S Corp Distributions Over Basis: Form 7203 and Capital Gain

What happens when S corp distributions exceed my basis?

An S corporation's nondividend distribution is tax-free up to your stock basis, and the part above it is capital gain. Stock basis is, roughly, what you paid or put in for your shares, plus the profit you were taxed on, minus what you took out and the losses you deducted. The tax-free part lowers your basis. The excess is treated as gain from the sale or exchange of property (26 U.S.C. 1368(b)). Basis cannot go below zero, so an excess leaves your stock basis at zero for that year; later distributions are tested against basis rebuilt through income, capital you add or stock you buy. If the company was once a C corporation or its S election ended, see the section on former C corporations first.

You, not the corporation, must track basis. Schedule K-1 shows the distribution but not how much of it is taxable, and the IRS expects you to be able to show you had enough basis (IRS: stock and debt basis).

A case is not simple when:

• your preparer or tax software shows Form 7203 with distributions above basis;
• basis was never tracked, or distributions have run ahead of profit for several years;
• the company's books are behind or were never reconciled, so the income on your K-1s may itself be wrong;
• you deducted losses on past returns, because losses need basis too;
• you put in money, as capital or a loan, and cannot document it;
• returns went in without Form 7203 or without the gain;
• the corporation was once a C corporation, or its S election ended.

Gather: every Schedule K-1 and filed return, what you paid or contributed for the stock, loan papers and bank records for money you put in, the company's record of each distribution with its date, and its books (equity, distributions and shareholder loan accounts).

Is an S corp distribution over basis a long-term capital gain?

The excess is capital gain, long-term when you have held the S corporation stock more than one year and short-term otherwise (IRS: stock and debt basis). The holding period counts from the day after you acquired the stock; gifted stock generally takes the giver's holding period, and inherited stock is treated as held more than one year (26 U.S.C. 1223(2) and (9)). Short-term gain is taxed at ordinary rates, and most net long-term gain at 0%, 15% or 20%, depending on taxable income (IRS Topic 409).

The 3.8% net investment income tax may also apply. The Form 8960 instructions cover sales of S corporation stock, not excess distributions by name, so ask a preparer (IRS: Instructions for Form 8960).

Shares bought or received at different times each have their own basis and holding period, so splitting the gain between long-term and short-term takes share-by-share records (Form 7203 instructions; Form 8949 instructions).

Which distributions are tax-free, and in what order do basis adjustments apply?

A distribution is tax-free to the extent your stock basis covers it, and the test counts that year's income first, before nondeductible expenses and losses reduce basis (26 U.S.C. 1368(d)). The year's adjustments apply in this order (IRS: stock and debt basis; 26 CFR 1.1367-1(f)):

A shareholder can elect, by a statement attached to a timely filed return, to take losses before nondeductible expenses. It then applies to that company in all later years and does not change whether a distribution is taxable (Form 7203 instructions; 26 CFR 1.1367-1(g)).

Two results follow. A distribution early in the year can be covered by income earned later that year, as long as you keep the stock: if you sell shares during the year, the year's adjustments for those shares take effect just before the sale (26 CFR 1.1367-1(d)). A loss never protects a distribution, because losses come last: a year with a distribution above starting basis and a loss can produce a taxable gain and a suspended loss together.

Does profit reported in earlier years raise my stock basis?

Yes, profit reported on earlier K-1s raised your stock basis, and each year's ending basis is the next year's starting basis (Form 7203, Part I, line 1). Three limits apply:

• Taxable income raises basis only to the extent you included it in gross income on your return; tax-exempt income raises it too (26 U.S.C. 1367(b)(1); Form 7203 instructions).
• Earlier distributions and losses already lowered it, so basis is a running balance, not total profit.
• If past losses reduced your loan basis, a later net increase in basis (income above distributions, losses and nondeductible expenses) restores loan basis first, and only the rest raises stock basis (26 U.S.C. 1367(b)(2)(B); Form 7203, line 12).

For the year-by-year build, see S corporation shareholder basis.

Does a loan I made to the company count as basis for a distribution?

No, a loan you made to the company does not count when testing a distribution. A distribution is tested against stock basis only (IRS: stock and debt basis). Debt basis comes from money you personally lent the corporation, and it only helps you deduct losses after stock basis is used up. Distributions do not reduce loan basis (Form 7203 instructions).

Repaying a loan is a separate payment, reported in K-1 box 16, code E (Instructions for Form 1120-S), and part of it can be taxable if the loan's basis had been reduced (Form 7203 instructions, line 34). How that works and whether money is a loan or capital are in shareholder loans to an S corporation.

Can I fix it with more capital or a loan, and what are the limits?

More capital raises stock basis; a loan does not. Contributions to capital and additional stock purchases go on Form 7203, line 2, which excludes loans (Form 7203 instructions). The limits:

• Timing. Basis is generally figured at the end of the corporation's year (Form 7203 instructions; 26 CFR 1.1367-1(d)), so money put in after year-end is not part of that year's figure. For a distribution, the statute adds back that year's income items and does not mention capital put in later (26 U.S.C. 1368(d)). Form 7203 adds capital put in during the year (line 2) before it tests distributions (line 6 against line 5), and its instructions do not say whether the date matters (Form 7203). Do not assume money put in late in a year covers an earlier distribution; a preparer should decide that, with the dates and bank records.
• Proof. The IRS says to consider whether a shareholder had the means to make a claimed contribution or loan (IRS: stock and debt basis).
• Relabelling. Renaming a past distribution is not a fix. The IRS can reclassify payments to a shareholder-employee as wages, which carry payroll tax (IRS: S corporation compensation). Whether money counts as a loan is in shareholder loans; pay is in owner salary.

Does the excess gain raise my basis, and what happens to losses I could not use?

No, the excess gain does not raise your stock basis; basis stays at zero. Form 7203 says not to increase stock basis for the capital gain reported on the excess (Form 7203 instructions, line 6). Later income, capital and stock purchases raise it from zero.

A loss larger than your basis is suspended: a loss you could not deduct this year, carried to a later year. It keeps its character, carries forward without limit, and is deductible only as basis is restored. If you dispose of all your stock it is generally lost, with exceptions such as a transfer to a spouse or former spouse under section 1041 and a loss left over when S status ends (IRS: stock and debt basis; 26 CFR 1.1366-2). Form 7203, Part III tracks the carryforward. Gain from an excess distribution does not restore basis, so it does not free a suspended loss.

What goes on Form 7203, Schedule K-1 box 16D, Form 8949 and Schedule D?

The corporation reports the distribution on your K-1, and you report any gain on your own return:

File Form 7203 with your return for any year you received a nondividend distribution, even one your basis fully covers. It is also required when you claim a loss, dispose of stock or receive a loan repayment (Form 7203 instructions).

Does a distribution over basis show on Schedule L or Schedule M-2?

No, the corporation's Schedule L and Schedule M-2 do not show the excess. The corporation reports each shareholder's distributions in box 16, code D, without testing them against that shareholder's basis, and the gain is figured on the shareholder's return. Schedule M-2 tracks the accumulated adjustments account, the running total of the corporation's own undistributed income, not any shareholder's stock basis, so the two can differ (Instructions for Form 1120-S). For retained earnings and Schedule L, see recording S corporation distributions and a balance sheet that will not balance.

What if I already filed without the gain, or never tracked basis?

If a filed return left out a gain, the usual steps are to rebuild basis from the first year, then correct each affected return. The IRS says to file an amended return, on Form 1040-X, when income changes (IRS Topic 308).

1. Rebuild stock basis from cost or contribution, then each year's income, distributions, nondeductible expenses and losses in that order. The burden is on you to show enough basis (IRS: stock and debt basis).
2. Find the first year distributions exceeded basis. That year's ending stock basis is zero. For each later year, start from the prior year's actual ending basis, add capital and that year's income, and apply the year's reductions in order.
3. Figure each affected year's gain on Form 7203, Form 8949 and Schedule D.
4. Check losses taken in those years. A loss beyond basis is not allowed that year, so a past deduction may need correcting too.
5. A return that left out income is generally corrected on Form 1040-X for that year, and a federal change can change the state return. The IRS can generally assess more tax up to three years after a return is filed, or six if the income left out is more than 25% of the gross income stated on it; there is no limit if no return was filed or the return was fraudulent (26 U.S.C. 6501). Interest and penalties are in amending for income left off past returns.

If a K-1 looks wrong, ask the company for a corrected one and do not change your copy. If you cannot agree, the K-1 instructions point to Form 8082 (K-1 instructions).

What if the S corporation was once a C corporation?

Only if the corporation still has accumulated earnings and profits from C corporation years, or from a merger or reorganization (IRS: stock and debt basis), can part of a distribution be a taxable dividend instead of a return of basis. Without them, the basis rule above applies in full. Earnings and profits are, roughly, profit earned as a C corporation and never paid out as dividends; the accumulated adjustments account is the running total of the S corporation's own undistributed income.

With accumulated earnings and profits, a distribution first reduces the accumulated adjustments account and is taxed under the basis rule above. Next it is a dividend, up to the accumulated earnings and profits. Any remainder falls back under the basis rule (26 U.S.C. 1368(c)).

Dividends are reported on Form 1099-DIV, not in box 16, code D, and do not reduce stock basis. The corporation can elect to pay out earnings and profits first for one year, if every shareholder who received a distribution that year consents. It makes the election by attaching a statement to its timely filed original or amended Form 1120-S for that year (extensions count), naming the election and stating that each shareholder consents. It cannot be undone, so a professional should decide it (26 U.S.C. 1368(e)(3); 26 CFR 1.1368-1(f); Instructions for Form 1120-S).

If the S election ended (for example, an ineligible owner or a revocation), payments after it are taxed under the C corporation rules, apart from one relief: cash paid in the post-termination transition period (generally one year after the last S year, or until that year's return is due, with extensions, if later) is applied against stock basis, up to the accumulated adjustments account (26 U.S.C. 1371(e); 1377(b)). For the wider picture, including what ends an election, see how S corporations are taxed.

Example

These examples are illustrative; all figures are in US dollars. Assume cash distributions, no accumulated earnings and profits from C corporation years, and no other basis adjustments. In the first two examples, basis already includes the year's income.

A distribution larger than basis

A shareholder's stock basis is $40,000. The company distributes $55,000. The first $40,000 is tax-free and takes basis to zero. The $15,000 excess is capital gain, long-term if the stock was held more than one year. Basis stays at zero going into next year.

A loan does not cover it

An owner has $10,000 of stock basis and lends the company $30,000. The company then distributes $25,000. Debt basis is not used to test a distribution, so stock basis covers $10,000 and the other $15,000 is capital gain. A later repayment of the loan is a separate payment, tested on its own.

This year's income counts first; a loss does not

A founder starts the year with $5,000 of stock basis and has no loans to the company. The K-1 shows $20,000 of income, and the founder took $30,000 in distributions. Basis rises to $25,000 first, so the distribution leaves a $5,000 excess gain. If the K-1 had shown a $20,000 loss instead, nothing would raise basis: the distribution would exceed the $5,000 basis by $25,000, that amount would be gain, and the whole loss would be suspended.

Distributions ahead of profit for two years

A shareholder paid $20,000 for the stock. Year 1: income $10,000, distributions $40,000. Basis rises to $30,000, so $10,000 is gain and basis falls to zero. Year 2: income $15,000, distributions $25,000. Basis rises from zero to $15,000, so another $10,000 is gain. Both years carry a gain that neither K-1 shows.

Different for you?

• A preparer says Form 7203 shows the distribution is above basis, or basis was never tracked while distributions ran ahead of profit: the true basis, the year each gain falls in, whether a contribution or loan can be documented and whether earlier returns need correction decide the result. Get corporate tax help.
• The company's books are behind, distributions were never recorded as distributions, or the balance sheet will not tie: basis starts from the company's income, so the books come first. See recording S corporation distributions and a balance sheet that will not balance, and get bookkeeping help.
• You filed returns without the gain or deducted losses beyond basis: see amending for income left off past returns and get corporate tax help or individual tax help before filing corrections.
• The corporation was once a C corporation, or its S election ended: old earnings and profits, or the C corporation rules after an election ends, change which payments are dividends or gain. See how S corporations are taxed and get corporate tax help.
• You need basis worked out year by year: use S corporation shareholder basis.
• You lent money to the company, or the company paid your personal bills: see shareholder loans and personal expenses paid by an S corporation. If you cannot document the money you put in, get corporate tax help.
• You live in Canada, or in another country, and own the S corporation: that country may tax the same payment under its own rules. See owning a US S corporation from Canada and get cross-border tax help.
• Owners received unequal distributions, or you are taxed on K-1 income with no cash: see disproportionate distributions and pass-through income without a distribution.