Avoiding Basis Pitfalls: Key Tax Insights for Passthrough Entity Owners

When it comes to owning a passthrough entity—like an S corporation or partnership—understanding your tax basis isn’t just a bookkeeping detail; it’s critical for managing your taxes and avoiding unpleasant surprises. Whether you’re a small business owner or an investor in such entities, failing to monitor and manage your basis can result in excess distributions and unexpected tax liabilities. Here's what you need to know to stay compliant and maximize your tax efficiency.

Your basis represents your investment in a passthrough entity. It begins with the amount you initially contribute or invest and adjusts over time based on profits, losses, additional contributions, and distributions.

Why is this important? Tax laws limit the amount of losses you can deduct and the distributions you can receive tax-free based on your basis. Taking distributions that exceed your basis or deducting losses without enough basis can trigger taxable income or disallowed deductions.

Example:

You invested $50,000 in an S corporation. Over the year, your share of profits added $10,000, and you took $60,000 in distributions. If your adjusted basis was $60,000, you’d have no taxable income. But if you took $70,000, the extra $10,000 could be taxable because it exceeds your basis.

How to Avoid Being in Excess of Basis

Here are steps to ensure you don’t find yourself with unexpected tax issues:

Track Your Basis Continuously: Keep a running total of your contributions, share of income, and distributions. This helps you stay on top of changes to your basis year by year. Typically your tax accountant will have this prepared in the tax return.

Understand Limits on Loss Deductions: Losses in passthrough entities can only offset income up to your basis. If you’ve used up your basis, any additional losses must be carried forward until your basis increases.

Coordinate with a Tax Professional: Different types of passthrough entities (S corps vs. partnerships) have varying rules about basis adjustments and distributions. Ensure your records align with IRS regulations.

What Happens If You’re in Excess of Basis?

If you take a distribution that exceeds your basis, then the excess is treated as taxable income, often classified as a capital gain. This creates an unnecessary tax burden that proper planning could avoid.

Example:

You took $80,000 in distributions when your adjusted basis was only $70,000. The $10,000 overage would be subject to capital gains tax.

On the flip side, claiming losses without sufficient basis will result in those losses being disallowed for the current year. While they may be carried forward, you lose the opportunity to offset income and potentially lower your tax liability in the present year.

Understanding and managing your basis is essential for anyone with a passthrough entity. Whether it’s tracking contributions and distributions or ensuring you don’t claim losses in excess of your basis, staying informed protects you from unnecessary taxes and keeps your financial picture clear. If you need help calculating your basis or navigating tax laws for passthrough entities, our team can assist. Contact us at info@mkhstaxgroup.com for guidance tailored to your situation.