What happens with negative K-1 distribution of US S-Corporation?

How to you distribute losses on a K1 for S-Corporation shareholders?

Answer by Wray Rives CPA CGMA:

There are a number of issues and facts to consider with S Corp losses.

Not Earned Income/Not Passive Income

The flow through income from an S Corp is not earned income, but it is not necessarily passive income/loss. Since most of the time the S Corp shareholder is actively involved in operating the business, any loss is typically an active loss, meaning it can be used to offset other ordinary income including wages.

S Corp Basis

While the S-Corporation losses are not generally subject to passive loss rules, the owner does have to take into consideration his basis in the S Corp stock and any limitations basis may create. Basis just means cost or investment in an asset, in this case investment in the S Corp stock. Basis in S Corp stock is commonly generated because the shareholder invested or contributed money or assets to the business or the shareholder received a share of S Corp profits in prior years. It is important to note that S Corp shareholder basis is not a static number like basis in C Corp stock. S-Corporation stock basis tends to change every year.

Basis Limitations

If the company has losses, the shareholders are allowed a deduction on the shareholder’s tax returns to the extent the individual has basis. Without basis, those losses are suspended/carried over to offset future income or basis. That negative basis is carried over on the S Corp’s books.

Losses and NOL

Sufficient losses can create an NOL on the individual shareholder’s return and any NOL is carried over at the shareholder’s level, not at the corporate level.

Passive Loss

Finally if by chance the shareholder is not actively involved in the business, then the loss is a passive loss and is subject to passive loss rules on his personal tax return, so disregard all of the above discussion. The stockholder can only use passive S-Corporation losses to offset other passive income items.

What happens with negative K-1 distribution of US S-Corp?