Book Basis Explained: What Is Your Book Basis and What Does It Mean?

Rebecca A. Casarez, CPA

Rebecca A. Casarez, CPA

What is book basis accounting-ProAdvisor CPA

What is Your Book Basis?(Capital/Equity/Shareholder/Ownership)
What Does it Mean?

In order for you to understand what Basis is, we need to go back to the beginning… Literally, the beginning of starting a business in the garage with your friends, starting your own company, when you buy stock in a company and so on. The beginning of OWNERSHIP in a company.

Every business has “owners” to the company, which can be shown as partners, equity owners, shareholders etc… depending on the type of business formed (corp, partnership, sole proprietorship), number of “owners” and preference. For instance, a corporation has “shareholders”, each purchasing common stock to get the rights to their portion of the “company pie”, so to speak. This is more easily understood since buying shares of stock in the open market is common practice. However, when forming a partnership, each partner needs to contribute something of value in order to have earned their rights to their percentage of that partnership entity.

So,in order to get the rights of owning their share of  that “pie”, you must give something up for it (usually CASH, but could be property, stock, land, patents and so on…). For our purposes of general explanation, we assume that CASH is given up for the ownership rights and that the Fair Value of the CASH is equal to the trading value of the ownership being issued.

When an “owner” provides CASH (or other property) in exchange for their portion of the company, it is called contributing capital (or property) to the company. This is shown on the Balance Sheet, in the Equity section. (refer to Balance Sheet article) The value assigned to the capital contribution is called BASIS and is the starting point for both financial and tax methods of accounting.

What is Book Basis:

In financial accounting, businesses must follow accrual accounting, GAAP rules with little exception, when preparing externally used Financial Statements. Likewise, businesses must follow the Internal Revenue Code (IRC) when preparing Income Tax returns. There are also various state and county rules that businesses must follow when reporting business activity. I know, I know, you are probably bored and terrified at the same time. Although not exactly exciting material, OR the reason why you wanted to be your own boss and start your own company, understanding your basis and the fundamentals are crucial to your success as a business owner.

What is Tax Basis:

Tax Basis is the value of ownership in a business (or any other asset, like equipment or shares of stock). Tax Basis is different (or could be) than Book Basis, and a big reason is that the Internal Revenue Code (IRC) treats transactions differently for tax purposes than GAAP does for financial reporting purposes.

Tax Basis determines how much Income Tax, Penalties, and Capital Gains (Losses) and other tax treatments are applied to each owner, especially when it comes to pass through entities (S-Corporations, LLCs, Partnerships etc…).

Simple Example:

Peter and Paul form a partnership: P&P Plumbing, LLC. Peter contributed (gave) $80,000 to P&P Plumbing, and Paul gave $20,000. This means that P&P Plumbing now has $100,000 in the Bank as an asset and $100,000 in Owner’s Contribution in Equity.

This also means that Peter OWNS 80% and Paul OWNS 20% of P&P Plumbing,LLC. These percentages and amounts are what will be used to apply both financial and tax accounting rules when the LLC conducts business that impacts the Equity of the company.

In year one, the company had $100,000 in Net Income (Profits). Since this is an LLC, a pass through entity, the Company itself does NOT pay Income Tax, but passes through tax benefits, burdens and so on, to each owner. This income also increases the stated Tax Basis of the owners. Depending further analysis of the circumstances, the BOOK BASIS may increase too.

(This is an overly simplified method to provide general knowledge. Please seek advice from your CPA or tax accountant when making decisions or planning for your business).

Overview:

“Basis” is an accounting term to describe an owners invested interest in a company – which starts with what each “OWNER” contributed to buy/earn their shares of the company.. Simply put, Basis is the individual measurement an owner (Partner or Shareholder) recognizes as THEIR portion or share to the company’s annual PROFITS, ASSETS and/or OBLIGATIONS (LIABILITIES).

BASIS increases or decreases when any one of these happens:

    1. When the Business (or Asset) has PROFITS (LOSSES)
    1. When the Business (or Asset) DISTRIBUTES (DIVIDENDS) directly to the owners
  1. When the Business (or Asset) is SOLD (either in whole or in segments).

Book Basis is a financial accounting term and Tax Basis is what is reflected on the company’s and/or individual income tax returns. Basis (both Book and Tax) change based on each year’s Profits (Losses) and/or Distributions (Dividends). This means that next year’s BASIS could be different than this year’s BASIS.

The following are FAQ about Tax Basis and Passive Activity Loss Rules:

(q) What is a Schedule K-1 and how does it impact You?

A Schedule K-1 is an IRS form that is produced when a Partnership or S-Corporation Tax Return is filed. Each Equity Owner (Partner or Shareholder) receives a personalized K-1 that reflects their’ PORTION of the company’s current year Profits (Losses) as well as any non-deductible, owner responsible expenses incurred by the company (such as Charitable Donations or Distributions).

The K-1 is then PASSED THROUGH to the respective Owner’s (Partner’s or Shareholder’s) and is reported on the individual’s income tax return (1040, Schedule E).

(q) How does a Company’s Losses affect the Individual’s tax return?

So, if the K-1 has a loss from the company, can YOU deduct those losses on your personal tax return? The answer is not an immediate “yes” or “no”.

Losses are only deductible if (all three must be present):

ONE: The reported loss on the Individual Owner’s K-1 is less than the Individual Owner’s tax basis FOR THAT YEAR. Refer to above explanation on how the Tax Basis fluctuates each year.

TWO: The basis is considered “at risk”: You’re at risk in any activity for the:

1. Money and adjusted basis of property you contribute to the activity  

or

2. Any amounts borrowed IF:

  • You’re personally liable for repayment, or
  • You pledge property (other than property used in the activity) as security for the loan

THREE: The losses are not passive. In other words, the owner must be actively participating in business operations. (IRS Pub 925 (rev 2016) emphasis added).

All three conditions above must be met for the loss rules to be applied.

Simple Example:
(continuing from above example)

In year one, instead of $100,000 Net Income, P&P Plumbing has a ($90,000) Net Loss, and Paul gets a K-1 showing 20% of the Net Loss.

The question is, can Paul take the $18,000 as a loss on his personal income tax return to offset other forms of Income, like the $82,162 he earned in the brokerage account at Edward Jones?

Using the above criteria:

    1. Is the $18,000 less than the $20,000 tax basis that Paul has? YES
    1. Is Paul have “at risk” for the activity? He personally gave the $20,000 originally to P&P Plumbing to create his basis in the company, so yes he is “at risk”.
  1. The losses are not passive. Did Paul work in the company actively throughout the year or is he just collecting dividend payments for his initial investments (like a silent partner)?

*This final step is the biggest hurdle to cross. Even though the K-1 reports a Loss, if this loss is passive to the individual, the loss is not allowed for that year (few exceptions apply and assuming no other passive activity for Paul).

Though this may seem like an easy “YES, Paul can take the $18,000 as a long on his personal income tax”, It isn’t that easy. Unfortunately, this question seems simple but is actually quite technical. In order to properly assess the question correctly a CPA or Tax Accountant should be consulted to look at all other factors that have an affect on “Paul’s” or an individual’s taxes.

Bottom line is, both you and your CPA, or Tax Accountant, needs to know your basis because:

  1. Your tax basis will determine (to an extent, as explained above) how much of the business’ losses are deductible.  If you don’t know how much basis you have in the business, you won’t know how much you are able to deduct.
  2. Your basis will determine the amount of gain or loss on sale of the business, partner share, or stock.
  1. Your annual Schedule K-1 often looks incorrect or inconsistent due to the changes made annually. If you have changed accountants over time, they may not have been calculating your basis correctly and applying the correct balances.

Your CPA or Tax Accountant should be involved throughout your ownership of every investment company to properly advise you on tax and accounting changes and how they will impact you on an individual level.

Sources:

Corporations, Partnerships, Estates, and Trusts 2017 Edition. Authors: Hoffman, William; Raabe, WIlliam; Maloney, David; Young, James. Publisher: South-Western Cengage Pages: 14-4 to 14-8.

IRS.gov (2016). Publication 925. Retrieved July 24, 2017 from: https://www.irs.gov/publications/p925/ar02.html#en_US_2016_publink1000104595

Disclaimer:
This publication is designed to provide information of federal tax and accounting laws and/or regulations. It is presented with the understanding that the author is not rendering legal or accounting services.
This text is not intended to address every situation that arises or provide specific, strategic tax and/or accounting planning advice. This text should not be used solely to answer tax and/or accounting questions and you should consult additional sources of information, as needed, to determine the solution to tax and/or accounting questions.
This text has been prepared with due diligence. However, the possibility of mechanical or human error does exist and the author accepts no responsibility or liability regarding this material and its use. This text is not intended or written by the practitioner to be used and cannot be used by a taxpayer or tax return preparer, for the purpose of avoiding penalties that may be imposed.

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