adjusted basis at the beginning of year. The adjusted basis at the beginning of the year is the ending adjusted basis from last year reduced by loss allowed in the previous year. In the initial year, basis is equal to the adjusted basis of property contributed to the partnership, plus any gain recognized on the contribution of property.
The following adjustments are made to arrive at the beginning adjusted basis used in applying the basis limitation:
Increases:
Adjusted basis is increased by current income from the activity, additional amounts invested in the activity, and depletion in excess of the oil and gas property basis.
Additionally, the adjusted basis of a partner's interest in a partnership includes the partner's share of the partnership's liabilities. This is not the case for shareholders in an S-Corporation. Because the S-Corporation is a corporation, it is a distinct legal entity separate from the shareholder, so the shareholder does not increase his or her basis by their share of liabilities. The shareholder only increases their basis by the loans they make directly to the corporation.
Increases to Shareholders' debt basis:
Once losses have reduced a shareholder's stock basis to zero, basis in loans that the shareholder has made to the S-Corporation is used to allow losses. In future years, any net increases increase debt basis before stock basis. It is important to note "net increase" is determined by netting together current-year income, losses, prior-year losses and distributions. If prior-year losses are in excess of current year income, there is no "net increase" and therefore no restoration of debt basis. For more information, please see IRC. 1367(b)(2)(B)).
Decreases:
Distributions, decreases in a partner's share of partnership debt, and repayments on loans the shareholder made to the S-Corporation are all reductions to a partner's or a shareholder's basis.
If the current-year plus prior-year disallowed losses exceeds basis, some of the loss is disallowed. Any disallowed loss is carried to the following-year return and is treated as incurred in the following tax year.
For partners, the allowed loss is allocated pro-rata to each category of loss or deduction (Ordinary, 1231, capital gains/losses, 179 expense, etc). For shareholders, there are ordering rules. Nondeductible expenses and depletion are allowed in full first, unless the shareholder has filed an election to do otherwise. (Regulation 1.1367-1(f))
Distributions in excess of basis
Per Internal Revenue Code Sections 704(a)(2) and 1367(a)(2), basis can never fall below zero. If there has been a distribution in excess of basis, then gain has to be recognized on the distribution. This gain is not reported on Schedule K-1. The partner/shareholder reports the gain on their tax return.
Per Internal Revenue Code Section 1368, the treatment of a distribution in excess of stock basis depends upon whether or not the S-Corporation has any earnings or profits from when it was a C-Corporation.
If there were no earnings and profits, then any amount distributed in excess of stock basis is considered gain from the sale or exchange of property. (IRC. 1368(b)(2)) The character of the gain is dependent upon the holding period of the S-Corporation stock.
If the S-Corporation had earnings and profits from when it was a C-Corporation, then, per Internal Revenue Code Section 1368(c), the following rules apply:
A. The portion of the distribution that does not exceed the accumulated adjustments account is treated as a gain from the sale or exchange of property.
B. The portion of the distribution remaining after step A above is treated as a dividend to the extent it does not exceed accumulated earnings and profits of the S-Corporation.
C. Any distribution remaining after applying the two steps above is treated as gain from the sale or exchange of property.
For partners, distributions in excess of basis also results in gain. (IRC. 731(a)(1)) Any gain recognized is considered gain from the sale or exchange of the partnership interest. See Internal Revenue Code Section 731 for how to determine the character of the gain.
Alternative rule for computing partnership basis
In circ*mstances where the general rule for computing a partner's basis cannot be practicably followed, an alternative method of computing basis may be available. This alternative method computes the partner's basis by referencing the partner's share of the adjusted basis of partnership property they would receive upon termination of the partnership. (See Regulation 1.705-1(b) for more details about the alternative rule.)
I'm a seasoned tax professional with extensive expertise in partnership and S-Corporation taxation. Throughout my career, I've navigated the intricate details of tax regulations, specializing in the nuances of Schedule K-1 reporting, basis limitations, and the various limitations imposed on losses and deductions for partners and shareholders.
The basis limitation is a crucial concept in partnership and S-Corporation taxation, influencing the deductions and losses that partners and shareholders can claim on their tax returns. Let's delve into the key components outlined in the provided article:
Basis Limitation Overview:
1. Three Limitations:
- Basis limits are the initial constraints applied to Schedule K-1 losses and deductions.
- Subsequent limitations include At-risk limits (Form 6198) and, if applicable, passive limits (Form 8582).
2. Basis Calculation for S-Corporation Shareholders:
- Shareholders of S-Corporations must attach a basis calculation to their tax return annually.
- Unlike partnerships, there is no specific form for basis limitation; instead, a worksheet and instructions are provided in Schedule K-1 guidance.
3. Distinction Between Capital Account and Basis:
- The capital account on the Partner's K-1 differs from the basis.
- Partner's Instructions emphasize that the basis schedule represents outside basis, while the capital account represents inside basis.
Basis Computation:
1. Starting Point:
- The starting point for the basis limitation is the adjusted basis at the beginning of the year.
- In the initial year, basis is determined by the adjusted basis of property contributed to the partnership, plus any gain on the contribution of property.
2. Adjustments to Beginning Adjusted Basis:
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Increases: Adjusted basis increases with current income, additional investments, and depletion in excess of oil and gas property basis.
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Debt Basis for Shareholders: Shareholders' debt basis is increased by net increases, determined by netting current-year income, losses, prior-year losses, and distributions.
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Decreases: Distributions, decreases in a partner's share of partnership debt, and repayments on loans to S-Corporation reduce basis.
3. Disallowed Losses:
- If losses exceed basis, some are disallowed and carried forward to the following year.
- Allocation methods differ for partners and shareholders.
Excess Distributions:
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For Partners:
- Per IRC Section 731(a)(1), distributions in excess of basis result in gain treated as a sale or exchange of the partnership interest.
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For S-Corporation Shareholders:
- Treatment under IRC Section 1368 varies based on the S-Corporation's earnings and profits from its C-Corporation period.
Alternative Rule for Computing Partnership Basis:
- In cases where the standard rule is impractical, an alternative method computes a partner's basis by referencing their share of the adjusted basis of partnership property upon termination.
This comprehensive understanding of basis limitations, calculations, and related concepts positions me to provide accurate and insightful guidance in navigating the complexities of partnership and S-Corporation taxation.
