One of the most important things to know about an investment is its tax basis. For each investment, the tax basis is a critical component in determining the amount of taxable gain or loss that a taxpayer must realize when the investment is sold. The calculation of tax basis can get complicated, but we’ll give a brief overview here. Remember that it is important to consult a tax professional to ensure that your calculation of tax basis is correct.

 

Tax Basis Defined

Before we get into the nuances behind calculating tax basis, it is important to have a good understanding of what it is. Tax basis (sometimes referred to as “cost basis”) is often defined as the original value or purchase price of an asset or investment for tax purposes.

In its simplest form, tax basis is simply what you paid for your investment. In more complex situations, an investment’s tax basis can go up or down throughout the life of the investment. One example is rental real estate. Each year, investors may take a deduction for tax depreciation on their rental properties that reduces the basis of the properties. However, they may also increase their basis in the asset when they pay for improvements, such as to replace a roof.

The Calculation

Each type of investment calculates tax basis in a slightly different way.  It is important to note that the main difference between each calculation is most likely a result of how that entity is classified for tax purposes. For purposes of this article, we’ll give a brief overview of each:

 

C Corporations – As the most common type of investment, companies taxed as C Corporations include essentially everything listed and traded on the major stock exchanges. This means that generally, cost basis of C Corporate stock is simply what the investor pays for it.

 

However, if an investor is contributing directly to a C corporation (and not purchasing shares on a secondary exchange), the basis is calculated as follows:

 

Basis of the property contributed

+ Gain recognized by the shareholder on the transfer (if any)

- Any cash or the FMV of other assets received in exchange for the property contributed

- Any liability transferred to the corporation

Shareholder’s Initial Cost Basis

 

For C Corporations, this is the only cost basis calculation that must be done.  The tax basis in C Corporate stock is not changed annually based on the performance of the company.

 

S Corporations – While less common investments than C Corporations, S Corporations are often a tax entity used by small or closely held businesses.  The calculation for basis in an S Corporation is somewhat more complex.  The key difference is that cost basis must be calculated for each shareholder each year.  This is in stark contrast to C Corporations, which only require a one-time calculation.

 

For shareholders purchasing S Corporation stock, the basis in their shares is just what they paid for them.  For individuals contributing assets to an S Corporation, their basis is equal to the basis of the contributed property less any debt relief related to that property upon contribution.  After each year, an S Corporate shareholder must calculate their new basis in their shares with the following formula:

 

Prior Year’s Ending Basis

+ Cash or Property Contributions

+ All items of income or gain* (including tax exempt income)

- Distributions to Shareholders

- Nondeductible Expenses

- All other items of deduction or loss*

Shareholder’s Current Year Ending Basis

 

*Note that all non-separately stated items are first aggregated and then put into the formula.  An increase if the amount is positive and a decrease if it is negative.

 

Partnerships – Often used for investors, venture capital, and private equity, partnership are becoming a more commonly used tax entity.  The calculation for partnerships is nearly identical to S Corporations, with one major difference.  That difference is that partnerships include “deemed cash contributions and distributions” in the initial and each annual basis computation.

 

Deemed cash contributions and distributions are simply the amount of debt that each partner is allocated at the end of the year.  This key distinction was put in place by the Department of the Treasury because partnerships are designed to allow partners to contribute and distribute property without recognizing any gain or loss.  Thus, including debt obligations in a partner’s cost basis in their partnership interest helps mitigate any potential gain that may otherwise be recognized upon contribution.  After each year, a partner in a partnership must calculate their new basis in their partnership interest with the following formula:

 

Prior Year’s Ending Basis

+ Cash or Property Contributions

+ All items of income or gain* (including tax exempt income)

+ Deemed Cash Contributions (aka: debt the partner is responsible for)

- Distributions to Shareholders

- Deemed Distributions to Shareholder (aka: debt relief a partner receives)

- Nondeductible Expenses

- All other items of deduction or loss*

Shareholder’s Current Year Ending Basis

 

*Note that all non-separately stated items are first aggregated and then put into the formula.  An increase if the amount is positive and a decrease if it is negative.

 

Conclusion

As you can see, the calculation of tax basis can get really complicated once an investor moves beyond simple investments.  It is vital to consult a tax advisor to help accurately determine the cost basis of complex assets and investments.  Remember, a correct calculation may just save you a whole bunch in extra taxes when you decide to sell!