A partner in a partnership and a shareholder in an S corporation hold similar responsibilities and serve similar purposes in each type of business. When a business experiences losses that are passed through to either a partner or a shareholder tax deductions will encounter a limit based on the calculated owner basis or amount the owner has the risk of losing. One major difference between the two types of ownership could make a difference if significant levels of losses are expected to be generated.
Taxpayers who own an interest in a partnership or S corporation stock often do not realize the tax complications that accompany the ownership of these two interests. As flow-thru entities Partnerships or S corporations allow its partners and shareholders to avoid double taxation however when it comes to tracking the basis of the partnership interest or S corporation stock the task is a bit more complicated.
Business Structure and Taxation
There are several different business structures that a small business can choose to be organized under. Partnerships and S corporations both allow the company to avoid taxation at the company level and pass any deductions income and losses on to the partners or shareholders. As company owners the value of a partner’s or shareholders holding in the company is considered their basis. Understanding basis is important when the time comes to sell or pass on the owner’s share on to heirs. Basis is also important when it comes to tax reporting because any losses passed through to an owner’s individual tax return cannot exceed the owner’s basis.
Partnership or S corporation ownership basis can be determined by calculation. Basis begins with the amount of money an owner puts into the business through money paid for S corporation shares or an initial cash investment that was used to start the partnership. Monetary contributions or company profits in addition to those initial cash investments will increase the owner’s basis. Any losses or distributions of cash to the shareholder/partner will decrease the owner’s basis. In short taking the additions and subtractions calculates basis.
Basis and Borrowed Money
Basis changes dramatically for S corp shareholders and partners when it comes to the business of borrowing money. Partners are allowed to include their share of borrowed funds in their basis if the loan is personally guaranteed by the partner but an S corp shareholder cannot include borrowed money to their basis even if it is personally guaranteed. For example a business with two owners who each contributed $10000 cash as an initial investment then borrows an additional $20000 for which the loan is personally guaranteed. If the business in the example were an S corp the calculated basis would be $10000 (initial investment) per shareholder. In a partnership each partner’s basis would be $20000 (initial investment + loan) since the partner personally guaranteed the borrowed funds.
When profits or losses occur in a partnership or S corp business they cycle through the individual owners to be claimed on their own tax returns. Deduction of losses is limited to the basis in the company. So if an owner’s basis is at zero net losses cannot be deducted on their individual income tax return. Remember certain debt backed by a partner’s personal guarantee is included in a partner’s basis and not in an S corp shareholder basis so tax benefits are affected differently in the two types of ownership. A partnership structure may be the best route for a new business that expects to undergo significant tax-deductible losses with loans that are personally guaranteed.
For more information on how to structure your business or determine basis for your company click here for a first consultation and a Lindemeyer employee will contact you with more information.