To know how to adjust S Corporation stock basis, we first need to answer the question: What is stock basis? Stock basis is the amount of original value or cost of the shares, which is needed for tax purposes. For S Corporations, though, stock basis becomes a moving target because it goes beyond just the original cost of the shares. Stock basis for S Corporations also considers annual fluctuations in income or loss, and deductions.
To determine the income, loss, and deductions, all shareholders (including the ESOP) in an S Corporation will receive a Schedule K-1 that reflects these numbers annually. Certain line items on the Schedule K-1 will increase the stock basis, and certain line items will decrease the stock basis. For example, ordinary income, separately stated income items, and tax-exempt income will increase the stock basis, while ordinary loss, nondeductible expenses, and non-dividend distributions will decrease the stock basis.
Once you have determined the total annual adjustment from the Schedule K-1, it is then divided by the total number of shares, resulting in a cost basis adjustment per share.
Why is it important to keep track of the annual stock basis adjustments in an S Corporation? First, it is the responsibility of the shareholder (the ESOP, in this case) to keep track of the stock basis. Secondly, if participants are permitted to receive lump sum distributions in the form of stock from the ESOP, then their stock basis needs to be calculated for tax purposes for their 1099-R Form.
If you are an S-Corporation ESOP sponsor, it is important that you provide your plan administrator with the annual Schedule K-1 Forms, so that they can assist in calculating the annual stock basis adjustments.
* Note: This does not apply to C Corporations.