S Corporations - Shareholder Basis

S corporation shareholders report and pay taxes on their pro-rata share of the financial institution's taxable income to avoid the double taxation that applies to C corporation income. To the extent after-tax earnings are distributed as dividends, C corporation shareholders pay a second tax; S corporation shareholders, in contrast, receive the distributions tax-free.

If the earnings are retained, the double tax on C corporations is a little harder to detect, but it is very real. Undistributed after-tax earnings increase the value of C corporation stock, but they do NOT increase the stockholder's tax basis in the stock. As a result, the accumulated earnings are taxed again as capital gain when stock is sold.

In contrast, the basis of a share of S corporation stock increases by its share of undistributed taxable income. All income and gain items, including tax-exempt income, increase the S corporation stock basis; all items of loss and deduction decrease the basis. As noted, only undistributed S corporation income increases basis; distributions reduce the basis of S corporation stock.

Finding the original basis can be a challenge. Some places to look for this information:

• If shares were purchased from an individual or from the financial institution directly, their basis would be the actual purchase price paid for those shares.
• If shares were obtained by gift, then their basis would be that of the donor. This information is generally found on Schedule A of Form 709 - U.S. Gift (And Generation -Skipping Transfer) Tax Return.
• If shares are inherited from a family member, then their basis would be the fair market value (FMV) at the date of death (or the alternative valuation date if so elected by the executor of the estate). This information is generally found on Schedule B of Form 706 - U.S. Estate (And Generation-Skipping Transfer) Tax Return.
• Many times basis information can be found attached to the initial tax return of the bank holding company if the bank holding company was formed by bank shareholders exchanging their bank stock for bank holding company stock.