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.