A client took $35,000 out of their S Corporation, thinking it was tax-free. 

Come tax season, they were hit with a $7,000 surprise capital gains bill.

Why?
Because no one was tracking something called basis. 

Not them, not their bookkeeper, not even their accountant.

This is not an uncommon mistake.

When most small business owners choose an entity type, they’re thinking about tax savings. You’ve probably heard an S Corp can save thousands on self-employment taxes. Or that a Partnership offers more flexibility with ownership and profit splits.

But basis (and not tracking it properly) can quietly make or break your tax bill when you take money out of the business.

Let’s break down:

• What basis is
  
• How it works differently in Partnerships vs. S Corps
  
• And how to avoid one of the most common and costly tax mistakes small business owners make

What Is Basis?

Your basis is your investment in the business from the IRS’s perspective. It’s not just how much money you put in. It’s a running balance that changes each year based on profit, loss, contributions, distributions, and (sometimes) debt.

Your basis matters because it affects:

• How much you can take out of the business tax-free
  
  
• How much loss you can deduct on your personal tax return
  
  

Here’s the golden rule:

You can’t take tax-free distributions in excess of your basis.

If you do? The excess is treated as a capital gain and you’ll owe tax on it.

Partnership Basis: Debt Works in Your Favor

In a partnership, your basis includes your share of the business’s liabilities.

Here's how it’s calculated:

• Initial capital contribution
  
  
• + Share of income
  
  
• + Additional contributions
  
  
• + Share of business debt
  
  
• – Share of losses
  
  
• – Distributions
  
  

The inclusion of debt is a big deal. It means you can often take larger distributions without triggering a capital gain, because your basis is higher.

This gives partnerships a unique edge in basis flexibility, especially for businesses that operate with loans, credit lines, or other liabilities.

S Corporation Basis: A Tighter Rulebook

In an S Corp, basis works differently. Business liabilities do not increase your basis.

Here’s the S Corp formula:

• Initial capital contribution
  
• + Share of income
  
• + Additional contributions
  
• – Share of losses
  
• – Distributions
  
  

That’s it. No debt included.

So if your business borrows $100,000 and you draw from that loan, it does not raise your basis. And if you take a distribution that exceeds your basis? You could trigger a capital gain, even though the money came from a business loan.

That’s why many S Corp owners get blindsided. They assume all draws are tax-free. But unless they’re tracking basis correctly, they’re at risk.

Why Basis Errors Happen

Here are the two most common reasons small business owners get this wrong:

1. Borrowing money and treating it like a draw

S Corp owners often take distributions from loan proceeds. But loans don’t increase basis. So that “owner draw” can trigger capital gains without warning.

2. Bad or missing basis tracking

Basis is a rolling number. It carries forward every year. If your CPA isn’t tracking it, or if you switched accountants, you could be relying on the wrong starting point.

 Basically, Know Your Numbers Before You Withdraw

Basis can mean the difference between a tax-free distribution and a surprise IRS bill.

Here’s how to stay safe:

• Track basis yearly
  Don’t assume your CPA has it right. Keep your own records of contributions, income, losses, and distributions.
  
  
• Stay within your basis
  Before taking a distribution, confirm you have enough basis to cover it. If not, you may want to wait or contribute capital first.
  
  
• Use loans carefully
  If you need to pull money from the business temporarily, consider a properly documented shareholder loan, not a distribution.
  
  
• Understand your entity type
  If your business is debt-heavy, a partnership might give you more basis flexibility than an S Corp.

Want to know how these new tax cuts apply to you personally? 

Book a free discovery call with our team and we’ll walk you through it.

👉 Book your call now 

🎙 ABOUT THE PODCAST
The Small Business Tax Savings Podcast is your go-to resource for cutting-edge tax strategies to help entrepreneurs legally slash their tax bills. Hosted by Mike Jesowshek, CPA, this show breaks down complex tax topics into clear, no-fluff insights so you can keep more of your hard-earned money.

Transcript

[00:00:00] What if I told you that taking money out of your own business could trigger capital gains tax even if you didn't sell a single thing? This isn't some iris loophole. It's something most business owners and even a lot of accountants overlook, and it's called Your Basis. I had a client who thought they were playing it safe until they found out a $35,000 distribution came with a $7,000 surprise tax bill.

[00:00:23] Why? Because their basis had quietly eroded. In this episode, we're diving into the most boring sounding concept that might just save you thousands, and I'll show you why basis matters, how it's different for partnerships versus S corporations, and how to avoid accidentally turning tax free money. Into a capital gain nightmare.

[00:00:42] Alright, so let's dig into it. Welcome to the Small Business Tax Savings Podcast, your ultimate guide to legally slashing your tax bill while building your wealth. Get ready to unlock the secrets of tax savings with your host Mike Che, [00:01:00] CPA.

[00:01:04] The first thing I wanna talk about is what is basis and why does basis even matter? So the easy, simple definition of basis is that basis represents an owner's investment in a business when it comes to tax purposes. So why does it matter? Basis helps determine how much an owner can withdraw tax free, and also what the allowable losses are from that business that can offset other income for the tax year.

[00:01:29] Now, the key rule to think about when we're talking about basis is that you can not take tax free distributions beyond. Your basis. So if you take tax tax-free, if you take distributions over and above your basis, now they become taxable. Now lemme go through a client story. We had a client that thought they were taking tax-free distributions.

[00:01:47] They were taking money out. They were taking money out, they had some loans outstanding, they're taking money out, and all of a sudden it comes up to tax time and they have this surprise capital gain tax bill because they took more outta their company than they had [00:02:00] in basis. And we're gonna break down what basis is how it calculates.

[00:02:03] It's a relatively easy calculation. From, a a, a general standpoint, but we're also gonna talk about why it happens and how to avoid it. So there's different types of basis rules based on your entity type. And this might come into play when you're choosing an entity type to determine which one might make the sense based on your business operations.

Partnership Basis Explained

[00:02:22] First we wanna talk about is partnership outside basis. So this is, if you're a partner, you have 50, 50, 60 40, you have 10, 10, 10, 10, whatever it is. This would be for partnerships and you, the way you calculate basis for a partnership is whatever your initial investment is, plus any income that that business operates, plus any additional contributions.

[00:02:44] That you make to that partnership minus any losses that that partnership has, minus any distributions that that partnership has. And then you also add in your share of liabilities to that calculation as well. And a basis is a constantly, it's a, it's a, it's a [00:03:00] snowball. It just continues to go. So this is not something that ends on 1231 each year.

[00:03:04] And restarts a basis calculation is something that goes on year after year after year. And it's a rolling basis calculation. So for a partnership, you have your initial investment. Plus any income from the business, minus any losses from the business, plus any contributions if you're, if you're making more, putting more money into the partnership, that adds to your basis when you take money out of the partnership, that decreases your basis.

[00:03:28] And if you have any liabilities that you're responsible for, that increases your basis. Now let's look at it from an S corporation. 'cause we talk about S corporations all the time, but there is some limiting items here. So let's look at an S Corp basis. What we just talked about was for partnerships, S corp, you have your initial investment, plus any income that the business generates, plus any contributions, additional contributions that you put into the business, minus any losses from the business and minus distributions.

[00:03:56] That's it. Initial investments plus income, [00:04:00] plus contributions, minus losses, minus distributions. Now you'll notice one thing I didn't talk about was liabilities with an S corporation. Outside loans and things that do not increase your basis in an S corporation. And this is where we see so many people get caught and so many people get hit with a surprise, capital gain tax bill.

How Distributions Affect Taxes

[00:04:22] So let's talk about distributions. Tax distributions are considered tax free. Now, distributions are tax free, but they also don't reduce the profit in your business. So let's say you had a hundred thousand dollars in profit and you take a hundred thousand dollars in distributions, you're still paying taxes on a hundred thousand dollars.

[00:04:39] Now those distributions were not taxable, but the profit is. So let's say you have a hundred thousand dollars in profit and you take no distributions, you're taxing a hundred thousand dollars. If you have a hundred thousand dollars in profit and you take 40,000 in distributions. You're taxing a hundred thousand dollars.

[00:04:52] If you have a hundred thousand dollars in profit and you take a hundred thousand dollars in distributions, you're taxing a hundred thousand dollars. So the distributions generally. Are [00:05:00] not taxed. You're taxed on the profit of your business. And so tax distributions are considered tax free if you have basis, if you have enough basis to cover that tax, that distribution, there's no additional tax impact.

[00:05:12] But what happens if you take distributions in excess of your basis? Any amounts exceeding basis. Have tax consequences they're gonna hit, get hit with capital gain tax. Now, in a partnership excess basis, as tax says, as a capital gain, but with a partnership, if you have debt, that adds to your basis, that's a key thing with an S corporation.

Planning Strategies to Avoid Tax Traps

[00:05:33] Distributions in excess of basis is tax as a capital gain. Now we're gonna go through a case study to to, to go through some planning opportunities because this is not what I would say something we see with every single business owner. So a lot of business owners, this might not have come into play, but we're gonna talk about when it does come into play.

[00:05:48] Why it comes into play in some planning opportunities to avoid this unwanted additional capital gain tax on that. Now, real quick, if you're looking for tax strategies that you can actually implement, I built a software [00:06:00] called Tax Zone where we don't just show you how to save on taxes, we help you turn those strategies into real dollars saved with clear step-by-step guidance in full implementation modules within the software.

Real-Life Example: Partnership vs. S Corp

[00:06:10] If you're serious about paying the least amount of taxes legally possible this year, click the link below in the description and book a free discovery call with our team. Alright, now back to basis. So let's go through a real life breakdown. Let's go through some, through some facts. Let's say that your initial contribution, initial investment is $20,000, and let's say that your business had $10,000 in income and $5,000 in debt, and you took distributions of $35,000.

[00:06:36] So let's look at an S corporation. Your basis is gonna be the initial amount, $20,000. Plus income of $10,000. That's gonna be your basis before you take any distributions. So $20,000 plus $10,000, that's $30,000. If you took distributions, I mentioned, of $35,000, that's gonna exceed your basis by $5,000.

[00:06:57] And that $5,000 in excess [00:07:00] of your basis is gonna be taxed as a capital game. But now let's look at a partnership. The partnership basis is gonna be a little bit different. It's gonna be that initial stock amount, that initial amount, $20,000. Plus the profit, the income of $10,000 plus the debt of $5,000.

[00:07:16] So your basis in a partnership is gonna be 35,000. In an S corporation, it was only 30. Why? Because the debt doesn't add to your basis in an S corporation, but it does a partnership. So now let's say you take distributions of $35,000, that's what your total basis is, so there's no capital gain there. If you were having to take distributions of 40,000.

Why Capital Gains Get Triggered

[00:07:36] Then you would've exceeded your basis in that partnership. And again, same thing with an S corporation. $5,000 would be taxed as a capital game. So let's talk about why this happens and, and how to avoid it. The main reason that this happens, especially for S Corporation, is liabilities. You have credit cards, you have loans, you have various different liabilities in an S corporation, and these liabilities do not increase [00:08:00] basis.

[00:08:00] So let's say you go out. You buy a piece of equipment, you buy something and you, you, you get a loan for $500,000. You owe this money, but now you got $5,000, $500,000 into your bank account because it was a loan that you received. If you take that $5,000 and just move it to your personal account. Now, first off, that probably wouldn't be allowed, per se, that transaction, but let's just say it.

[00:08:22] That happens. You get a loan for $500,000 in your ass corporation, and you move that $500,000 into your personal bank account as an owner's draw distribution. Well, that loan did not increase your basis by $500,000. Loans. Don't do that in an S corporation. So in that situation, you're likely gonna have distributions in excess of basis.

[00:08:41] This is the most common reason that we see this happen. You have a lot of loans, but you're still taking draws of some of that loan money potentially, and that's what creates this issue. The other times we see this happen is just simply tracking errors. Remember I talked about how basis is something that goes year to year to year.

[00:08:56] It's a rolling. Calculation. And so sometimes if [00:09:00] you switch accountants, if you're not paying attention, if you're not tracking these different items, you could have a different starting basis from prior year that was wrong, and now you're creating an error here. And so that's where you can have some unintended consequences where maybe you didn't actually take distributions in excess of basis, but due to a tracking error you did.

Planning Strategies to Avoid Tax Traps

[00:09:18] So that's why we wanna make sure, and we're gonna talk about planning opportunities next, we wanna make sure that we treat this correctly. Alright, so let's talk about some planning opportunities around basis. First off, we want to keep a consistent record of our basis. Keep track of all income, any money you're putting into the business, any distributions.

[00:09:34] We wanna have a track record and if you think your accountant is doing it for you, they might. But let's also keep your own. So again, how do we calculate basis? It's how much money did we put into the business to start it? We're tracking all the profits that we have in our business year after year, after year, minus losses we have in our businesses year after year, after year.

[00:09:50] We're adding back any additional money we may be put into the business, and we're subtracting any distributions that we have now. If you have a partnership, we also get to factor in your share of [00:10:00] liabilities. The next thing we wanna do is adjust distributions. Keep your distributions within your basis.

[00:10:06] If you're tracking this on a regular basis, you can't on a regular, occurrence, what your basis is on a regular, on a regular occurrence. So we want to keep distributions within that basis so that we're not taking distributions in excess of basis. And now getting hit. With a capital gain tax, we might convert distributions to loans.

[00:10:23] So instead of taking a distribution, maybe we issue a short term shareholder or partner loan where the business is gonna loan the money instead of, and that we have to pay back and it has to be legit. We have to have paperwork, we have to have paying interest rates. We have to do all the important stuff.

[00:10:37] But maybe instead of taking it as a distribu. We take it as a loan. Now this can be, we have to be very careful with this piece because the IRS could look at this as a bonafide distribution if we don't properly set this up. So again, we have to have loan paperwork, we have to be making payments, we have to be charging a, a reasonable interest rate and all those different things if we go down this route.

[00:10:56] But it sometimes it can be an easy opportunity if you're just [00:11:00] in a weird year where you just need that kind of short term loan to help get past that. So again, that's the opportunity instead of taking a distribution. That would cause you to be in excess of your basis. Maybe we take a shareholder loan and that that provides that opportunity.

[00:11:14] We can also increase basis through contributions, so we can contribute capital before taking distributions. Now, if you need the money it, this probably doesn't make sense, but some opportunities there might be opportunities here. And then also for S corporation owners, you might wanna consider a salary.

[00:11:30] Versus a distribution for tax efficiency. Now, we would never say take a salary more than what's reasonable necessary, because obviously that's the, that's the benefit behind an S corporation. But sometimes there might be some planning there, especially if we're just looking year to year. There might be some overlap in one year to the other where this might make, make sense in an opportunity.

What Impacts Basis

[00:11:49] So let's look at, kind of an overall look at this. What factors into basis does debt factor into basis? So ask your question, if I have [00:12:00] liabilities, if I have loans, does that impact my basis? Well, in a partnership, it would increase your business, it or your basis debt would increase your basis in a partnership with an S corporation does not have any impact on your stock basis.

[00:12:15] What about distributions? Distributions in a partnership and an S corporation reduce your basis. What about income? Income, profit from your business? Profit from your business, increases basis in a partnership and an S corporation. What about losses? Losses from your businesses? Losses decrease your basis in both a partnership and an S corporation.

[00:12:36] Now what happens? If you take a distribution in excess of your basis in your partnership or an S corporation, either one, you're gonna hit, get hit with capital, gain tax on whatever amount of that distribution is over and above your basis. So that's the key thing that we talk, talk about again, the biggest difference between a partnership and an S corporation.

[00:12:56] Is debt. Debt increases basis in a partnership, but with [00:13:00] an S corporation, it has no effect. And that's why we see a lot of people run down this trap. Whenever we see people run down this trap, they're more than likely in a S corporation, they have some type of liability or loan outstanding that's causing.

[00:13:11] This impact if you don't have liabilities alone, but your accountant's telling you that you have distributions in excess of basis, I would say there's more than likely a, not a tracking error, something from year to year tracking that you wanna look into, and make sure you look into that before actually filing that tax return.

Final Takeaway & Next Steps

[00:13:27] So here's the bottom line. If you're not tracking your basis, you're gambling with your tax bill and the IRS, they don't care if it was an accident. What they care about is what's on paper. Don't be the business owner surprised by a tax bill you didn't see coming. Instead, be the one who's planning ahead.

[00:13:42] Keep clean books and make sure you look at every distribution the smart way. If this opened your eyes, don't forget to subscribe. Hit that button and share it with a business owner and save them this painful surprise to. And if you want help from our team of Tax Pros navigating this along with many other different tax strategies, [00:14:00] visit tax elm.com.

[00:14:01] That's TAX elm.com, or click the link into the description for a free discovery call. We're helping people you legally lower your tax bill every single day. Thanks for listening, and I'll see you on the next one. Thanks for tuning in to the Small Business Tech Savings Podcast. We hope today's episode sparked some brilliant ideas to help you save on taxes and grow your wealth.

[00:14:25] If you loved what you heard, hit the subscribe button and share the wealth with fellow entrepreneurs. For a treasure trove of tax saving resources, visit tax Savings podcast.com. There you'll find tools, guides, and all the info you need on reducing your taxes. Let's elevate your business to new heights together.

[00:14:46] Remember the insight shared here for educational purposes and not specific tax or legal advice. Always consult with a qualified professional for your unique situation. Until next time, keep thriving and saving.