Tax Basis Basics for Business Owners: Why It Determines Gain, Loss, and Deductions

Basis is one of those concepts that sounds academic until it costs real money. A shareholder takes a distribution and discovers it is taxable. A member sells an interest and cannot support the cost figure. A loss cannot be deducted because basis ran out. In each case, someone did not track basis.

The definition

Basis is, roughly, the amount of your after-tax investment in something. When you sell it, the gain or loss is the amount you receive minus your adjusted basis. For depreciable property, basis is the starting point for depreciation deductions. For ownership interests, basis limits losses and controls the tax treatment of distributions.

How initial basis is determined

Purchase: basis is generally the cost, including sales tax, freight, installation, and related costs, plus any debt assumed.
Contribution to an entity: the owner's basis in an interest is generally the cash contributed plus the adjusted basis of property contributed, and adjustments for liabilities in partnerships.
Gift: the recipient generally takes the donor's basis (carryover basis), with special rules for losses.
Inheritance: basis is generally stepped up (or down) to fair market value at the date of death, in many cases, which can eliminate built-in gain. Rules on this may change and involve exceptions.
Exchange: basis carries over from the old asset in a like-kind exchange of real property, adjusted for boot and other items. See real estate in an LLC or personal name.
Compensation: property received for services is generally taxable at fair value and that becomes basis.

Adjustments over time

Increases to basis include additional capital contributions, improvements that add value, and, for pass-through owners, income allocated to the owner. Decreases include depreciation, distributions, casualty losses, and, for pass-through owners, losses allocated to the owner and nondeductible expenses.

The result is adjusted basis, which is the number that matters at sale.

Basis in pass-through entities

S-corp shareholders have stock basis (and debt basis for direct loans). Income increases it, and losses and distributions decrease it. Guarantees of corporate debt generally do not create basis. See S-corp shareholder basis.

Partners and LLC members have "outside basis" in their partnership interest, which includes their share of partnership liabilities. Partners also have capital accounts, which are different. The partnership has "inside basis" in its assets. Sales of interests and distributions of property involve interplay between inside and outside basis. See multi-member LLC taxes.

Sole proprietors have basis in individual business assets, not in "the business" as one item. Sale of a sole proprietorship is treated as the sale of each asset, with each asset's own gain or loss and character. See selling a business: tax basics.

Loss limitation ordering

When an owner has a loss from a pass-through business, several limits apply in order:

Basis limitation. Losses are deductible only to the extent of the owner's basis (stock plus debt basis for S-corps, outside basis for partners). Excess losses are suspended and carried forward.
At-risk limitation. Losses are limited to the amount the owner is at risk: cash and property contributed and certain borrowed amounts for which the owner is personally liable. Nonrecourse borrowing generally does not count except in qualified real property financing.
Passive activity limitation. Losses from passive activities (activities in which the owner does not materially participate, and most rental activities) can offset only passive income, with exceptions such as the special allowance for smaller rental losses for active participants subject to income phase-outs. Real estate professionals have more favorable treatment under specific tests.
Excess business loss limitation. For noncorporate taxpayers, a limit on total business losses that can offset nonbusiness income in a given year, with excess carried forward as a net operating loss.
Net operating loss rules for carryforwards, including limits on the percentage of taxable income that can be offset.

Each step uses information that should be tracked annually. Tax software often handles the ordering when the correct data are entered. Owners with significant losses or multiple activities should get professional help. See S-corp tax return guide.

Practical record keeping

Keep a basis file for each asset and entity:

Purchase records: closing statements, invoices, and contracts.
Improvement and capital expenditures.
Depreciation schedules by year.
Entity K-1s and basis worksheets.
Records of contributions, loans, and distributions.
Gift and inheritance documentation: valuation reports and estate filings.
Prior tax returns, which contain many of these amounts.

Keep basis records for as long as you own the asset plus the period of limitations on the return in which you dispose of it. Many owners store them permanently.

Basis in inherited or gifted business interests

If you inherit a business interest, an appraisal at the date of death can support the stepped-up basis. If you receive a gift, get the donor's basis records. Lacking those records can result in a zero basis assumption by the IRS in some situations, which produces maximum gain on sale.

Basis and selling a business

Basis in each asset determines the gain. The character of the gain (capital or ordinary) depends on the asset type and depreciation history. Purchase price allocation among assets affects both parties. See purchase price allocation. Goodwill created internally generally has zero basis, so gain on it is typically all capital gain for the seller, while a buyer amortizes purchased goodwill over 15 years.

Basis and gifting or transferring to family

Transfers to family members, trusts, or entities for estate planning should consider basis. A gift retains the low basis while inheritance can eliminate it. Advisers weigh income tax basis against estate tax and other planning goals.

Common mistakes

Never tracking basis for S-corp or partnership interests.
Confusing capital account with tax basis.
Assuming personal guarantees create basis in an S-corp.
Ignoring depreciation when computing gain on sale.
Losing records of contributions and improvements.
Forgetting suspended losses carried forward.
Deducting losses beyond basis, at-risk, or passive limits.
Using the wrong basis for gifted or inherited property.
Not adjusting for nondeductible expenses.

An annual basis review

At the end of each year: update each owner's basis for income, losses, contributions, and distributions. Compare to the K-1. Note suspended losses. Check that distributions did not exceed basis. Save the schedule with the tax file. If you are missing years, reconstruct from returns and bank records.

For help building or repairing basis records, AE Tax Advisors can assist, and a discovery call is a good first step.