Shareholder Basis, The Retained Earnings for LLC’s & S-Corps

Keeping track of your shareholder basis (also called “Stock Basis” by some people) is something that many accountants will not do for you, and yet is extremely important. Your shareholder basis is the equivalent of a large publicly traded corporation’s “retained earnings” … or what people mean when they say, “Apple has so much cash!”.

When you initially start a business, chances are you have to put some of your own money into the business bank account.  That is your initial shareholder basis.  You’ve already paid tax on that money, so you can withdraw that money from your company bank account at any point and NOT pay any taxes on it.  That money can be viewed as a 0% interest loan that you (the human being) gave to your new company… or shareholder basis… that you can take back at any time (either as cash, tax losses, or some other “asset” with “value”).

Let’s say next year you’ve made a ton of money and you can easily take back that initial cash deposit you made into the company bank account.  Go ahead!  You can do so and there’s no taxes to be paid, just like the repayment of a 0% loan.

Changes is Shareholder Basis

Shareholder basis (“SB” hereafter) is increased by the income you receive and decreased, but not below zero, by any loss, deductions or distributions on the Form K-1 you receive.

For example, SB at the beginning of the year is $100,000 and you receive Form K-1 (For an S-Crop… same concepts/line items with a K-1 from an LLC but Box numbers will be different) with the following amounts:

Box 1	Ordinary Business Income (loss)	(8,000)
Box 2	Rental Income	4,000
Box 4	Interest Income	2,000
Box 9	Net Section 1231 Gain (Loss)	1,900
Box 16A	Tax Exempt Interest *	500
Box 16D	Distribution**	16,000

* Tax Exempt Interest increases shareholder basis. Basis is increased by this amount to preserve the nature of the Tax-Exempt income. If the shareholder fails to include Tax Exempt Interest in the calculation, then the Tax-Exempt Interest will be taxed when the business is liquidated or sold (even though it shouldn’t be taxed).  This is also true of the 2020 tax exempt EIDL grants, forgiven PPP Loans, etc.  They all “behave” or are accounted for in this manner.

** Non-dividend distributions reduce SB, while dividend distributions do not. Box 16D on schedule K-1 reflects non-dividend distributions. Dividend distributions will be reported on Form 1099-DIV.

Assuming no debt basis and using the ordering rules, SB is increased by income and reduced by distributions, losses and deductions:

Beginning of Year SB                               $100,000

ADD:

Rental Income                                                      4,000

Interest Income                                                    2,000

Net Section 1231 Gain (Loss)                           1,900

Tax Exempt Interest                                               500

SB before distribution                              108,400

LESS:

Shareholder Distribution***                   16,000

SB before loss and deductions               92,400

            Ordinary Income (Loss)                                       (8,000)

End of Year SB                                           $84,400

***Since there is adequate SB before distribution, the distribution of $16,000 is non-taxable.

 

IDEAS How to Use Shareholder Basis

You could of course just distribute the shareholder basis back to the owners (i.e. you).  Alternatively, you could use that capital like large corporations and “invest”.  A corporate brokerage account can be opened via TD Ameritrade for free. You can put those assets into investment grade corporate bonds and earn 3% interest.  That interest is added to the company’s income, just like income from business operations. You could earn interest via preferred shares of stock, interest payments on cryptocurrency, dividend payments from blue chip S&P 500 companies, etc… the risk profiles are endless and up to you.  If there is more than one owner, of course that complicates things. But then, you can also just distribute the basis to owners and they can do all these things in their own personal brokerage accounts.  C-corps, that’s another blog!

This is not materially different if you made those bets via your personal taxable brokerage account or via your corporate brokerage account, the P&L is the same. However, any excess income generated by these investment activities via the corporate brokerage account, can be distributed as 401K profit sharing contributions in order to avoid taxes (or some other idea, they’re out there). Have enough shareholder basis doing this and just use the dividend profits in the corporate brokerage account and pass that through as 401K contributions.  You could use other company retirement accounts to execute this as well, such as a SEP IRA, SARSEP, Keough, Defined Benefit Pension Plan, etc.  Or, keep things simple, just distribute the basis as cash to shareholders and pay the tax.

NOTE: S corporations cannot make more than 25% of annual income via “passive” income, which corporate brokerage income would be classified as (unless you intend to have Trader Tax Status within the corporate account).  LLC’s are not limited like S-Corps (i.e. passive income limitation) and how most ultra-wealthy invest their assets.