S Corp Distributions, Basis and Form 7203: A Worksheet Guide for Firms

S corp distributions look the same on a bank statement however they end up taxed. A $45,000 transfer to the owner in December could be a nontaxable return of basis, a capital gain, or, in a corporation with old C-corp earnings, a dividend. The wire doesn't say which. The basis schedule does, and in many client files that schedule is either missing or rebuilt the week the return is due.

This guide is for the firm that has to answer that question for a book of S-corp clients: the tax partner who approves the year-end distribution, the preparer who builds the Form 7203, and the Reviewer who signs the return. It covers the S corp shareholder distribution rules as the Code and regulations state them, a three-year stock and debt basis roll-forward for one client, AAA ordering when the corporation has accumulated earnings and profits, the loan-or-distribution question, the one-class-of-stock rule, and the logic of Form 7203.

It ends with a worksheet your firm can paste into the client file and a Reviewer checklist. Every rule below cites the subsection it comes from. Where a source wasn't available to read, the text says so.

How are S corp distributions taxed? For an S corporation with no accumulated earnings and profits (E&P), a distribution isn't included in income to the extent of the shareholder's adjusted stock basis (it reduces that basis instead), and any excess is treated as gain from the sale or exchange of property (IRC §1368(b)). If the corporation has accumulated E&P, the distribution comes first from the accumulated adjustments account (AAA) under the same basis rule, then as a dividend to the extent of E&P, then against remaining basis (IRC §1368(c)). Basis is adjusted each year in a set order: increases first, then distributions, then nondeductible expenses, then losses (26 CFR §1.1367-1(f)). A shareholder who takes a loss, receives a distribution, disposes of stock, or receives a loan repayment attaches Form 7203 (Instructions for Schedule E, 2025). Rules as of 2026-09-26. Not tax advice.

Key Takeaways

• Order matters: stock basis goes up for income first, then down for distributions, then for nondeductible expenses, then for losses (26 CFR §1.1367-1(f)), so distributions get first claim on basis.
• Losses stop at basis: the loss a shareholder can take is capped at stock basis plus debt basis, and the excess is suspended and carried to later years, personal to that shareholder (IRC §1366(d)(1), (2); 26 CFR §1.1366-2(a)(6)).
• Debt basis comes back first: once a loss has reduced debt basis, later net increases restore the debt before any of it restores stock (IRC §1367(b)(2)(B); 26 CFR §1.1367-2(c)(1)).
• Excess distributions are gain: in the example below, $160,000 against $111,000 of stock basis produces $49,000 of gain (IRC §1368(b)(2)).
• E&P changes the ordering: with accumulated E&P, distributions come from AAA first, then as a dividend, then against basis (IRC §1368(c)).
• Form 7203 has four triggers: a loss claimed, a distribution received, a stock disposition, or a loan repayment received (Instructions for Schedule E, 2025).

What this guide covers, and what it leaves to other pages

This page starts after the salary decision. How the owner's pay divides between wages and distributions, and why the split matters, is covered in S-corp salary vs. distribution. Running owner payroll, withholding and the W-2 is covered in owner payroll for S-corp clients. Both are worth sending to a client who asks "why can't I just take draws?"

What's left is the question your firm owns once salary is set: how is the cash that leaves the corporation after payroll taxed, and can the file prove it? That's a basis question. It sits inside the wider tax planning work a firm does for its S-corp book, and it's the part most often done from memory.

Stock basis: what moves it and in what order

S corp basis has two parts, stock and debt, and both are tracked per shareholder. IRC §1367(a)(1) increases the shareholder's stock basis by three items: separately stated income items (including tax-exempt income, per §1366(a)(1)(A)), nonseparately computed income, and the excess of depletion deductions over the basis of the depletable property.

IRC §1367(a)(2) decreases stock basis, but not below zero, by five items:

• Distributions that aren't included in income because of §1368.
• Separately stated loss and deduction items.
• Nonseparately computed loss.
• Expenses of the corporation that aren't deductible and aren't chargeable to capital account.
• The shareholder's oil and gas depletion deduction, within limits.

The regulations define the fourth item narrowly. Noncapital, nondeductible expenses are items for which no loss or deduction is ever allowable, not items that are merely deferred. The listed examples include fines and penalties not deductible under §162(f), expenses tied to tax-exempt income under §265, losses disallowed under §267(a)(1), and the disallowed portion of meals under §274 (26 CFR §1.1367-1(c)(2)). Capital contributions also add to basis; §1.1367-1(a)(2) confirms that other Code provisions adjust stock basis alongside §1367.

Two details catch preparers. First, a distribution taxed as a dividend isn't a §1367(a)(2)(A) decrease, because it's includible in income. Dividends don't reduce stock basis. Second, the per-share rule: adjustments are made per share, per day, and a decrease that exceeds one share's basis spills over to the shareholder's other shares in proportion to their remaining basis (26 CFR §1.1367-1(c)(3)).

The ordering rule

For any corporate tax year beginning on or after August 18, 1998, the adjustments go in this order (26 CFR §1.1367-1(f)):

1. Increases for income items and excess depletion.
2. Decreases for distributions.
3. Decreases for noncapital, nondeductible expenses and oil and gas depletion.
4. Decreases for items of loss and deduction.

Distributions sit ahead of losses. In a year with both a loss and a distribution, the distribution is tested against basis first, and the loss gets whatever basis is left. The statute backs this up for distribution testing: §1368(d) applies the distribution rules after the §1367(a)(1) increases for the year, and 26 CFR §1.1368-1(e)(2) says the same for years beginning on or after August 18, 1998.

The §1.1367-1(g) election

A shareholder may elect to take losses and deductions (step 4) before nondeductible expenses (step 3). Under the election, nondeductible expenses that exceed stock and debt basis carry to the next year as nondeductible expenses. The shareholder makes the election by attaching a statement to a timely filed original or amended return agreeing to that carryover rule. Once made, it applies to that S corporation in later years unless the Commissioner permits a change (26 CFR §1.1367-1(g)).

The election matters most for a client with large nondeductible expenses in a loss year. The worked example shows its effect in dollars.

Debt basis: what counts and how it comes back

Debt basis is the shareholder's adjusted basis in bona fide indebtedness of the S corporation that runs directly to the shareholder. Whether a debt is bona fide is decided under general federal tax principles and depends on all the facts and circumstances (26 CFR §1.1366-2(a)(2)(i)).

Guaranteeing a bank loan doesn't create debt basis. Acting as surety or accommodation party doesn't either. If the shareholder later pays on a guaranteed loan, debt basis increases by the amount paid (26 CFR §1.1366-2(a)(2)(ii)).

Open account debt

Shareholder advances not evidenced by a separate written instrument are open account debt when the aggregate outstanding principal is $25,000 or less at the close of the corporation's tax year. All advances and repayments during the year are netted at year end and treated as a single debt (26 CFR §1.1367-2(a)(2)(i), (d)(2)(i)). If the net balance exceeds $25,000 at year end, the whole balance is treated as a debt evidenced by a written instrument for every later year (26 CFR §1.1367-2(a)(2)(ii)). For the workpaper, that means one column for open account debt and one column for each written note.

Reduction

After the §1367(a)(1) increases, if losses, deductions, nondeductible expenses and oil and gas depletion exceed stock basis, the excess reduces (but not below zero) the basis of debt the shareholder holds at the close of the corporation's tax year (IRC §1367(b)(2)(A); 26 CFR §1.1367-2(b)(1)). Distributions aren't on that list. A distribution can reduce stock basis to zero, but it never reduces debt basis. A debt repaid, disposed of, or forgiven during the year isn't held at the close of the year and isn't reduced.

Restoration

In a later year, any "net increase" restores the reduced debt basis before it can increase stock basis (IRC §1367(b)(2)(B)). The regulation defines net increase as the amount by which the shareholder's income items exceed the §1367(a)(2) decreases for the year, which the regulation lists as losses, deductions, noncapital nondeductible expenses, certain oil and gas depletion deductions, "and certain distributions" (26 CFR §1.1367-2(c)(1)). Three limits apply:

• Restoration applies only to debt held at the beginning of the year in which the net increase arises.
• Debt basis can't be restored above the debt's adjusted basis under §1016(a), ignoring the prior-year S-corp reductions under §1016(a)(17), determined as of the start of that year.
• Distributions reduce the net increase, so a large distribution in a profitable year can leave the debt unrestored.

With more than one reduced debt, the net increase goes first to any debt repaid during the year, to the extent needed to offset gain on the repayment, then pro rata to the rest (26 CFR §1.1367-2(c)(2)).

Repayment

When a debt is repaid during the year, restoration is effective immediately before the first repayment. If the reduced basis isn't fully restored, the repayment is a recognition event to that extent (26 CFR §1.1367-2(d)(1)). This is where a client who repays a shareholder loan in a year with thin income can recognize gain on money they lent the corporation. The worked example is built so the restoration covers the repayment; the file should show the test either way.

Loss limitation and suspended losses

The aggregate losses and deductions a shareholder takes into account for a year can't exceed stock basis plus debt basis (IRC §1366(d)(1)). The statute fixes what each basis figure includes:

• Stock basis is determined after the year's increases and distributions (§1366(d)(1)(A)). The regulation also takes nondeductible expenses and oil and gas depletion into account, unless the §1.1367-1(g) election is in effect (26 CFR §1.1366-2(a)(4)(i)).
• Debt basis is determined without regard to any adjustment under §1367(b)(2) for that year (§1366(d)(1)(B)). The regulation's parallel rule for the debt portion, 26 CFR §1.1366-2(a)(4)(ii), wasn't among the text reviewed for this guide; read it before a year where restoration and a loss meet on the same note.

Losses over the limit aren't lost right away. A disallowed loss is treated as incurred by the corporation in the succeeding tax year with respect to that shareholder (IRC §1366(d)(2)(A)), and it keeps its character in each later year it carries into (26 CFR §1.1366-2(a)(3)). The carryover is personal to the shareholder. It can't be transferred, and if the shareholder transfers all of the stock, it's permanently disallowed (26 CFR §1.1366-2(a)(6)(i)). The exception is a transfer between spouses or incident to divorce, which moves the suspended loss to the transferee (IRC §1366(d)(2)(B); 26 CFR §1.1366-2(a)(6)(ii)). A separate rule lets suspended losses be taken during the post-termination transition period if the S election ends, limited to stock basis (IRC §1366(d)(3)).

Suspended losses are shareholder attributes. The corporation's return doesn't carry them. If the firm doesn't keep the carryover schedule, nobody does.

Worked example: a 3-year stock and debt basis roll-forward

Illustrative example. Your client owns 100% of a calendar-year S corporation that has been an S corporation since formation, so it has no accumulated E&P. The owner contributed $10,000 at formation. A Reasonable Compensation Study supports a salary of $95,000 each year; the wage is deducted by the corporation before the ordinary income or loss below. Each year the corporation has $1,500 of nondeductible expenses (penalties and the disallowed share of meals). No oil and gas items, no property distributions, no other shareholders.

Year 1: an ordinary income year

The corporation reports $120,000 of ordinary business income and $2,000 of interest income. The owner takes $90,000 in distributions.

No debt. No suspended losses. The distribution is tested against $132,000 of basis, so none of it is gain.

Year 2: the loss year, with a shareholder loan

Revenue drops. The corporation reports a $85,000 ordinary loss and $1,000 of interest income. Early in the year the owner took $10,000 in distributions. Mid-year the owner lends the corporation $50,000 on a signed note with a fixed maturity and stated interest.

The loss limit is stock basis plus debt basis:

• Stock basis for the limit: $40,500 + $1,000 income − $10,000 distributions − $1,500 nondeductible expenses = $30,000.
• Debt basis: $50,000 (the note is held at year end).
• Limit: $30,000 + $50,000 = $80,000.
• Loss allowed: $80,000. Suspended: $85,000 − $80,000 = $5,000.

The client deducts $80,000 this year and carries $5,000 into Year 3. Without the loan, the limit would have been $30,000 and $55,000 would have been suspended. That difference is why the note needs to hold up as bona fide debt, which the loan section below covers.

With the §1.1367-1(g) election. If the owner had the election in effect, nondeductible expenses would come after the loss. The stock basis for the limit would be $31,500 (before the $1,500 of nondeductible expenses), so the limit becomes $31,500 + $50,000 = $81,500. The loss allowed rises to $81,500, the suspended loss falls to $3,500, and the $1,500 of nondeductible expenses carries into Year 3 as a nondeductible expense. The election buys $1,500 of current deduction at the cost of a permanent change in ordering for this corporation. The rest of the example assumes no election.

Year 3: recovery, restoration and a repayment

The corporation reports $110,000 of ordinary income and $1,000 of interest income. The owner takes $45,000 in distributions. In November the corporation repays $20,000 of the note. The $5,000 suspended loss from Year 2 is treated as incurred this year.

First, the net increase for debt restoration (26 CFR §1.1367-2(c)(1)):

• Income items: $110,000 + $1,000 = $111,000.
• Less all §1367(a)(2) decreases: distributions $45,000 + nondeductible expenses $1,500 + carried loss $5,000 = $51,500.
• Net increase: $111,000 − $51,500 = $59,500.

The reduced debt basis is $50,000, so $50,000 of the net increase restores the note. The restoration is effective immediately before the November repayment (26 CFR §1.1367-2(d)(1)), so the $20,000 repayment comes out of a fully restored $50,000 basis. No gain on the repayment.

The remaining $9,500 of net increase goes to stock. On the stock schedule, that shows as increases of $111,000 less the $50,000 diverted to debt:

The two schedules tie: $59,500 of net increase, $50,000 to debt and $9,500 to stock. The $45,000 distribution isn't taxed because it's within the $61,000 of stock basis; it reduces that basis instead. The suspended loss is fully used.

Three years, one client, and the file needs five things to support it: the K-1s, the distribution ledger, the note, the repayment record, and this roll-forward.

Distributions in excess of stock basis

Change one fact. In Year 3 the owner takes $160,000 in distributions instead of $45,000, and the corporation makes no repayment.

• Net increase: $111,000 − ($160,000 + $1,500 + $5,000) = −$55,500. There's no net increase, so the note isn't restored. Debt basis stays at $0 against a $50,000 face.
• Stock basis before distributions: $0 + $111,000 = $111,000.
• Distributions of $160,000 exceed stock basis by $49,000.
• Under IRC §1368(b)(2), the $49,000 excess is treated as gain from the sale or exchange of property.
• Ending stock basis: $0. The $5,000 carried loss has no stock or debt basis to absorb it and stays suspended. The $1,500 of nondeductible expenses has no basis left to reduce.

For stock held as a capital asset, that gain is generally capital gain, long-term or short-term by the shareholder's holding period. The capital-asset and holding-period rules themselves (IRC §§1221, 1222) sit outside this guide; confirm the character on the client's facts.

The client took $49,000 more cash than its stock basis could absorb, and still has an unrestored $50,000 reduction sitting on the note. If the corporation repays that note next year before income restores it, the repayment is a recognition event too (26 CFR §1.1367-2(d)(1)). A basis schedule rolled forward before the December distribution would have shown the $111,000 ceiling. Whatever S corp distribution tax calculator a firm uses, the numbers it needs are this roll-forward, run before the cash moves.

AAA vs basis: ordering with and without accumulated E&P

Basis and AAA are different accounts that firms often blur. Stock basis belongs to the shareholder. The accumulated adjustments account belongs to the corporation and isn't apportioned among shareholders (26 CFR §1.1368-2(a)(1)). AAA starts at zero on the first day of the first S year, rises for income items other than tax-exempt income, and falls for losses, deductions and nondeductible expenses (other than federal taxes from C years and expenses related to tax-exempt income). Unlike basis, AAA can go below zero for losses. Distributions reduce it, but not below zero (26 CFR §1.1368-2(a)(2), (a)(3)).

Which ordering applies depends on one test: does the corporation have accumulated E&P as of the end of the tax year in which the distribution is made (26 CFR §1.1368-1(c), (d)(1))?

No accumulated E&P: §1368(b)

Most corporations that were S corporations from formation have no accumulated E&P. For them, the rule is basis only: distributions reduce adjusted stock basis and aren't included in income to that extent, and the excess is gain (IRC §1368(b)). AAA is still tracked, but it doesn't decide the tax result. The three-year example above is a §1368(b) corporation.

Accumulated E&P: §1368(c)

A corporation that was once a C corporation, or acquired one, may carry accumulated E&P. For it, each distribution runs through three tiers (IRC §1368(c)):

1. The portion that doesn't exceed AAA is treated under §1368(b): applied against basis, gain above it.
2. The next portion is a dividend to the extent of accumulated E&P.
3. Anything left is treated under §1368(b) again.

Two computational rules apply. For distributions during a year, AAA is measured at the close of the year without regard to any net negative adjustment for that year (IRC §1368(e)(1)(C)). If total distributions exceed AAA at year end, the AAA is allocated among them in proportion to their size (IRC §1368(c), flush language; 26 CFR §1.1368-2(b)).

Illustrative example. Your client is the sole shareholder of a corporation that converted from C status and still carries $20,000 of accumulated E&P. The owner took one $65,000 distribution. AAA available for it, measured at the close of the year before distributions and without any net negative adjustment, is $30,000. The owner's stock basis after the year's increases and before the distribution is $60,000.

The same $65,000 from a corporation with no E&P would have been $60,000 applied against basis and $5,000 of gain. The E&P test changes the answer, so the file needs the E&P figure, not an assumption. The Code and regulations also allow an election to treat distributions as coming from E&P first (IRC §1368(e)(3); 26 CFR §1.1368-1(f)(2)); its terms weren't reviewed for this guide, so check the regulation before relying on it.

Shareholder loan or distribution? The documentation test

Money moves between owner and corporation in both directions, and each direction carries its own recharacterization risk.

Owner to corporation. The Year 2 loss deduction above depends on the $50,000 note being bona fide indebtedness that runs directly to the shareholder. The regulation leaves that to general federal tax principles and all the facts and circumstances (26 CFR §1.1366-2(a)(2)(i)). If the advance isn't bona fide debt, the debt basis the Year 2 deduction relied on isn't there, and the $50,000 of loss taken against it is exposed. A guarantee creates no debt basis until the shareholder pays on it (26 CFR §1.1366-2(a)(2)(ii)).

Corporation to owner. The more common problem is the reverse: cash the owner takes, booked as a "loan to shareholder," with no note and no repayments. If it isn't a real loan, it's a distribution, tested against basis like any other, or possibly compensation. In the Year 3 variant above, a $160,000 withdrawal booked as a loan would hide $49,000 of gain until someone reclassified it.

Courts decide these questions on factors developed in case law. That case law isn't in the sources used for this guide, so the list below is the general shape of the analysis, not a citation:

• A written note signed at the time of the advance.
• A stated interest rate and a fixed maturity or repayment schedule.
• Repayments actually made on that schedule.
• Security or collateral, where the amount warrants it.
• The borrower's ability to repay from something other than future distributions.
• Consistent treatment on the books, the balance sheet and the return.
• Board or owner approval, and treatment matching a loan to an unrelated party.
• No pattern of new "loans" that are forgiven or rolled into distributions.

Two reporting points tie the file to the return. The corporation reports repayments of loans from shareholders to the shareholder who received them, in box 16 of the K-1 with code E, and property distributions with code D (Instructions for Form 1120-S, 2025, lines 16d and 16e). If the K-1 shows code D and the books show a loan, one of them is wrong.

Disproportionate distributions and the one-class-of-stock rule

A small business corporation can't have more than one class of stock (26 CFR §1.1361-1(b)(1)(iv); IRC §1361(b)(1)(D)). The regulation's test: a corporation has one class of stock if all outstanding shares confer identical rights to distribution and liquidation proceeds. Differences in voting rights are disregarded (26 CFR §1.1361-1(l)(1)).

The key word is "confer." Whether shares confer identical rights is decided from the governing provisions: the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (26 CFR §1.1361-1(l)(2)(i)). A commercial contractual agreement, such as a lease, employment agreement, or loan agreement, isn't a governing provision unless a principal purpose of the agreement is to circumvent the one-class requirement. So two owners with different salaries under their employment arrangements don't, for that reason alone, have two classes of stock.

What about the client who distributed $60,000 to one 50% owner and $40,000 to the other? The same paragraph answers it carefully. A corporation isn't treated as having more than one class of stock as long as the governing provisions provide for identical distribution and liquidation rights. But distributions that differ in timing or amount, whether actual, constructive or deemed, "are to be given appropriate tax effect in accordance with the facts and circumstances" (26 CFR §1.1361-1(l)(2)(i)).

Read together, the practical steps are these:

• Check the governing provisions first. An operating agreement, bylaw or shareholder agreement that gives one owner a preferential distribution right is the problem. A one-off uneven transfer under identical governing provisions is a different problem.
• Give the difference a tax effect. Uneven distributions don't disappear. The file should say what the excess was, from the facts as they stood when the cash moved: a loan to that owner, compensation, or a distribution. A note drafted later or a catch-up distribution doesn't change what the original payment was.
• Use the specific safe rules where they fit. State income tax payments or withholding for some shareholders are disregarded, provided the constructive distributions are taken into account (26 CFR §1.1361-1(l)(2)(ii)). A governing provision that bases distributions on varying interests after an ownership change during the year doesn't alter the rights, though distributions not made within a reasonable time may be recharacterized (26 CFR §1.1361-1(l)(2)(iv)).
• Know where relief sits. Inadvertent breaches of the one-class requirement are addressed under IRC §1362(f), which the regulation cross-references (26 CFR §1.1361-1(l)(6)).

Debt instruments get their own treatment. Straight debt isn't treated as a second class of stock (26 CFR §1.1361-1(l)(5)(i)). It must meet every part of the definition: a written unconditional obligation to pay a sum certain on demand or on a specified date; interest and payment dates not contingent on profits, the borrower's discretion or similar factors; not convertible into stock or any other equity interest; and held by an individual (other than a nonresident alien), an estate, or an eligible trust. The regulation also has safe harbors for unwritten shareholder advances of $10,000 or less in the aggregate and for obligations held in the same proportion as the stock (26 CFR §1.1361-1(l)(4)(ii)(B)); read the specific terms before relying on either.

Form 7203 walkthrough

Form 7203 is the shareholder's stock and debt basis computation, filed with the shareholder's individual return. The corporation or the firm may help assemble it, but the computation is the shareholder's.

Who attaches it. The 2025 Instructions for Schedule E say a shareholder who claims a deduction for their share of an aggregate loss from an S corporation, receives a distribution, disposes of stock, or receives a loan repayment from an S corporation checks the box in column (e) on the appropriate Schedule E line and attaches Form 7203. A CPE source reviewed for this guide phrases that trigger as a non-dividend distribution. Because the form computes one shareholder's basis in one corporation's stock and debt, firms generally prepare one per corporation, and one for each spouse who holds shares. The Form 7203 instructions themselves weren't among the sources read, and filing triggers can change by year, so confirm the triggers and the per-corporation, per-spouse practice against the current-year instructions before filing season.

Some firms prepare it every year for every S-corp shareholder, trigger or not, for a practical reason: a basis schedule kept only in the years the form is required has to be rebuilt from old K-1s when a trigger hits.

Part I: shareholder stock basis. Part I follows the §1367 ordering: beginning basis, capital contributions and income items from the K-1, then distributions, then nondeductible expenses and oil and gas depletion, then the allowable loss and deduction items carried back from Part III. Distributions in excess of basis come out of this part as the gain figure. In the Year 3 variant above, Part I would show $111,000 of basis before distributions, $160,000 of distributions, and $49,000 of gain.

Part II: shareholder debt basis. The regulation reduces and restores each indebtedness separately and nets open account advances into a single debt (26 CFR §1.1367-2(a)(2)(i), (b)(3), (c)(2)), so Part II carries each loan in its own column, with open account debt as one. Confirm the column layout in the current instructions. Each column follows the loan's face amount, the debt basis, restoration from net increases, and gain on repayment of a debt with reduced basis. In the example, Part II carries note 1 from $50,000 of face and basis in Year 2, to $0 basis after the loss, to $50,000 restored and $30,000 after the repayment in Year 3.

Part III: loss and deduction items. Part III lists each type of loss and deduction, current year and carried over, and splits what's allowed between stock basis and debt basis. What isn't allowed carries forward by type. When losses of different types exceed the limit, the allowed amount is allocated among them in proportion to their size, counting carried-over items in the total (26 CFR §1.1366-2(a)(5)). In Year 2 of the example, Part III would show $85,000 of ordinary loss: $30,000 allowed from stock basis, $50,000 from debt basis, $5,000 carried forward.

Tie-outs the Reviewer should run. Part I distributions to K-1 box 16 code D. Part II repayments to box 16 code E. Part I nondeductible expenses to box 16 code C (Instructions for Form 1120-S, 2025). Part III carryovers to last year's Part III. Beginning basis to last year's ending basis, with any difference explained.

Copy-ready basis worksheet

Paste these tables into the client's workpaper, one set per shareholder per S corporation. Amounts shown are the Year 2 figures from the worked example; replace them with the client's.

Worksheet A: stock basis roll-forward (26 CFR §1.1367-1(f) order)

Worksheet B: debt basis, one column per written note plus one for open account debt

Worksheet C: loss limitation and carryover

Worksheet D: distribution test

Worksheet E: loan file

Once the worksheet is filled in, the distribution workpaper holds the basis roll-forward, the K-1s, the distribution ledger, E&P and AAA support where they apply, the loan file with its repayment records, and the Study behind the salary. For how firms organize and retain that file, see reasonable compensation documentation and workpapers.

Reviewer checklist

Run this before the return is signed and, for December distributions, before the cash moves. The S-corp year-end tax planning checklist puts the basis check ahead of any year-end distribution; this is the detail behind that item.

• Beginning stock and debt basis tie to last year's ending figures, or the difference is explained.
  
• Every K-1 item that moves basis appears on Worksheet A, including tax-exempt income and nondeductible expenses.
  
• Adjustments follow the §1.1367-1(f) order, or the §1.1367-1(g) election statement is on file and applied every year since.
  
• Distributions tie to K-1 box 16 code D and the bank ledger, by shareholder.
  
• Distributions above stock basis are reported as gain.
  
• Accumulated E&P status is documented for the corporation. If E&P exists, the §1368(c) tiers are applied and AAA is measured without the year's net negative adjustment.
  
• Each shareholder loan has its own debt basis column, a note, and a repayment history.
  
• Restoration uses the net increase after distributions and applies only to debt held at the start of the year.
  
• Repayments of debt with unrestored reduced basis produce gain on the return.
  
• The loss limit uses stock basis after distributions and nondeductible expenses, and debt basis determined under §1366(d)(1)(B).
  
• Suspended losses carry forward by type and match last year's Part III.
  
• Distributions were made in proportion to ownership, or the difference is documented with its tax effect.
  
• Governing provisions (articles, bylaws, shareholder agreements) give identical distribution and liquidation rights.
  
• Form 7203 is attached if any current-year trigger applies, one per corporation per shareholder.
  
• The salary behind the year's distributions traces to a completed Study the Reviewer has signed off.
  

Where the Reasonable Compensation Study fits

Each example assumes the corporation deducted the supported $95,000 salary before computing the K-1 income or loss the basis schedule starts from. The salary isn't a basis figure. But it decides how much cash is left to distribute, and that's where most distribution questions start.

The sequence that holds up: the firm completes the reasonable-compensation analysis in the Study, the Reviewer signs off on the supported salary, payroll pays it, and whatever cash the business can spare after that is the distribution. The basis roll-forward and the E&P status then tell the firm how that distribution is taxed.

The ratio of distributions to salary is the reclassification signal a firm watches: a screening figure, not a rule. A high ratio invites the question of whether some of the distributions were really wages, but the answer turns on all the facts. In the example the owner took $90,000, $10,000 and $45,000 against a $95,000 salary: ratios of 0.95, 0.11 and 0.47. Change the facts to a $30,000 salary and $155,000 of distributions and the ratio is about 5.17 to 1. No ratio is a safe harbor, and the split itself is covered in S-corp salary vs. distribution. The point for this guide is narrower. When distributions run far ahead of wages, the wage is what gets tested, and the firm defends it with the Study's evidence, not the distribution history. The limiting case, distributions with no wage at all, is covered in what happens when an S-corp owner takes no salary. What an examiner asks for, and how the Study answers, is in reasonable compensation audit defense.

So the distribution workpaper has two halves. The Study documents the evidence behind the salary. The basis and E&P schedules document how the rest was treated under §1368. Both stay subject to the Reviewer's judgment.

Frequently asked questions

Are S corp distributions taxable?

For a corporation with no accumulated E&P, distributions aren't included in income to the extent of the shareholder's stock basis (they reduce it), and any excess is treated as gain from the sale or exchange of property (IRC §1368(b)). With accumulated E&P, part of a distribution can be a dividend (IRC §1368(c)).

What order do S corp basis adjustments follow?

Increases for income, then decreases for distributions, then nondeductible expenses and oil and gas depletion, then losses and deductions, for years beginning on or after August 18, 1998 (26 CFR §1.1367-1(f)). A shareholder can elect to take losses before nondeductible expenses (26 CFR §1.1367-1(g)).

Do distributions reduce debt basis?

No. Only losses, deductions, nondeductible expenses and oil and gas depletion in excess of stock basis reduce debt basis (IRC §1367(b)(2)(A); 26 CFR §1.1367-2(b)(1)). Distributions reduce stock basis only, and the excess over stock basis is gain.

Does a shareholder's guarantee of a bank loan create basis?

No. A guarantee alone creates no debt basis. A payment the shareholder makes on the guaranteed loan increases debt basis by the amount paid (26 CFR §1.1366-2(a)(2)(ii)).

Who has to attach Form 7203?

Per the 2025 Instructions for Schedule E, a shareholder who claims a loss from an S corporation, receives a distribution, disposes of stock, or receives a loan repayment attaches Form 7203. Confirm the triggers in the current-year Form 7203 instructions.

Do uneven distributions create a second class of stock?

Not by themselves, if the governing provisions give all shares identical distribution and liquidation rights. Distributions that differ in timing or amount are given appropriate tax effect based on the facts and circumstances (26 CFR §1.1361-1(l)(2)(i)). A governing provision that grants unequal rights is the risk.

What happens to losses that exceed basis?

They're suspended and treated as incurred by the corporation in the next year with respect to that shareholder, keeping their character (IRC §1366(d)(2); 26 CFR §1.1366-2(a)(3)). They're personal to the shareholder and are lost if the shareholder transfers all of the stock, except in a transfer between spouses or incident to divorce (26 CFR §1.1366-2(a)(6)).

Sources and as-of dates

Rules as of 2026-09-26. Worked figures are illustrative and recomputed for this guide.

Conclusion

A distribution is only as clean as the basis schedule behind it. Roll stock and debt basis forward in the regulation's order, test the distribution before the cash moves, keep the loan file and the E&P status in the workpaper, and attach Form 7203 when a trigger applies. Actual results vary based on income, industry, and state.

The salary comes first. TracePrep ships the Reasonable Compensation Study, which documents the evidence behind the compensation figure every distribution decision starts from, with a source on every number. The Reviewer signs off before it's final, and the workpapers stay with the Firm.

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Not tax advice.

TracePrep is a software product from TracePrep Inc., not a CPA firm. This content is operator experience for educational purposes; it is not tax advice and has not been reviewed by a licensed CPA. Consult a qualified tax professional for guidance on your specific situation. Source citations in TracePrep workpapers support audit defense but do not guarantee IRS outcomes.