IRS Issues New Form 7203 to Track and Report S Corporation Basis
The subchapter S rules apply basis limitations in various circumstances, including the ability of an S corporation shareholder to deduct S corporation losses. An S corporation shareholder has basis in his/her stock and if he/she is also a creditor of the corporation, he/she has basis in her debt. Basis is particularly important in determining gain or loss on the sale of an S corporation’s stock or repayment of a shareholder loan.
Effective for 2021, the Internal Revenue Service (“IRS”) requires S corporation shareholders to prepare and attach Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, to the taxpayer’s Form 1040 to track and report stock and debt basis. The form must be filed if the shareholder:
- Is claiming a deduction for its share of an aggregate loss from an S corporation (including an aggregate loss not allowed last year because of basis limitations);
- Received a non-dividend distribution from an S corporation;
- Disposed of stock in an S corporation (whether or not gain is recognized); or
- Received a loan repayment from an S corporation.
The loss limitations primarily have to do with the shareholder’s ability to deduct S corporation losses. Losses can first be deducted against the shareholder’s basis in his/her debt and then to the extent of his/her basis in his/her S corporation stock.
In order for a shareholder to deduct an S corporation loss, the shareholder basically has to jump over three (3) hurdles in addition to the basis limitation. The three hurdles are as follows:
- At risk limitations;
- Passive activity limitations; and
- Business loss limitations.
This article is concerned with basis limitations. If a shareholder does not have sufficient basis then a loss cannot be deducted and there is no need to look at the subsequent hurdles for that year. Losses not used in a year are carried over to subsequent years.
Form 7203 was released by the IRS in December 2021 to keep track of stock and debt basis. Form 7203 and the instructions are attached to this article. In short, Form 7203 is a glorified basis worksheet. It replaces the prior IRS 2018 worksheet that was supposed to be attached to returns but practically no one attached it. Form 7203 is required to be attached by all shareholders to their Form 1040 tax returns, including individuals, trusts and estates who meet the above-mentioned criteria. The S corporations do not have to attach the Form 7203 to Form 1120S. While the form must be attached in four (4) situations, we recommend preparing the form every year, whether it needs to be attached or not. This will make it much easier in the event the form has to be attached many years down the road since then you would otherwise have to go back and start from scratch.
The rules for stock and debt basis are quite complex. This article is a very basic discussion. Interestingly, the IRS estimates that the time it takes to learn the law applicable to Form 7203 is fifteen (15) minutes.
In preparing Form 7203, it would be a safe bet to assume that a client has probably not supplied an accurate basis number. For a new client, you should reconstruct the basis number. The first place to start would be to review the prior K-1s. If the IRS 2018 worksheet has been prepared, that should be reviewed as well. Again, it cannot be assumed everything was done accurately. If the K-1s were prepared accurately over the years, then you can get all the operational data from those forms.
A separate Form 7203 is needed for each shareholder who owns stock in the S corporation. A separate Form 7203 is also needed for each block of stock for each shareholder (i.e. they became owners of different blocks of stock at different times). A separate Form 7203 is needed for each block of stock if part of it is redeemed or otherwise disposed of. A separate Form 7203 is needed for each spouse who is a shareholder.
In addition to loss limitations, a shareholder’s basis is important for other reasons. To the extent of the shareholder’s stock basis, cash distributions will not be taxable for the shareholder. Further, if a shareholder sells his/her stock, the gain or loss on such stock sold will be determined based on the shareholder’s stock basis. Note that basis cannot be negative and therefore will never be lower than zero. Instead of stock basis going negative, a distribution in excess of basis is treated as an amount realized from the sale of stock (capital gain or loss). Also, repayments of a loan in excess of basis are treated as income from the sale of the note.
It is important to note that distributions reduce stock basis before the losses are allowed. This basically results in cash coming out tax-free and the loss being deferred if the distribution was up to or in excess of basis. In many cases, this is better than deducting a loss (which probably has a 30% to 45% benefit to the taxpayer) and then having the distribution be taxable.
Form 7203 seems contrary to the regulations in terms of how to treat suspended losses. The statute and regulations provide that in determining current year allowed losses, the current loss year is combined with suspended losses carried over from prior years. On the other hand, Form 7203 allows deduction of the carryover loss only after adjusting the basis for non-dividend distributions (as compared to the regulations allowing it prior to non-dividend distributions). If this results in a detrimental result to the taxpayer, consideration should be given to overriding the preparation software if it follows the instructions of Form 7203 instead of the regulations. If the IRS regulations are followed instead of the instructions for Form 7203, do you have to file Form 8275, Disclosure Statement? It would not appear so since you were following the IRS regulations.
In completing Form 7203, you start with stock basis in the beginning of the year. In computing the beginning stock basis, you have to know how the stock was acquired.
If the stock was purchased, then you start with its cost. If property was transferred into the S corporation in exchange for stock then you have to review I.R.C. Sections 351, 357(c), and 358. Generally, basis would equal cash plus the adjusted basis on the proper exchange for the stock plus boot. Boot would result to the shareholder where liability assumed by the S corporation exceeds the basis in the property. A contribution to the capital of the shareholder’s own note does not result in an increase in S corporation basis for the shareholder.
If the stock is acquired by an inheritance, then the beginning stock basis is fair market value at the decedent’s date of death (or alternative value, if applicable).
If the stock is acquired by gift, then the beginning stock basis would carry over from the donor. The stock basis is increased, but not above the fair market value of the property, by any gift tax paid attributable to appreciation in the value as of the date of the gift. For example, if X gifts Y $1,000 fair market value stock with a $500 basis, Y’s basis is $500. However, if X gifts Y $1,000 fair market value stock with a $400 basis and a gift tax is paid on the appreciation of value, Y’s basis in the stock is $400 plus the amount of gift tax paid. Note that in determining the loss on a sale of gifted stock, basis cannot exceed the property’s fair market value on the date of the gift. If X gifts Y $200 fair market value stock with $500 value basis, Y’s basis for determining loss is $200.
Basis in debt is not combined with stock basis in determining whether a distribution based on stock ownership is taxable.
If an S corporation shareholder is selling his/her stock and owns different blocks of stock, the shareholder can identify which shares are being sold. If the shareholder wants to minimize gain then the price would be allocated to high basis shares. If the shareholder wants to use suspended losses, then allocate the gain to low basis shares so the remaining high basis shares can utilize the suspended losses.
In computing an S corporation shareholder’s basis in debt, start with the initial loan balance, add additional loans by the shareholder, deduct principal payments, deduct losses allocated to loan basis and then restore basis for any S corporation income allocated to the loan. Debt basis is restored prior to stock basis being restored. Note that basis is computed separately for each loan.
Part II of the Form 7203 requires that the debt be classified as either being evidenced by a formal note or an open account debt. The instructions for Form 7203 require that if an open account at the end of the year are in excess of $25,000, then the next year they will be treated as evidenced by a formal note. If the loan is repaid and the basis of the debt is less than the face value of the debt, then there will be income recognized. The basis of the debt would reflect the shareholder’s share of income (or losses) for the year. The basis of the note at the time of the repayment cannot be determined until the income for that year is computed as of the end of the year and allocated to the shareholder creditor’s note.
If the shareholder creditor has multiple loans, then income for the year is first allocated to the basis of the loan that is repaid and then allocated pro rata to the other loans.
What is the character of the gain on a loan repayment? If the debt has been evidenced by a formal note, or treated as evidence of a formal note, then gain will result in capital gain that should be reported on Form 8949 and Schedule D.
Any open account debt, including that with an account balance in excess of $25,000, will result in ordinary gain and should be reported on Form 4797, Sale of Business Property. While the IRS requires an open account that is in excess of $25,000 be classified as “formal note”, that apparently just applies for basis purposes and not for determining the character of the gain. All shareholder loans should be evidenced by a promissory note.
Note than an S corporation shareholder making loans to S corporation cannot do so indirectly through another S corporation (brother/sister) or by guarantying the debt. A shareholder who acts as a guarantor of S corporation debt does not get basis until the shareholder actually makes payment on the loan. Likewise, co-borrowing by the S corporation and its shareholder does not create basis nor does placing a lien on the shareholder’s property securing the guarantee create basis.
In one taxpayer victory case, the shareholder borrowed money from a bank and lent it to the S corporation. It was always carried on the books as a loan and payments were made. The S corporation repaid the loan (which would have resulted in taxable income to the shareholder since the repayments were non-deductible) and the shareholder lived on the loan repayments. The IRS claimed that this should be compensation subject to employment taxes. However, because all the formalities were complied with, the amounts advanced by the taxpayer were treated as loans.
Concerning cash distributions by our S corporations that has C corporation earnings and profits, cash distributions can result in any of three (3) tax treatments (singularly or in combination). These are as follows: (1) tax free reduction of shareholder stock basis; (2) gain from the sale of stock; or (3) taxable dividend income. Taxable dividend income would apply in those situations where an S corporation has earnings and profits from the time it was a C corporation. If an S corporation has C corporation earnings and profits it must maintain a AAA account to distinguish income accumulated as an S corporation from that as a C corporation.
A distribution by an S corporation with S corporation earnings and profits and no C corporation earnings and profits is tax free to the extent of stock basis with the excess being treated as a gain from the sale of stock. No AAA account is required to be maintained.
If an S corporation has earnings and profits and C corporation earnings and profits, then to the extent of its AAA account, the distribution is not treated as a distribution of C corporation earnings and profits unless it exceeds the AAA account, in which case it is treated as distribution of C corporations of earnings and profits and a taxable dividend. Distributions in excess of earnings and profits is treated as distribution by an S corporation of its earnings and profits (i.e. tax free to the extent of stock basis, with the excess being capital gain).
You may want to treat a cash distribution as one of C corporations earning and profits if you are trying to eliminate C corporation earnings and profits because the S corporation has passive income. No allocation can be made of distributions to C corporation earnings and profits before the AAA account is adjusted unless an election under I.R.C. Section 1368(e)(3) is made. Note that if the distribution is treated as earnings from C corporation and profits, the S corporation stock basis is not reduced.
The AAA account is a corporate account and not a shareholder account. In many respects, but not all, adjustments to basis also results in adjustments to the AAA account. For example, while stock basis is increased by capital contributions and by tax free income, the AAA account is not so adjusted. Also, stock basis cannot be negative but the AAA account can be.
Concerning Paycheck Protection Program (“PPP”) loans, the IRS has provided that the recipient of the loan may treat amounts forgiven as being excluded from gross income. The amount of PPP forgiveness increases the shareholder’s basis (but not the AAA account). What is the timing of the step-up? In Rev. Proc. 2021-48, an S corporation received and spent a PPP loan in 2020 applied for forgiveness in 2021 and was granted forgiveness in 2022. The IRS ruled that the taxpayer may report the timing of the PPP forgiveness in any one of those three (3) years. Normally forgiveness of debt is reported as income at the time of the debt forgiveness and this is a generous ruling by the IRS.
The importance of maintaining accurate basis records cannot be over emphasized. The IRS position is that if the taxpayer cannot prove basis then the basis is zero. The burden of proof is on the taxpayer. The courts have allowed the taxpayer to use an estimated basis based on the Cohan rule, which allows taxpayers to rely on reasonable estimates in certain circumstances when there is some factual basis for NJ 39 F.2d 540 (2d Cir. 1930).
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