ESOP S Corporation Basis Adjustments
My previous blog post discussed the Importance of Tracking Cost Basis in ESOPs. Today I want to expand on this topic and discuss how S Corporation Basis Adjustments apply to ESOPs and impact cost basis as well.
IRS Revenue Ruling 2003-27 provided guidance that an ESOP is required to adjust its basis in S corporation stock under IRC Section 1367(a) for the ESOP's pro rata share of the corporation's items. It also provided that upon the distribution of S corporation stock by an ESOP to a participant, the stock's net unrealized appreciation under IRC Section 402(e)(4) is determined using the ESOP's adjusted basis in the stock.
To determine the cost basis adjustment, the S corporation should issue the ESOP trustee a Schedule K-1. Detailed instructions for determining the cost basis adjustment using the values reported on the Schedule K-1 can be found on the IRS Website. In summary, the following values are used to determine the cost basis adjustment:
A shareholder's stock basis is increased by (using Schedule K-1 line items):
|1. Ordinary income
|2. Separately stated income items
||Lines 2 - 10|
|3. Tax exempt income
||Lines 16a & 16b|
|4. Excess depletion
A shareholder's stock basis is decreased, but not below zero, by:
|1. Ordinary loss
|2. Separately stated loss items
||Lines 2 - 12d|
and 14l, 14m
|3. Nondeductible expenses
|4. Non-dividend distributions
|5. Depletion for oil and gas
Tracking the cost basis of shares in an ESOP allows participants the opportunity to elect NUA tax benefits. To further complicate NUA determination, stock of an S corporation held by an ESOP is subject to the same basis adjustments required by any other S corporation shareholder. Detailed recordkeeping of the stock transactions and related cost basis on an annual basis is a best practice and will alleviate frustration and inaccuracy in the future.