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S Corporation
Income & Loss Rules

Master how S corporation income, deductions, and losses pass through to shareholders and the basis limitations that control deductibility.

CPA Regulation (REG)

What Is an S Corporation?

An S corporation is a corporation that elects pass-through taxation under Subchapter S of the Internal Revenue Code. The entity itself generally pays no federal income tax: instead, all items of income, deduction, gain, loss, and credit flow through to each shareholder's individual return.

Pass-Through
Income and losses reported on shareholder's Form 1040 via Schedule K-1
Limited Liability
Shareholders enjoy corporate liability protection while avoiding double tax

Separately vs. Non-Separately Stated Items

The S corporation must separate items that could affect shareholders differently from the ordinary business income (loss) that is reported as a single figure.

Separately Stated
Capital gains/losses, Section 1231 gains, tax-exempt interest, charitable contributions, rental income, foreign taxes
Non-Separately Stated
Ordinary business income or loss (net of cost of goods sold, salaries, rent, depreciation, etc.)

How Income Flows Through

S Corporation Schedule K-1 Shareholder A
\( 50\% \) share
 Shareholder B
\( 30\% \) share
 Shareholder C
\( 20\% \) share
 Pro-rata allocation based on ownership % and days held

The Pro-Rata Allocation Rule

Under IRC Section 1377(a), each shareholder's share of any S corporation item is allocated on a per-share, per-day basis. If a shareholder's ownership changes mid-year, the annual amount is divided by 365 days and allocated according to shares held each day.

Shareholder Basis: Annual Adjustments

A shareholder's stock basis is adjusted annually in a specific order. Getting the sequence right is critical for determining loss deductibility.

1
Increase for income items: ordinary income + separately stated income + tax-exempt income
2
Decrease for distributions (but not below zero)
3
Decrease for non-deductible, non-capital expenses (e.g., \( 50\% \) meals, penalties)
4
Decrease for deductible losses and deductions (limited to remaining basis)

Loss Limitation Hierarchy

Before an S corporation shareholder can deduct a loss on their individual return, the loss must survive four hurdles applied in order.

HURDLE 1 Stock Basis Limitation HURDLE 2 Debt Basis Limitation HURDLE 3 At-Risk Limitation HURDLE 4 Passive Activity Rules IRC §1366(d) IRC §1366(d)(1) IRC §465 IRC §469 ↓ Deductible Loss on Form 1040

Stock Basis vs. Debt Basis

Losses first reduce stock basis to zero, then may reduce debt basis if the shareholder has personally lent money to the S corporation. Guarantees of corporate debt do not create debt basis.

Stock Basis Debt Basis
Source Capital contributions + accumulated income Direct loans from shareholder to S corp
Increased by Income, additional contributions Additional direct lending
Reduced by Distributions, losses, non-deductible expenses Losses (after stock basis is zero)
Guarantee of bank loan? No effect No effect

Key Distinction: S Corp vs. Partnership

One of the most tested CPA exam distinctions: how entity-level debt affects an owner's basis for deducting losses.

S Corporation Partnership
Entity debt increases owner basis? No Yes
Owner guarantee of entity debt? No basis Increases basis
Direct loans from owner? Yes: debt basis Yes: increases basis
Nonrecourse debt? No effect Shared among partners

Step-by-Step: Deducting S Corp Losses

1
Calculate stock basis. Start with beginning basis, add income items, subtract distributions and non-deductible expenses.
2
Compare loss to stock basis. Deduct losses up to remaining stock basis (reduce basis to zero).
3
Apply excess to debt basis. If loss exceeds stock basis, deduct additional amount up to the shareholder's debt basis.
4
Suspend the remainder. Any loss still exceeding combined stock + debt basis is suspended and carried forward indefinitely.
5
Apply at-risk and passive rules. Losses passing basis hurdles must still clear at-risk (IRC §465) and passive activity (IRC §469) limitations.

Example 1: Basic Loss Deduction

Alexis owns 100% of an S corporation. Her stock basis at the beginning of the year is \( \$40{,}000 \). The S corp reports an ordinary loss of \( \$25{,}000 \). She has no debt basis.

Beginning Basis
\( \$40{,}000 \)
\( - \$25{,}000 \) loss
\( = \$15{,}000 \)
 Result
Ending basis: \( \$15{,}000 \)
Deductible loss: \( \$25{,}000 \)
Suspended: \( \$0 \)

Example 2: Partial Suspension

Brian owns 100% of an S corp. Beginning stock basis: \( \$20{,}000 \). He also made a direct loan to the S corp of \( \$10{,}000 \) (debt basis). The S corp's ordinary loss: \( \$35{,}000 \).

1
Apply \( \$35{,}000 \) loss against \( \$20{,}000 \) stock basis: stock basis reduced to \( \$0 \). Remaining loss: \( \$15{,}000 \).
2
Apply \( \$15{,}000 \) remaining against \( \$10{,}000 \) debt basis: debt basis reduced to \( \$0 \). Remaining loss: \( \$5{,}000 \).
3
Deductible loss: \( \$30{,}000 \). Suspended loss: \( \$5{,}000 \) (carried forward indefinitely).

Example 3: Ordering with Distributions

Clara: 100% S corp owner. Beginning basis: \( \$50{,}000 \). During the year, the S corp reports \( \$20{,}000 \) ordinary income, makes a \( \$30{,}000 \) cash distribution, and has a separately stated capital loss of \( \$25{,}000 \).

1
Add income: \( \$50{,}000 + \$20{,}000 = \$70{,}000 \)
2
Subtract distribution: \( \$70{,}000 - \$30{,}000 = \$40{,}000 \)
3
Subtract loss: \( \$40{,}000 - \$25{,}000 = \$15{,}000 \). Entire capital loss is deductible.

Suspended Losses: Restoration

Suspended losses carry forward indefinitely and become deductible when the shareholder's basis is restored. But suspended losses do not transfer to another person.

Basis Restored By
Future S corp income, additional capital contributions, or additional direct loans
Lost Forever If
Shareholder sells or gifts all stock, or the S election is terminated

Distribution Rules for S Corps

Unlike C corporations, S corp distributions are generally not dividends. They follow a specific ordering tied to the Accumulated Adjustments Account (AAA).

1
Tax-free return of basis from AAA (reduce stock basis, no tax)
2
Taxable dividend from accumulated E&P (only if the S corp was formerly a C corp)
3
Additional return of basis (reduce remaining stock basis)
4
Capital gain to the extent distribution exceeds all basis

Common Mistakes to Avoid

✕ Guarantees = Basis
Guaranteeing S corp debt does NOT create debt basis. Only direct loans from shareholder to the S corp count.
✕ Wrong Ordering
Applying losses before adding income and subtracting distributions. The four-step ordering is mandatory.
✕ Ignoring Debt Basis
Forgetting that excess losses (after stock basis is zero) can reduce debt basis from direct shareholder loans.

Question 1 of 5

A shareholder has a stock basis of \( \$30{,}000 \) and no debt basis. The S corp reports an ordinary loss of \( \$45{,}000 \). How much loss can the shareholder deduct this year?

Question 2 of 5

Which of the following creates debt basis for an S corporation shareholder?

Question 3 of 5

When adjusting S corporation stock basis, in what order are the following applied?

Question 4 of 5

An S corporation was formerly a C corporation with \( \$50{,}000 \) accumulated E&P. It makes a \( \$70{,}000 \) distribution to its sole shareholder whose stock basis is \( \$40{,}000 \) and AAA is \( \$40{,}000 \). How is the distribution taxed?

Question 5 of 5

A shareholder's suspended S corp losses are permanently lost in which of the following situations?