Busy tax practitioners often focus on issues of immediate urgency, which can sometimes leave them susceptible to making errors when
determining the tax basis of interests in business entities, including C corporations, S corporations, and partnerships. (References to corporations and partnerships include limited liability companies treated as such for tax purposes.)
Basis is important at the time of transactions, such as distributions and dispositions of business interests. Those transactions can arise and move forward swiftly. Basis, however, can be difficult to determine, particularly where it hasn’t
received scrutiny over an extended period. If taxpayers cannot meet the burden of establishing basis, the IRS can claim the taxpayer has a zero basis. Familiarity with the basis rules and good record keeping can help you limit income recognition on
taxable business transactions.
A property’s adjusted basis reflects its initial basis and any subsequent adjustments. The initial basis depends on the circumstances surrounding its acquisition. Generally speaking, purchased property
receives a cost basis; property acquired in nonrecognition transactions (such as corporate reorganizations) takes a carryover or substituted basis; property acquired by inheritance takes a “stepped-up” basis; and property acquired by gift
takes a carryover basis (limited to fair market value for purposes of determining future losses).1
After the initial basis is established, adjustments are required. For example, capitalized costs associated with a property will
increase its basis. Depreciation, depletion, and amortization on assets decrease their basis.
Specific basis rules and adjustments are prescribed regarding corporate stock and partnership interests. Here are some highlights:
- Shareholders have a separate basis in each share of corporate stock.2 Thus, blocks of stock acquired at different times usually have a different per-share basis.
- Ongoing earnings and losses of C corporations generally do not affect stock basis. However, distributions not treated as dividends for tax purposes typically reduce stock basis.3 Also, capital contributions and other corporate transactions
often require basis adjustments.
- S corporation stock basis generally increases to reflect earnings and decreases to reflect losses. Distributions by S corporations generally reduce shareholder stock basis.4
- Partners take a “unified” basis in their partnership interests, even if they are of different types (such as preferred and ordinary LLC units).5 Such basis fluctuates based on partnership operating results and changes in the
partners’ shares of liabilities.6
Inattention to basis considerations can result in errors regarding basis. Keep in mind the following generalities:
- Where there are significant variations in per-share C or S corporation stock basis, distributions can result in gain recognition, even where the shareholder’s overall basis exceeds the amount distributed.
- Stock redemptions involving deemed dividends generally result in basis “hopping” to other shares.7 Such hops can cause large basis disparities that may result in unexpected income on later distributions or dispositions.
- Contributions to wholly owned corporations in exchange for stock may have different basis consequences than capital contributions treated as Section 351 exchanges under the “meaningless gesture” doctrine.8
- Under complicated rules for determining partners’ shares of partnership liabilities, partnership interest basis can decrease (sometimes unexpectedly) as a result of transactions such as repayments, modifications, refinancings, and so on.
A few best practices to avoid these sorts of problems include ongoing record keeping and a periodic review of basis in significant assets. Where records are incomplete, basis can sometimes be reconstructed through a review of tax returns and other
records. Finally, in tax controversies, circumstantial or other secondary evidence (including testimony) can be helpful in establishing some basis.9 1 IRC Sections 1012, 358, 1014, and 1015. Broadly, a carryover basis is determined from the basis of a transferor/former owner, and a substituted basis is determined by reference to the basis of other property transferred in a transaction. Special rules beyond the scope of this article apply to consolidated return groups, controlled foreign corporations, and compensatory equity.
2 Johnson v. United States, 435 F.2d 1257 (CA-4, 1971).
3 IRC Section 301(c)(2).
4 IRC Section 1367.
5 Rev. Rul. 84-53, 1984-1 CB 159.
6 See generally IRC Sections, 705, 752, and regulations thereunder.
7 Reg. Sec. 1.302-2(c), Examples 2 and 3. Those adjustments can sometimes present planning opportunities.
8 Lessinger v. Commissioner, 85 TC 824 (1985), rev’d on other grounds, 872 F.2d 519 (CA-2, 1989). In “meaningless gesture” contributions, additional basis is apparently spread among outstanding shares rather than apportioned to shares received under general Section 351 and 358 principles. AM 2020-005 (May 9, 2020).
9 Cohan v. Commissioner, 39 F.2d 540 (CA-2, 1930).
Mark L. Lubin, CPA, JD, LLM, is special counsel at the law firm Chamberlain Hrdlicka in Philadelphia. He can be reached at firstname.lastname@example.org