 Hello and welcome to this session in which we will discuss the S shareholder stock spaces, which is composed of their stock basis and their debt basis. So let's review first what we know. We learn about the stock basis in a prior session and how are the stock basis established is when the shareholder contribute property and we'll use the adjusted basis of that property. The shareholder might also contribute cash that's going to increase the stock basis. The shareholder might contribute services and we'll use the fair market value of the services which would increase the stock basis. If the S corporation, if the corporation pays back the shareholder any cash that's going to reduce your basis, any liabilities assumed by the corporation basis part of the adjusted basis reduces the stock basis and any gain recognized from the contribution of the property. If you recognize the gain, it means it's taxable. Once it's taxable, it's going to increase your basis. So this is the initial establishment of the stock basis. Once the stock basis are established, what's going to happen is this. It's going to go up and down after it's established. It's going to go up by any corporate income items such as dividend, tax exempt interest. Yes, tax exempt interest will increase your basis. Although it's not taxable, it will increase your basis and ordinary business income. Simply put, it's going to increase by separately and non separately stated items. If the shareholder makes any additional contribution, of course, contribution will increase your basis. The opposite of those two is true. When the corporation incur a loss or has a deduction items or non deductible expenses, those will reduce the stock basis of the shareholder and any distribution which the opposite of a contribution will reduce the stock basis of the S shareholder. Then we will come up with the stockholder basis ending share, ending shareholder stock basis. So this is what we learned in a prior session. Now what we need to talk about is the debt. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. Now if you notice that the stock basis does not include any corporate libraries, so simply put what's going to happen is this. S shareholders have a separate debt basis for direct loans made to the S corporation. So if the shareholder loaned the corporation money, guess what's going to happen? We are going to have a separate basis, it's called the debt basis for that loan. Now so the tax basis equal to the sum of the stock basis which we talked about and the debt basis. The debt basis include the direct loans made by the S shareholder to the S corporation. So simply put you loan money to the corporation directly, well that's part of your debt basis. What happened if there's a third party loan made to the S corporation? Well it does increase the shareholder debt basis if, this is the third party, this is not the shareholder, the loan is coming from the bank, the loan is coming from somewhere else. If the shareholder makes payment then technically it becomes the shareholder's responsibility, therefore it will increase the debt basis or the shareholder is the primary signatory on the note, the primary signer on the note with the corporation being the guarantor. Under those circumstances a third party loan to the S corp increases the shareholder debt basis. To sum it up the tax basis is composed of the stock basis and the debt basis that we just learned about on this slide. Now why is this important? Why do we need to know about the stock basis and the debt basis? Well because we have to deal with something called losses limitation. The combat, the combat abuses associated with deduction are excessive losses by taxpayer. Simply put they are as introduced four losses limitation. Simply put you cannot keep on deducting those losses as the S corporation incur losses well you cannot be, you should not be able to absorb or losses unless there are certain limitation. The first limitation is you have to have a tax basis, you have to have at risk limitation, you have to have a passive income loss limitation, this is covered in a separate session and it applies to the shareholder on the individual level and there's an access business loss limitation. Again this is covered in a separate lesson and those two applied to the individual level. So the first two limitation which is the tax basis and the address limitation are applied at the entity level. They limit the amount of losses incurred at the flow through entities that may, that may pass through to the shareholder. So simply put you can deduct losses up to your tax basis up to your at risk amount. The remaining two limitation they apply to the individual individual tax return and again we have a separate recording for these losses in a separate session. Starting with the tax basis limitation what does that mean? It means in order to deduct a loss passed through by an S corporation the shareholder must have sufficient stock basis and sufficient debt basis. So you have to have a basis okay? The basis are composed of stock and debt. You have to have those. A loss and access of the tax basis is suspended until the basis are reinstated. So if you have any losses that's fine they get suspended. Once you re-establish your basis you can take them again once you establish your tax basis. The access loss may be carried forward indefinitely however any suspended losses is lost if you sell your interest in that S corporation. If you dispose of your interest it's gone. So a loss that passes through to an S shareholder reduces first their stock basis then their debt basis. In contrast when you are reinstating first you have to reinstate your debt basis then you reinstate your stock basis. So on the way down first you knock out your stock basis you reduce your stock basis. Once that's done you start to reduce your debt basis. On the way on the way backward the first you reinstate your debt basis you pay back your debt then you reinstate your stock basis. Let's take a look at an example to illustrate this concept. Just GIST incorporated on January 1st year 2 and immediately elected the S status on that date the corporate sole shareholder Andy contributed $17,000 in cash and loaned the company $7,000. By the end of year 2 the corporation has capital loss of 20,000 or losses of 20,000 ordinary income loss. Determine Andy's beginning stock basis and debt basis. What's their beginning stock basis? The cash contributed and the debt basis is the 7,000. So the beginning stock is 17. So you should do you'll have stock basis and for that stock basis you would say okay my beginning stock basis is 7,000 and you have if you want to put here debt basis and you say my debt basis are 7,000. Together they compose your tax basis. So ignoring any limitation other than tax basis limitation determine the amount that capital loss can be absorbed sorry 17 the stock basis and 7,000 is the loan. So together they represent the tax tax basis of 24. Before deducting any loss Andy has a tax basis of 17 of 24,000. 17 is the stock and 7,000 is the debt. Therefore the pass through loss of 20,000 may be deducted in its entirety but how is it deducted? How do we deduct this? As we mentioned first is you deduct from your stock basis. First you deduct from your stock basis. Your stock basis go down to zero. Now you have 3,000 remaining because you have 20,000 in losses. Then you deduct the 3,000 from the debt basis which will make your basis equal to 4,000. So the stock basis is reduced first. Therefore the stock basis at the end of the year equals to zero. Obviously you wiped out the whole thing. The remaining loss of 3,000 reduce your debt basis as a result your debt basis equal to 4,000. Now let's assume for the sake of illustration the capital loss was 24,000. Well if that's the case the remaining 7,000 if that's the case would reduce your debt basis to zero. Now why is that important? Let's assume in year three the just kids ink pay back Andy the loan and paid back the loan and they paid back Andy $5,000 and they said this is a payment for the loan that you gave us initially of 7,000. Well guess what? The basis in the loan is zero. This $5,000 loan becomes taxable as capital gain. So make sure you're aware of this. If your debt basis are wiped out used to absorb losses then the corporation pays you back money in form of a loan saying this is your money back. Well guess what? Your loan was used up. This is basically capital gain because you made an investment you used it up now they're giving you back extra money they basically you lend you lend the money you used it up and losses you absorbed it you took a deduction if they give you access of that loan it's a capital gain. Now let's talk about the second limitation with the which is the at risk basis limitation. Well the at risk amount does not include non-recourse libraries simply put after you compute your tax basis what you do is you will deduct from your tax basis the non-recourse liability and you to come up with the at risk amount simply put if there was no non-recourse liabilities tax basis and at risk will be the same. Why do you deduct non-recourse liabilities because the shareholders are not personally liable for those liabilities they're not at risk therefore at risk amount is computed by deducting the non-recourse liabilities from the shareholder tax basis. Now recourse liabilities if you have a recourse liability it means you are personally responsible for that loan it increase both your tax basis as well as the at risk at risk basis because you are responsible the non non-recourse liabilities increase only the tax basis there's an exception for non-recourse liabilities that is secured by a real state by a real property and this is usually with real state people those are referred to as qualified non-recourse liabilities those if it says qualified non-recourse liabilities they increase the tax basis as well as the at risk basis amount let's take a look at an example to illustrate this concept for an 80 ownership interest in a newly formed VC Inc and as corporation Victor contributed $20,000 in cash equipment with a basis of 51 fair value of 60 we don't care about the fair value if we're talking about the basis Victor loaned the corporation 11,000 that that is borrowed by the company on a non-recourse basis okay so we borrowed the money it's a non-recourse basis we borrowed it from Victor determine Victor tax basis and at risk basis in the VC well Victor tax basis is computed as followed adjusted adjusted basis of contributed property 51,000 also contributed cash of 20 and direct loan to the S corporation of 11,000 all in all the tax basis is 82,000 now this tax basis has basically two components has a stock basis which is if you look at the stock basis 51 plus 20 which is 71 is the stock basis and we have 11,000 in that basis in that basis together they will give us 82,000 as tax basis now it's worth mentioning that the tax basis is the sum of those two why because once we compute the at risk basis what do we have to do we have to deduct this loan because this debt is non-recourse debt non-recourse debt should not be included at the at risk basis it tells us it's a non-recourse therefore Victor at risk basis is 82 if we have asked you about the at risk basis minus 11,000 minus the debt will come back the at risk amount is 71,000 so the at risk amount is equal to the stock basis because the total amount loan to the corporation represent a non-recourse debt non-recourse debt what should you do now what should you do go to far hat lectures and look at additional multiple choice through false exercises that's going to help you understand the difference between stock basis and debt basis which is stock basis and debt basis equal to your what tax basis why is it important to know the tax basis because the tax basis is the first limitation that you are going to use to absorb losses study hard this topic is important good luck and of course stay safe