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Tax Basis of a Business Entity
“Basis” is largely a tax concept. By definition, basis is the value that an individual pays for an asset. If the asset is later sold or disposed of for a higher amount, there is a gain. If it is sold for a lower amount, there is a loss. One unique aspect of basis in a business entity is that it includes the value paid for the equity ownership, as well as the value of any business liabilities assumed in a partnership or LLC.
- Example: ReadyBiz, LLC purchases equipment for $10,000 in cash and signs a promissory note for $15,000, ReadyBiz’s basis in the equipment is $25,000. If ReadBiz purchases multiple pieces of equipment together, then the tax basis must be attributed to the item based on its individual value. Determining the basis is important in determining tax consequence when the equipment is later sold.
Increase in Tax Basis
A business owner’s basis increases as more funds are invested in the business. In an entity that elects pass-through taxation, the owner’s basis further increases if the business makes a profit that is taxed to owners but not distributed. Conversely, if the business suffers a loss that is deducted on the equity holder’s personal tax return, then it reduces the basis in the business.
- Example: Sam starts a new business named Store, Inc., and elects to be taxed as a pass- through entity under Subsection S of the IRC. She then invests $10,000 in the business. Her basis in the business is therefore $10,000. In the first year, the business makes a profit of $5,000. Since profits pass through to the owners, Sam pays personal income taxes on this $5,000, but leaves it in the business (i.e., reinvests it). Sam’s basis in the business is now $ 15,000. The following year, the business loses $3,000. Same reports these losses on his personal income tax return. His basis in the business is reduced to $12,000 because he used the $3,000 loses to offset other income.
- Example: In the above example, Sam may elect for Store, Inc. to be subject to corporate taxation under Subsection C of the IRC. In such a case, Sam will only pay dividend taxes on distributions of profits by Store, Inc., to her. If she pays tax on those distributions, then reinvests them back in the business, her basis in the business increases.
- Note: A person’s basis cannot be reduced below zero ($0). If this happens, the person will be assessed a tax to bring the basis back up to zero.The depreciation of assets reduces the basis of those assets because it allows for the return of value paid for the asset in the form of depreciation deductions. The reduced basis is known as the adjusted basis. Entrepreneurs and equity investors track their basis to determine any gain or potential income tax liabilities from future distribution of profits or sale of the business.
- Example: Store, Inc., claims $500 of depreciation deductions on its equipment. The adjusted basis would be $9,500 (i.e., take the $10,000 basis from the above purchase of equipment and subtract $500). Depreciation, amortization, and deducted losses are effects that can lower a business’ basis in equipment.
What are the basis and at-risk limitations?
An equity holder’s basis is generally determined by a combination of the amount of an owner’s investment (capital basis), and, for pass-through tax entities, the amount that the investor has at-risk in the business venture (debt basis). As the name implies, at-risk means that the equity investor has the possibility of losing these funds. An equity investor who invests funds in the business venture in exchange for equity ownership has an at-risk basis of that amount. In some pass-through entities (excluding an S corpora4on), an equity holder’s at-risk amount also includes any loans to the business that the equity holder personally guarantees.
- Example: Victoria invests $1,000 in John’s business (an LLC). Victoria also personally guarantees a SBA loan to the business for $500. Her basis in the business is $1,500 ($1,000 + $500).
- Note: Basis is essentially the outer limit of what you may be able to deduct. At-risk elements may prevent full recognition of loss to the extent a partner is not subject to risk of repayment of some or all of the partnership debt allocated to her.
Raise Basis and At-Risk Amount
The ability to raise one’s basis and at-risk amount in a business by personally guaranteeing a loan is a strong consideration in choosing an entity form. Business owners may need to use business losses to offset other income. Basis may limit an owner’s ability to use those loses, as she cannot deduct losses that reduce her basis below zero ($0).
- Example: In the example above, Victoria’s basis is $1,500. The LLC takes a loss in a year for which Victoria’s allocation is $2,000. She has other income of more than $2,000 that she would like to offset with the LLC losses. Unfortunately, Victoria is limited by her basis amount and may only offset $1,500 of her other income (assuming other rules of offset are met). If she offsets $1,500 of her other income with the LLC losses, her basis in the business will be reduced to $0. Likewise, her at-risk amount is now zero.
- Note: The ability to use loans made to the business to raise an owner’s basis is a complicated subject. In general, the ability to include a guaranteed loan amount in basis turns on what kind of entity the business is and on whether the owner-guarantor has recourse against anyone (including the business entity or other owners) if the business fails to repay the loan. If the business owner bears all of the risk for the business’ loan default, without the ability to seek contribution or reimbursement from others, then the guaranteed loan amount may be included in one’s basis.