Stock basis crucial aspect of cap gains reporting
Q: In 1991 another person and I formed a subchapter S corporation with each of us being 50 percent shareholders. The business had a steady stream of income from the start, so we arbitrarily awarded ourselves 1,000 shares of stock each that were valued at $1 per share. In 1999, the other partner left, and his shares were purchased by an LLC consisting of two members who were not part of the original business. Since a subchapter S corporation was not an option due to the existence of a shareholder that was an LLC, we formed a C corporation. From the very beginning, the equity section of our balance sheet has listed $2,000 as capital stock. On January 1 of this year I sold all of my shares to one of the members of the LLC who purchased them individually. We signed an agreement whereby the proceeds of the sale would be paid to me over a fiveyear period including interest. The buy-sell agreement includes an amortization schedule detailing the interest and principal amounts for each calendar year. I presume I will have to report the annual interest on schedule A and that it will be taxed at ordinary rates, but I’m not sure how the long-term capital gain is reported. First, what is my cost basis, $1 per
share? Second, do I just report the sale of 200 shares each year for five consecutive years and apply the principal payments received each year as the sale price for those shares?
A: The most difficult thing for you to determine is the basis of your stock. So let me start with the easy part and we’ll eventually get to the basis issue.
The interest income will be reported on schedule B of your tax return each year and will then carry forward to the first page of the return. The principal will be proceeds from an installment sale.
In the year of sale, you will report the sale of 1,000 shares and compute a “gross profit percentage” for the installment sale. This gross profit percentage is used to determine how much of each payment is taxable gain (the balance is a return of your basis).
For example, if stock is sold for $100,000 and the tax basis is $20,000, the gross profit percentage is the quotient formed by taking the gross profit on the sale ($80,000 in this example, which is the excess of the $100,000 sale price over the $20,000 basis) divided by the total contract sales price ($100,000 in this example).
So the gross profit percentage in my illustration is 80 percent. For each annual payment of principal on the buyer’s note, 80 percent is taxable capital gain and 20 percent is a tax-free recovery of your basis.
The trick in your case is determining the basis. It would equal the initial investment that you made to the S corporation (cash or the tax basis of any property contributed, with an adjustment for any liabilities that the corporation assumed in the original transfer).
This initial basis will then be adjusted for the operations and distributions during the years that the corporation was an S corporation. You say that the corporation had a steady income stream, and that income would increase the basis of the stock during the S corporation years.
As distributions of the profits are made to the owners of an S corporation, the basis of the stock is reduced because the distribution is not taxed provided there is enough basis in the stock.
If you look back at your copy of the tax returns during the S corporation years, your tax preparer’s software may well have kept track of your basis, and that would have been reported to you.
If there is no record of the basis, you will need to re-create it by use of the S corporation K-1 forms. These forms show income and expenses allocated to your interest, as well as distributions made by the corporation.
It is unlikely that the basis changed once the corporation became a C corporation. Changes would occur only if there were distributions made to shareholders that were reported as return of capital.