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Investing in stocks can generate a substantial passive income. But you should only invest your money after understanding the tax implications of your investments. For instance, owning stocks in a C corporation and an S corporation will affect your taxes differently.
To make matters more complex, the IRS replaced the 2018 Worksheet that helped S corporation shareholders determine their stock and debt basis with Form 7203.
The IRS issued several iterations of this form since 2021. Its most recent version was published in December 2022.
The form helps you track your stock and debt basis in an S corporation and calculate the gains and losses you can report on your tax return. You must attach this form to your tax return if you sell shares or receive a loan repayment from an S corporation during a tax year.
We’ll take you through the IRS Form 7203 to help you understand your tax obligations in 2023 and determine if you have to file it with Form 1040.
Table of Contents
The Basics of S Corporation Stock and Debt Basis
S corporations are pass-through entities, meaning all income, credits, deductions, and losses they generate are passed onto their shareholders. Hence, you must report any flow-through losses or income on your tax return if you own stocks in an S corporation.
To do so, you must track and adjust your stock basis annually. The initial stock basis equals the sum you paid to obtain stocks (provided you didn’t inherit the stock or received it as a gift) in an S corporation, plus the tax basis for the property you contributed to the corporation.
The most common reasons to determine and track a shareholder’s stock basis are:
- Establishing the taxability of distributions shareholders receive from an S corporation.
- Calculating the gains and losses of stock sales under Section 1001.
- Shareholders who receive losses from an S corporation can track their basis to determine how much of the loss they can use, suspend, or carry to the next tax year.
The gains and losses you can recognize on your tax return depend on the stock basis. Also, the deductions and losses listed on Schedule K-1 reduce the basis.
The debt basis is the amount a stakeholder loans to an S corporation, and it can increase if the stakeholder gives multiple loans to the corporation or decrease if the corporation pays off its debt.
It’s important to note that the debt basis can’t be below zero and that stakeholders can carry losses into the following year. Also, the debt basis will be zero if no debt exists at the start of the year. But that amount can be adjusted by deductions or losses from previous years.
Basis Limitations
Shareholders aren’t automatically eligible to claim a loss passed through from an S corporation if they receive a Schedule K1 containing a loss. According to the IRS, there are four types of loss limitations:
- Stock and debt basis limitations
- At risk limitations
- Passive activity loss limitations
- Excess business loss limitations
In most cases, shareholders in S corporations can claim pass-through losses only if they meet the criteria of these limitations. How much loss a shareholder can deduct depends on their stock basis in an S corporation.
Besides Form 7203, you may have to file Form 461, Form 8582, or Form 6198 with your tax return, depending on the information in Schedule K1. You can find more information about when you must file these forms in the instructions for Form 1120-S.
Deductions and losses disallowed in one tax year due to basis limitations are carried over to the next year.
IRS Form 7203 allows you to calculate your stock and debt basis and determine the limitations you may face when deducting credits, losses, and gains on your return.
A Glance at IRS Form 7203
Despite undergoing several changes since its introduction in 2021, the most recent version of IRS Form 7203 remains similar to its earlier iterations. The addition of item D is the most notable addition to the form’s new layout.
The item enables taxpayers to choose the stock acquisition method, which is particularly important for determining the stock basis and declaring the Regulations section 1.1367-1(g) election.
Part I
The form contains three parts, starting with the Shareholder Stock Basis section. You can pull most of the information you need to complete this part from Schedule K1, including the ordinary business income, net capital gains, or tax-exempt income.
However, you’ll have to calculate the stock basis at the beginning of the S corporation’s tax year and the basis of capital contributions or additional stocks purchased during a tax year on your own.
The calculation method you must use will depend on the stock acquisition method, so the share’s price will be your starting point when calculating the stock basis of the stocks you purchased.
On the other hand, if you inherited the stock, you’ll have to use its fair market value on the day the descendent died to calculate its stock basis.
Remember that you cannot combine the stock and debt basis when determining if distributions based on stock ownership are taxable.
Part II
The form’s second part has three sections that establish the amount of debt, adjustments to debt basis, and gain on loan repayment.
You must know the loan’s initial balance to determine the shareholder’s basis in an S corporation’s debt. Afterward, you must add other loans and deduct principal payments and losses assigned to the loan basis.
If a shareholder has more than one loan, each loan’s basis is calculated separately. The shareholders must declare on Form 7203 whether the debt is an open account or a formal note.
Open account debts that exceed the $25,000 threshold in the current tax year must be classified as a formal note the following year and tracked separately.
Taxpayers must list each loan separately since aggregating multiple loans from a shareholder to an S corporation into a single loan is against the IRS rules.
When establishing the adjustments to the debt basis, you must determine the restoration of the debt basis before repayment, nondeductible expenses, allowable losses in excess of stock basis, and other values necessary to compute the adjustment.
Part III
The final portion of the form lists the allowable loss and deduction items. You can enter any Section 179 deductions, charitable contributions, or business and capital losses you make or sustain during a tax year.
You should also include the allowable losses from stock and debt basis and carryover amounts from the previous and current year in this section of Form 7203. You must add up all lines in Part III of Form 7203 to calculate the loss you can claim on your tax return.
How and When to File Form 7203?
Owning stock in an S corporation doesn’t mean you must attach IRS Form 7203 to your annual tax return. You must submit this form to the IRS under the following conditions:
- You received a non-dividend distribution.
- You sold a portion or all stock in an S corporation.
- You received a loan repayment from an S corporation.
- You claimed a deduction for your share of loss attributed to you by S corporation. The same applies to losses disallowed in previous years due to basis limitations.
Although the annual filing of this form isn’t mandatory, filling it out at the end of each tax year is still advisable. Doing so will enable you to track your stock basis as it changes over the years and eliminate the need to browse through old Schedule K-1s.
The IRS may only allow losses on Schedule K-1 for future years if you file the form as required in the current year.
A handful of tax software products can create Form 7203, add it to a tax return and perform basic calculations based on the information you enter, so in most cases, you’ll have to attach the form as a PDF file to Form 1040 if you want to e-file your return.
Optionally, you can use the form’s paper version but remember that the IRS needs six to eight weeks to process tax returns filed on paper.
Frequently Asked Questions
Tracking the stock basis is the stakeholder’s responsibility, while the S corporation only issues Schedule K-1 to its stakeholders that outlines their gains, dividends, or losses. Consequently, S corporations aren’t required to file this form.
Shareholders in S corporations who don’t have loans or receive loan repayments from a company during a tax year can skip Part II of Form 7203.
You can use two Forms 7203 if you sell, redeem or dispose of stock in some other way. You should calculate the stock basis on the day of the sale on the first form and use the second form to determine the debt and stock basis at the end of the year.
Item D on Form 7203 offers five acquisition methods, and you can choose from the original shareholder, purchased, inherited, gift, or other options depending on how you acquired stock.
You must select the Other option if you acquired stock using methods outlined in Section 959(a)(2).
Relying on IRS Form 7203 to Track Your Stock Basis and Meet Your Tax Obligations
The IRS estimates that understanding the laws and regulations required to fill out Form 7203 takes 15 minutes, while preparing and submitting the form takes around 80 minutes.
This estimation doesn’t seem reasonable due to the complexity of the rules stakeholders in S corporations must follow when determining their stock and debt basis.
Even so, determining when you must file this form is straightforward. You must only attach it to your tax return if you dispose of stock, receive a non-dividend distribution, get a loan repayment during a tax year, or want to deduct a loss from your federal taxes.
It’s advisable to complete Form 7203 every year, even if you don’t have to send it to the IRS, because it will enable you to keep a record of your stock and debt basis in an S corporation.
Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
