One significant benefit of operating a business as an S corporation is the ability of the shareholders to report S corporation losses in their individual income tax returns and offset taxable income from other sources. However, this benefit is only available when the shareholders have an economic stake (evidenced by sufficient tax basis) to absorb the loss.
Taxpayers may be surprised by the IRS' rather strict view on what constitutes an economic stake. As a result, taxpayers may not finance their S corporations in the appropriate way, and may be surprised when the IRS disallows the benefit of the losses.
S corporations are often financed through a combination of capital contributions by their shareholders, and loans from one or more of those shareholders. Each shareholder/creditor then has initial tax basis in the stock and debt equal to the amount each contributed and loaned, respectively. The tax basis in each shareholder's stock is adjusted upward as taxable income is allocated to the shareholder, and downward as distributions are made as to that stock.
The tax basis in the stock and the tax basis in the debt are also adjusted downward (but not below zero) when a shareholder is allocated tax losses. Tax losses are first applied against stock basis and then, after stock basis has been reduced to zero, to debt basis. If taxable income is subsequently allocated to a shareholder holding stock and debt with previously reduced basis, the income first restores the basis in the debt up to the face amount of the debt, and the remainder of the taxable income then increases the basis of the stock.