Beware Distributions in Excess of Basis

As a shareholder or partner of an S Corporation or Partnership, many people are often taking money out of the company for various reasons. However, before continuing to casually take distributions from the business, the tax consequences of doing so need to be considered.

What is Basis?

While there is no limit on how many distributions a person can take in a year, as well as there is no dollar limit, distributions should not exceed the basis a person has in their business. Another term for basis is the capital investment someone has in the business.

Basis needs to be calculated for each shareholder or partner of an S Corporation or partnership at inception. It is then increased by items like their share of ordinary income, rental income, investment income or gains, and capital contributions. After applying the increases, it is then decreased by items like Section 179 deductions, charitable contributions, nondeductible expenses, and distributions. This is the ending basis for the year. This number then becomes your beginning basis for the following year, and it is then calculated year-over-year.

An Example of Basis

In any year, if a person takes distributions in excess of their basis, they will have to pay capital gains tax on their personal return for the excess amount. For example, Kelly is a shareholder of an S Corporation. In 2020, her basis before distributions is $15,000 and she took $20,000 in distributions. She will have to report the excess amount of $5,000 on her personal return as a capital gain and she will have to pay capital gains tax. 

Preventing Taking Distributions in Excess of Basis

How can someone prevent taking distributions in excess of basis if they are really needing the cash? For S Corporations, it is required that shareholders pay themselves reasonable compensation. If they are taking a reasonable salary then distributions should not need to be taken, or at least not a high dollar amount. If someone finds they still are needing the extra cash, then consider increasing the salary amount. For partnerships, the same applies except that it is called guaranteed payments.

Have you found yourself in a position where you are taking distributions in excess of basis? Reach out to MOD Ventures LLC and we can discuss different options with you.