This article explains how basis works, how to calculate it, and where partnerships and S corporations differ.
Jurisdiction note for Australian readers: this article covers U.S. federal pass-through tax rules only. All dollar figures are U.S. dollars. It isn't guidance on Australian tax treatment or a substitute for cross-border professional advice.
Key Takeaways
- Basis is your adjusted tax investment in your ownership interest, and it caps deductible pass-through losses.
- A K-1 capital account or entity book value is not your basis.
- Losses above basis are generally suspended, not lost immediately.
- Clearing the basis test is only the first step; at-risk, passive and excess business loss rules can still limit the deduction.
What Does "Tax Basis" Mean?
Tax basis is the tax-measured amount of your investment in an asset or pass-through interest. Loss deductions generally can't exceed it.
Basis moves every year:
- Up: contributions, allocated taxable income, tax-exempt income and (for partners) increased liability shares
- Down: distributions, allocated losses, nondeductible expenses and decreased liability shares
Outside Basis vs. Inside Basis
Outside basis is a partner's adjusted basis in the partnership interest. Inside basis is the partnership's basis in its own assets. The loss ceiling under section 704(d) uses outside basis, and it can differ from your K-1 capital account because of liabilities and partner-specific adjustments. Partners keep their own outside-basis records, as the Form 1065 instructions make clear.
Authorities to Know
- Partnerships: IRC 704(d) and 705
- S corporations: IRC 1366(d) and 1367
Current histories of these four sections do not list amendments that change their core mechanics, and 2026 IRS guidance has not rewritten how they apply. Confirm both against the latest IRC text and IRS releases before filing.
How Is Basis Calculated Before a Loss Is Deducted?
Start with last year's ending basis. Then apply this year's increases and reductions in the regulatory order.
| Stage | Partnership | S corporation (stock basis) |
|---|---|---|
| Increases | Contributions, allocated income, higher liability share | Capital contributions, allocated income including tax-exempt |
| Distributions | Reduce basis; liability decreases count as money distributions | Non-dividend distributions reduce stock basis |
| Other reductions | Certain nondeductible expenditures | Nondeductible expenses |
| Losses | Current and suspended losses share available basis pro rata | Taken last, subject to stock-plus-debt ceiling |
Ordering matters. Both sets of regulations put distributions before current-year losses, so a large distribution leaves less basis for your deduction. S shareholders can elect under Reg. 1.1367-1(g) to take losses before nondeductible expenses, but not before distributions.
A Worked Example
The IRS uses a historical illustration (2022 facts) on its S corporation basis page. Mark, a shareholder with no debt basis:
- Opening stock basis: $15,000
- Plus section 1231 gain: $4,000
- Less distributions: $12,000
- Less nondeductible expenses: $1,000
- Basis available for losses: $6,000
His K-1 shows a $20,000 ordinary loss and a $5,000 charitable contribution. Basis allows $4,800 of the loss and $1,200 of the contribution. The remaining $15,200 and $3,800 are suspended, and closing stock basis is zero. The figures show the ordering mechanics only; they are not a 2026 charitable-deduction calculation.
S shareholders report this on Form 7203. File it when claiming losses (including previously suspended ones), receiving a non-dividend distribution, disposing of stock, or repaying a shareholder loan.
How Do Partnership and S Corporation Basis Rules Differ?
Debt is the biggest difference.
Partnership Basis
Under section 752(a), an increase in your share of partnership liabilities is treated as a money contribution. Recourse liabilities follow economic risk of loss. Nonrecourse liabilities are allocated through several tiers, with the excess generally following profit shares.
The flip side: a liability decrease is a deemed money distribution. Under section 731(a)(1), money (including deemed money) exceeding your outside basis immediately before the distribution produces taxable gain.
S Corporation Basis
S shareholders track stock basis and debt basis separately. Under Reg. 1.1366-2, debt basis arises only from bona fide debt running directly from the corporation to the shareholder.
- Corporate borrowing from a bank does not create shareholder debt basis.
- A guarantee or co-signature alone creates none either.
- Payment on guaranteed debt may create basis to the extent paid.
- Distributions reduce stock basis only; debt basis can't shelter a non-dividend distribution above stock basis.
- Under Reg. 1.1367-2, repaying a loan whose basis was reduced by losses can trigger income unless basis is fully restored.
The regulation's open-account example: a $3,000 net repayment produces $1,500 of income.
The 2014 final regulations (T.D. 9682) established the direct-indebtedness and guarantee rules.
Keep records separate. The K-1, the corporate capital account and your basis schedule are related but not interchangeable. Shareholders, not the corporation, track their own basis.
How Does Basis Interact With Other Loss Limitations?
Both K-1 instruction sets apply the limits in order: basis, at-risk, passive activity, then excess business loss.
| Limit | Measures | Form | Disallowed amount |
|---|---|---|---|
| Basis (704(d), 1366(d)) | Adjusted tax investment | Form 7203 (S shareholders) | Carried forward under entity rules |
| At-risk (section 465) | Amount you could economically lose | Form 6198 | Carried to next year's at-risk calculation |
| Passive activity (section 469) | Material participation and passive income | Form 8582 | Carried forward; usable against passive income or on full taxable disposition |
| Excess business loss (461(l)) | Business losses above a threshold | Form 461 | Becomes an NOL carryover |
Basis Is Not "At Risk"
Cash, property and personally liable borrowing generally count as at risk. Ordinary nonrecourse financing generally doesn't. Qualified nonrecourse financing secured by real property can count if it meets the lender, security and other tests in Publication 925.
So a loss can clear basis and still be suspended under at-risk or passive rules. Track each carryforward under the limit that caused it.
2026 Excess Business Loss Thresholds
For 2026, the section 461(l) threshold is $256,000 (non-joint) or $512,000 (joint) under Rev. Proc. 2025-32. The 2025 figures were $313,000 and $626,000, so don't reuse them. P.L. 119-21 makes the excess business loss limit permanent.
What Should Owners Review for 2026?
Records Checklist
- Prior-year basis schedules and Form 7203
- All 2025 and 2026 K-1s
- Partnership agreement and liability allocations
- Contribution and distribution records
- Shareholder loan documents
- Tax return workpapers
Ways to Restore Basis
- Partners: additional contributions, allocated income or qualifying liability increases. Contributions tie up cash; liability increases add risk and can mean later deemed distributions if they fall.
- S shareholders: additional capital contributions or properly documented direct loans. Loan repayments can later trigger income if basis was reduced.
Suspended S corporation losses carry forward indefinitely while you remain a shareholder. Sell or transfer all your stock and remaining suspended losses are generally permanently disallowed, with a limited exception for spouse or former-spouse transfers.
If S status terminates, the post-termination ceiling is stock basis only.
Before Year-End
Review planned distributions, debt repayments, ownership transfers and restructurings. Each can reduce basis or trigger gain while suspended losses stay unusable.
Where VJM Global Fits
VJM Global provides accounting outsourcing for Australian businesses, including bookkeeping, tax returns, payroll and financial reporting. The firm has served 250+ Australian businesses.
Clean books and organised records give your tax adviser better inputs for basis work. This is general guidance and doesn't replace U.S. or Australian tax advice from a qualified adviser.
Frequently Asked Questions
What is the difference between basis limitation and at-risk limitation?
Basis caps deductions at your adjusted basis in the interest. At-risk caps them at the amount you're economically exposed to lose. A loss can pass one test and fail the other.
What happens to losses that exceed the basis limit?
The excess is generally suspended, not deducted currently. It can become deductible when basis is restored, subject to entity-specific carryforward and disposition rules.
What does "tax basis" mean?
It's your adjusted tax investment. It measures deductible losses, taxable distributions, and gain or loss on a later sale.
What does PYA basis limitation mean?
In Drake Tax, PYA means "prior-year adjustments." On Schedule E page 2 it flags previously basis- or at-risk-limited losses that are now deductible. Other software may use the term differently, so check your product.
How do I calculate my basis before claiming a pass-through loss?
Start with prior-year ending basis, then apply current-year increases and reductions in the regulatory order. Reconcile the result to your entity records.
What records support a basis calculation?
Keep K-1s, contribution and distribution records, liability schedules, shareholder loan documents, prior-year basis worksheets and entity agreements.
