The Importance of Basis Records in S-Corporation Banks and Bank Holding Companies

January 23, 2020 | Article

The IRS requires owners of S corporation banks and bank holding companies to track and report tax basis. The requirement is effective with tax years beginning in 2018. The owners of a pass-through entity must now attach, to their individual tax returns, a calculation of the tax basis in their shares if they:

  • Are allocated a loss;
  • Received a distribution;
  • Disposed of their ownership interest during the year; or
  • Received a loan repayment from the company.

Why was the basis requirement put into place?
It appears the IRS has noticed a relatively high rate of noncompliance. In response, the IRS has drafted and published a soft letter to send to taxpayers who have not attached a basis worksheet to their individual tax return.

What types of banks does the new basis requirement impact?
This new IRS requirement is likely to impact most S corporation banks and bank holding companies.

The most likely situations include:

  • The bank that has shareholders who disposed of their ownership interest

  • The bank that made distributions for the owners to pay their individual income taxes on their share of the bank’s income
  • Since the calculation of basis is cumulative, each taxpayer must update their basis in the entity annually, even if none of the events requiring tax return disclosure arise during the year. According to the IRS, the obligation to determine and disclose the tax basis is the owner’s. The owner will report and disclose the information needed on an attachment to Schedule E and include with Form 1040.

    Even though the obligation to determine and disclose tax basis is the owner’s, pass-through entities should maintain basis records for the owners and provide the calculation of the adjusted basis alongside the Schedule K-1s. Starting this process as early as possible is key. Ideally, the beginning basis for each owner will be updated as of the beginning of 2019.

    What is the benefit of maintaining basis records?
    Maintaining basis records has significant benefits for the pass-through entity. Many owners do not maintain basis records and the information that adjusts basis annually. Maintaining an entity’s basis records will facilitate a more accurate ownership list and improve the accuracy of the allocations on Schedule K-1s as part of the tax return. If the pass-through entity is maintaining basis, an opportunity opens for the entity to send a confirmation letter to every owner during the first week in January requesting confirmation of the ownership, of any changes in ownership, and the facts surrounding those changes.

    This confirmation identifies otherwise unknown gifts among family members, changes in trusts, deaths of owners, and unreported purchases and sales of shares. Therefore, maintaining basis records will vastly improve the accuracy of the allocations of income and distributions.

    Inaccurate Reporting Can Result in Termination
    S corporation banks are exposed to having their S-election inadvertently terminated by unreported shareholder actions, especially actions involving trusts and estates. Maintaining the shareholders’ basis facilitates more thorough annual due diligence to protect the validity of the S election. The S corporation bank will be better able to:

    • Follow-up on deadlines for former grantor trusts or testamentary trusts to dispose of shares
    • Ensure QSST and ESBT elections are timely filed
    • Change ownership information from decedents to estates and then to beneficiaries of the estate

    How do I maintain and report basis records?
    Basis will be more accurate if the pass-through entity, through its tax preparer, maintains the basis records. All the information for the annual adjustment of owners’ basis is available in the owner’s Schedule K-1. However, tax basis can be complex; the risk of error increases as the number of owners increases and transactions in shares become more frequent.

    If an owner uses up their basis, the pass-through entity can include a statement with the Schedule K-1 stating the amount of loss not allowable in the current year and will be carried forward, or the amount of gain that the owner should include in income. The statement is much more likely to have the attention of the owner’s tax preparer than just the information on page 1 the Schedule K-1.

    Finally, under the Tax Cuts and Jobs Act, if an individual owner pays their tax preparer to determine basis, the cost is nondeductible. If the entity pays to maintain the basis records as part of the annual tax return preparation, it is an ordinary and necessary business expense that reduces allocable taxable income on page one of the return.

    The importance of complying with the new basis requirement
    Pass-through entities should strongly consider maintaining basis records for their owners. These records will lower the possibility of incorrect basis and improve the accuracy of the Schedule K-1s.

    Next Steps
    With the exception of very simple ownership structures with only a handful of owners, we strongly encourage pass-through entities to maintain the basis records for their owners. These records will lower the possibility of incorrect basis as well as improve the accuracy of the Schedule K-1s. If your bank has not previously maintained basis, we can prepare the basis worksheets outside of busy season, preventing a slow-down of the current year tax return preparation.

    Please contact your Eide Bailly representative if you have any questions or would like to start tracking tax basis for your entity.

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