What happens if an S corporation loses money?
Income or loss from an S corporation passes through to the S corporation shareholders' individual tax returns.
How Loss Accounting Works
If two shareholders own equal chunks of an S corporation and the S corporation makes $200,000, for example, each shareholder reports $100,000 of income on his or her personal return. The individual shareholders then pay any income taxes owned on that $100,000 of profit when they file their personal returns.
In a situation where an S corporation loses money, the same accounting occurs. If an S corporation with two equal shareholders loses $200,000, each shareholder reports a $100,000 loss from the S corporation on his or her personal return. This $100,000 loss--the loss will look like a big deduction on the front of the individual's tax return--should save anywhere between $10,000 and $50,000 of taxes.
Loss Deductions Sometimes Limited
One common problem exists, however, with deducting S corporation losses. A shareholder, in order to claim an S corporation loss, must be losing his or her own money. Without getting into all of the gritty details, if the money that was lost in the S corporation was really borrowed from someone else, like a bank, the shareholder won't be able to claim the loss deduction on his or her personal return.
Restated in the language you might be hear from an accountant, an S corporation shareholder must have basis in the S corporation stock he or she owns or the shareholder must have made direct loans to the S corporation in order to claim the losses.
When Lost Deductions Occur
Let me talk just a little more about this problem of spending borrowed money to get tax deductions--also known as the curse of inadequate basis in an S corporation--because it's so darn common.
The common recipe for bungling S corporation loss deductions occurs at the end of the year. An S corporation realizes it's made a ton of money and that, surprise, this profit means shareholders will pay a ton of income taxes.
At this point, a helpful banker offers to loan the corporation, for example, $100,000 to buy a piece of equipment that can immediately be deducted. The thankful owner accepts the suggestion. Soon after, the new piece of machinery or equipment sits on the shop floor. And the S corporation owner sits in his office feeling, well, a little smug.
At some later point--probably during tax season--the S corporation's outside accountant tells the S corporation owner that while the S corporation can write-off the new equipment, the business owner will not be able to claim the deduction. The reason? Because the money that has been "lost" didn't come from the shareholder. Rather the money came from the bank. Bummer.
A Work-around for Lost Basis
By the way, there's a workaround for this problem if you spot the trouble before the year ends. You can have the bank to loan money to the shareholder and then have the shareholder loan the money directly to corporation. This back-to-back loan approach typically should not increase the shareholders' risk (because they're providing personal guaranties to the bank in order to get a loan). But the back-to-back loan does give the S corporation's shareholder or shareholders basis.
Additional Information You May Find Useful
If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.
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