Inside vs. Outside — Figuring debt basis


This week’s Tax Practice News webinar features a tax talk on Form 7203. While the form is required for shareholders of S Corps, the discussion around basis calculation and taxability of distributions from passthrough entities also extends to partnerships.

But figuring the basis is not as straightforward as one might originally anticipate. Challenges to start, most shareholders and partners of smaller, closely held businesses have not tracked their basis since commencing business. In some cases, depending on the age of the business and how long practitioners have been working with their client, reconstruction of basis could span several years and may be missing necessary information.

To further complicate the calculations, debt basis has to be considered for the sake of Form 7203 as well as properly determining the taxability of distributions or loss limitations.

In S Corps, debt basis may be easier to determine. Typically basis increases for any amounts that a shareholder has individually loaned to the corporation provided that debt is supported by a note.

In partnerships however, the calculation is not so straightforward. The basis of individual partners is affected by the debt of the partnership itself. Debt of the partnership is allocated to the partners typically according to their partnership percentages unless otherwise documented in the operating agreement.

For basic purposes, this typically applies to both recourse (guaranteed or collateralized) and nonrecourse debt. Debt is considered differently for at risk limitations than for basis calculation purposes.

Where most of this is coming into play, specifically with Form 7203, is the IRS seeking to ensure that loss limitations are being applied. Partners and shareholders are not allowed to take losses to the extent that they exceed both current year income as well as their individual basis in the organization.

Additionally, distributions—or draws—traditionally are non-taxable because partners and shareholders already are paying taxes on 100% of passthrough income. 

But if cash or property is being distributed beyond current year earnings, and again, beyond individual basis in the organization, those amounts are subject to capital gains taxes and are essentially treated as taxable dividends.

If you’re looking for more information on this topic, join us this Thursday at noon for this month’s tax talk. 

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