S Corporation Taxation: Shareholder Basis and Loss Limitations
By SimplyCPA · 11 October 2026
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- Eligibility: A domestic corporation with no more than 100 shareholders, only eligible shareholders (no nonresident aliens, partnerships or C corporations) and one class of stock.
- Pass-through: The S corporation files Form 1120-S; shareholders report their pro rata share of items from Schedule K-1, allocated per share per day.
- Basis: Stock basis plus debt basis — only loans the shareholder makes directly to the corporation count, not guarantees.
- Ordering: Increase basis for income first, then reduce for distributions, then non-deductible expenses, then losses.
- Distributions: Tax-free to the extent of basis when there's no accumulated E&P; with E&P, they come from the AAA first, then are taxed as dividends.
Electing S status
- Domestic corporation (or an LLC that elects to be taxed as a corporation).
- No more than 100 shareholders — members of a family can elect to be treated as one.
- Eligible shareholders only: individuals who are US citizens or residents, estates, certain trusts and certain exempt organisations. Nonresident aliens can't be shareholders — an important point for founders living in India.
- One class of stock — differences in voting rights alone are allowed.
- File Form 2553, signed by all shareholders, by the 15th day of the third month of the tax year for which it's to take effect (relief is available for late elections).
Pass-through of income
The S corporation files Form 1120-S (due March 15 for calendar-year corporations). Income, deductions and credits pass through to shareholders on a per-share, per-day basis, with separately stated items keeping their character. Shareholder-employees owning more than 2% are treated like partners for fringe benefits — their health insurance premiums are included in W-2 wages and deducted above the line.
Calculating shareholder basis
The ordering rules (Treasury Regulation 1.1367-1) apply each year:
- Opening stock basis
- + Income items, including tax-exempt income
- − Distributions (non-dividend)
- − Non-deductible, non-capital expenses (such as 50% of meals and penalties)
- − Loss and deduction items
Losses beyond stock basis then reduce debt basis — loans the shareholder made directly to the S corporation. Guaranteeing a bank loan to the company doesn't create debt basis. When later income arrives, debt basis is restored before stock basis.
Example: Sam owns 100% of an S corporation. Opening stock basis is $10,000; Sam has also lent the company $15,000. This year: ordinary loss $30,000, tax-exempt income $2,000, distributions $4,000.
Stock basis: $10,000 + $2,000 − $4,000 = $8,000, then the loss reduces it to $0 (using $8,000 of the loss).
Debt basis absorbs the next $15,000 of loss.
Deductible loss (subject to at-risk and passive rules) = $23,000; the remaining $7,000 is suspended and carried forward indefinitely.
Distributions
| Situation | Treatment |
|---|---|
| No accumulated earnings and profits (E&P) | Tax-free to the extent of stock basis; any excess is capital gain |
| Accumulated E&P from C corporation years | 1) Tax-free from the accumulated adjustments account (AAA) up to basis; 2) dividend to the extent of E&P; 3) tax-free return of remaining basis; 4) capital gain |
Distributing appreciated property triggers gain at the corporate level, which flows through to shareholders.
Corporate-level taxes
- Built-in gains tax — a former C corporation pays tax at 21% on net built-in gains recognised within five years of converting.
- Excess passive investment income tax — applies if the company has accumulated E&P and passive income above 25% of gross receipts. Three consecutive years can terminate the election.
Reasonable compensation
Shareholder-employees must take reasonable wages for services before distributions; the IRS can recharacterise distributions as wages subject to employment taxes. See tax planning for S corporations.
Study further in REG S corporation taxation.