This article explains the concept of basis and the underlying variations of basis. In addition, the business use of basis for investment purposes is explained and expanded upon to broaden the reader’s understanding of this term. This includes understanding basis for stocks, investment into private corporations, partnerships and trusts. Finally, a section addresses the tax complexity involved with calculating basis.
At the end of this composition, the reader will have a broader understanding of the term ‘basis’ along with a more sophisticated approach with its use.
- 1 Basis – Basic Concepts
- 2 Variations of Basis
- 3 Basis and Equity – They are not Equal
- 4 Basis of Investment in Small Business
- 5 Summary – Basis in Business
Basis – Basic Concepts
The simplest of all investment transactions is the purchase of stock utilizing a broker in the public market. The amount invested with private money is the basis (value) of the investment. Traditionally, this investment amount is paid with after tax dollars.
In effect the money invested is sourced from the taxpayer’s earnings from which income taxes have been paid. This is the purest form of basis.
But now, let’s modify this transaction a little and complicate basis. Instead of a traditional investment transaction, the money invested is a result of a retirement plan. The taxpayer funds the plan with his earned dollars, yet this value had not had income taxes paid on the amount (most retirement plans are tax-deferred investments). The investment as a whole is referred to as basis; yet, its tax basis is zero because the investment was made with pre-tax dollars. So now there are two variations of basis, traditional basis (the total investment made) and tax basis which in this case is zero.
So far there are two forms of basis, traditional which is the amount invested and the tax basis which is the amount of the investment having already had its income taxes paid.
To convolute this some more, basis is not always in the form of cash, actually the bulk of all basis in business is in the form of property, both real and personal. Many small businesses start out with capitalization from property and not in the form of cash. So the owner puts up an asset and allows the title to the asset to change to the name of the new business. Now basis is the value of property (cash, tangible and intangible) invested into an entrepreneurial endeavor. This basis may have untaxed and taxed elements. To illustrate, look at this example.
J&J Real Estate
Jim is a real estate manager and wants to forge a deal with Janice to develop Janice’s real estate. The two decide to join forces. Jim agrees to invest $50,000 of his own money into the partnership. Janice bought the land with her savings several years ago for $35,000 and it is currently worth $50,000. She transfers the land to the partnership.
What are the respective bases (plural form of basis) in the partnership?
Since both parties contributed $50,000 of value, both partners have a basis of $50,000 inside the partnership. However, the tax basis for each is different. See the table below:
Notice some new terms from above? The inside basis is always the value recognized from the business’ perspective, thus it is referred to as inside basis. However, on the outside, Janice only invested $35,000 of value. For tax purposes, Janice’s investment has a tax basis of $35,000. From the investor’s perspective, her basis in the investment via the partnership is $50,000 of value. In the partnership, each partner has a joint tenancy in the assets for all $100,000 of value. There are tax guidelines for the above; but for now, the contributions to the partnership are tax-free.
Remember the key for basis is the value of the investment made; this value can be different than the tax basis. The problem with this term is the multitude of variations and a sophisticated entrepreneur needs to understand these different meanings.
Variations of Basis
This section starts out with the more common terms of basis and ends with some far-reaching uses.
Often property is acquired for either personal or business purposes. This exchange (usually cash) has a dollar value involved. The asset purchased now has a dollar value known as cost basis. This cost basis almost always equals the tax basis. It is rare for cost basis and tax basis not to equal each other. It does happen though.
Cost basis is the value exchanged for the asset purchased. Often it is not purely cash, sometimes it includes a promise to pay. So the question becomes: What is the cost basis for the asset purchased?
Cost basis includes all items of value in exchange for the asset purchased. Therefore, the debt portion of the asset is considered basis. In a traditional asset purchase like a vehicle financed with a loan, the loan is paid back with after tax dollars. Thus the inclusion of a loan as basis in a purchase of an asset.
Adjusted or Adjusted Cost Basis
Once the asset is purchased, it often requires modifications, improvements or alterations to make it ready for use. These changes require additional investment of money. These additions increase the basis of the asset. This is referred to as adjusted basis or adjusted cost basis. Once the asset is placed in service, the tax code allows the taxpayer to depreciate the asset. Depreciation reduces the basis of the asset.
To complicate this adjusted basis issue more is the fact that book depreciation and tax depreciation use different depreciation schedules. Therefore the adjusted basis is further modified to include:
1) Adjusted Book Basis – the cost basis plus any additional capital investment less book depreciation *
2) Adjusted Tax Basis – the cost basis plus any additional capital investment less tax depreciation
* Book basis is often higher than tax basis because tax depreciation is accelerated in comparison to Generally Accepted Accounting Principles’ use of depreciation.
Adjustments can include losses from a natural disaster or a step-down due to market value changes. The term adjusted basis reflects a multitude of various increases and decreases.
When a taxpayer receives property as a result of inheritance the Internal Revenue Code Section 1014 changes the basis of the asset received to the fair market value on the date of death of the decedent. As an example, decedent buys Apple stock in 2008 for $70 a share and dies on August 12, 2016 whereby Apple stock closed at $108 a share. The decedent leaves the stock to his daughter. The daughter’s basis and tax basis are now $108 per share.
The fair market value is used for all assets transferred by the decedent to the heirs.
This basis change is referred to as ‘stepped-up’ and the taxpayer inherits a responsibility to track the respected asset(s) separately for tax purposes. All assets include tangible personal property (artwork, jewelry, autos, antiques, etc.), real property and investments including privately held positions in small business.
Sometimes gifts are made to a family member. The basis of the gift is the basis as held by the giftor (donor). This basis is carried over to the receiver from the transferor. This is sometimes referred to as substitute basis.
Spin-Off, Split-Off, Split-Up and Splint-Off
Sometimes corporations will divest themselves of business segments and the stock is rearranged by the issuance of new shares or splitting up existing shares. The corresponding basis of the old stock is allocated to the various new models, thus the new stock has a modified basis.
For example in a split-up of a company, the existing shareholders turn in their shares and receive new shares from the new entities. The basis in the new shares in the aggregate equals the basis prior to the split-up.
Basis and Equity – They are not Equal
When an investor or small business entrepreneur puts up money in a business venue, it is often referred to as ‘taking an equity position’ in that small business. The reason the term ‘equity’ is used is that an investment into small business is customarily recorded to that part of the balance sheet, i.e. the equity section of the balance sheet. Look at this simple balance sheet for a law firm:
. BARMOY & VICK P.C.
. Balance Sheet
. September 30, 2016
Current Assets $206,307
Fixed Assets 82,110
Total Assets $288,417
Capital Accounts $50,000
Current Earnings 176,714
Total Equity 226,714
TOTAL LIABILITIES AND EQUITY $288,417
So if this firm adds a new partner to the practice and this partner pays $25,000 to join, total capital accounts will increase to $75,000. Naturally, current assets increases $25,000 too (for the additional cash). It is because of the use of the term ‘equity’ that often the terms ‘equity’ and ‘basis’ seem interchangeable. For the reader, this is important to understand, basis and equity ARE NOT the same.
Equity was defined in Crane v. Commissioner of the Revenue, 331 U.S. 1, 67 S.Ct. 1047, 91 L. Ed. 1301, a Supreme Court case, as ; liens also means liabilities. In the above balance sheet, assuming all assets are actually equal to $288,417 (fair market value matches stated book value) and subtracting the liabilities, the equity position actually equals $226,714.
However, the basis of the partners may not actually equal $226,714. How so? First off, let’s start with some of the various forms of basis.
Cost Basis – Remember from above, cost basis is almost always the tax basis in business. In this case, current earnings for the year to date are $176,714. Since the tax return has yet to be filed for 2016, this dollar amount has yet to have taxes paid on it; therefore, the tax basis is the $50,000 associated with the capital account balances.
Adjusted Basis – To make the basis reflect the tax basis, many small businesses estimate the tax implications and adjust current earnings to reflect post estimated tax position. If 40% is used for tax purposes, then the liabilities and equity section will look like this:
Note, total liabilities and equity did not change in the aggregate; it is simply restated. Now the adjusted basis reflects the anticipated tax implications and equals $156,029.
Unadjusted Basis – The capital account balance plus the current earnings without tax adjustments equals the unadjusted basis or for the above $226,714.
So basis and equity are not necessarily the same. With this knowledge, we turn our attention to basis related to an investment in small business.
Basis of Investment in Small Business
When the term ‘basis’ is used it almost always refers to the tax basis version (tax basis is also known as cost basis). The traditional core investment into a business is with after tax dollars. A simple cash investment into stock is the purest form of using after tax dollars to invest into business. Partnerships recognize any contribution by a partner as tax free under Code Section 721 and corporations use Section 351 for the sale of stock.
What these two code sections prevent is recognition of gain to the contributing investor and non recognition of income for the business. This is all well and proper for a pure transaction. However, not all transactions of an investment in a small business are pure. More often the contributions have mixed elements complicating the investment. Here are the more common forms of mixed element contributions.
Property Contributed with Liabilities
It is normal for small business investors to contribute property instead of cash for their portion of the investment. The basis is simply reduced by the amount of any liabilities assumed by the business (refer back to the Supreme Court definition of basis). Again, this can get complicated depending on the value of the particular asset contributed. Take a look at this example:
Jim is opening up a carpet cleaning business and decides to contribute a van to the business. Jim bought the van two years ago for $24,000. He paid $4,000 down and borrowed $20,000. Now the van has a NADA book value of $18,000 and Jim still owes $16,000 on the loan. What is Jim’s basis for the stock received from the newly formed company?
Since this is a corporation, Section 351 of the Internal Revenue Code, the IRS basically allows the taxpayer to swap stock for the fair market value of the asset received less any liabilities. In this case, Jim’s stock is now worth $2,000 which is the $18,000 fair market value less the assumed $16,000 balance of the loan.
In the above example, Jim’s basis of $2,000 reflects the real value Jim has in the asset. This is Jim’s adjusted basis:
Initial Invested Basis $4,000 ($24,000 less $20,000 loan)
Decrease in Value for Use of Vehicle over 2 Years (2,000)
Actual Value Exchanged $2,000
Often though this isn’t the case. Usually the contributed asset’s loan value is greater than the fair market value. Using the same facts stipulated above except now the fair market value is $15,000, Jim’s basis of the transferred asset is a negative $1,000. Jim must recognize this $1,000 as income for tax purposes and his new basis in the business is zero for tax purposes. For the company, the asset is $16,000 and a corresponding long-term liability is posted for $16,000. Jim’s stock has a cost basis to Jim of zero once he pays the income tax on the negative $1,000.
Services Contributed as the Investment
‘Sweat Equity’ is really the most common form of capital contributed in small business. This is because the small business owner has so much at risk in the venture; so they work long hours to make the company successful. The IRS allows sweat equity to become basis in two different ways. The first is simple, whatever this value is to the company, it is recorded to the books of record and is income to the individual doing the work. This means the individual investor must pay income taxes on this value to recognize tax basis. Look at this example for Jim’s business.
In order to keep cash outlays minimal Jim decides that he will work for free for 3 months in his new carpet cleaning business. Jim figures his compensation is worth $12,500 to the company. To record this value, the company debits labor expense for $12,500 and credits stock for $12,500. Jim receives a W-2 at year-end including this $12,500 as income and pays income taxes on this amount. He now has a tax basis in his stock for $12,500.
The problem with this is that many taxpayers are forced to pay out cash to the IRS to obtain tax basis in their stock investment. Many small businesses fail within the first few years and if Jim’s carpet cleaning business fails, Jim will have to report a loss of $12,500 on his Form 1040 and recoup his taxes already paid into the IRS. This economic situation is not productive for Jim as he could have used that cash paid in taxes as additional investment in his business to possibly save the company.
To counter this, a second method is allowed by the IRS. The IRS allows a taxpayer to defer this tax payment by electing to claim his initial services as deferred income until realized. This second method is done by making a Section 83(b) election called a ‘Substantial Risk of Forfeiture’ on Form 1040 and pay the income tax in the year the taxpayer actually receives $12,500 of W-2 income related to this work. This means in the interim, Jim’s cost basis is zero for his stock investment (sweat equity) until he pays the tax on the $12,500 of value.
Purchase of an Existing Interest of a Business
The basis calculation gets a bit more complicated when addressing the purchase or sale of an interest in business. This is due to the complexity involved in calculating the two most common forms of taxation. The traditional form is commonly referred to as ordinary income tax which is typically determined at higher tax rates. The other tax is called capital gain tax and it has a lower rate.
The buyer of the interest in business recognizes basis as the amount paid for the ownership of his respective share. This is known as the investor’s outside basis. The seller however has a different formula for basis.
If the seller is actually involved in the business he already has an existing basis in his investment. In addition, there may be some unrealized ordinary income related to utilizing the cash basis of accounting for tax purposes. Therefore the difference between the tax basis and book (accrual based) basis is classified as ordinary income to the seller for his share (based on ownership). This unrealized ordinary income includes cash adjustments for:
* Accounts Receivable
* Prepaid Items
* Accounts Payable
* Accrued Expenses
* Accelerated Depreciation
In addition, any sales price in excess of the existing tax basis adjustment for these unrealized items (ordinary income) is classified as capital gain income and is taxed at a lower rate. A sales price of an interest in a business includes not only these unrealized items but deferred gains for fair market value increases associated with certain assets including:
* Fixed Asset Appreciation (common with real estate)
* Favorable Interest Rate(s) on Long-Term Debt
* Long-Term Contracts
This value is customarily taxed at capital gain rates if sold by an owner of a small business.
The Business Entity’s Basis in its Investments
Not only do the owners have basis in their investment, but the business entity has basis in its investments too. Once the entity is recognized for tax purposes, any assets purchased use the same rules of basis as an individual taxpayer. To really complicate matters, often the entity buys another entity (subsidiary) and has basis in that entity too. This tiering of basis can continue for many layers.
The entity’s basis in its investments is referred to as inside basis; whereas an owner’s basis is denoted as outside basis.
Summary – Basis in Business
Understanding the complexity involved with basis is an essential business principle for any entrepreneur. Basis is simply the value of an individual or entity’s investment in a business endeavor or asset. Basis has several variations and include:
* Cost Basis – Post tax investment value
* Adjusted Basis – Cost basis modified for improvements, alterations or additional capital investment
* Inside Basis – Basis of an entity’s investment in assets
* Outside Basis – The value post tax for the individual investor
* Stepped-Up Basis – Basis adjusted higher to fair market value due to death of the holder
* Carryover Basis – Also known as gift basis, it is the basis as held by the donor/giftor/grantor
Sometimes novice business entrepreneurs mix basis and equity when using these terms. Basis is traditionally the tax position (customarily tied to the cash method of accounting) and equity is the value of the investment in accordance the accrual method of accounting used with Generally Accepted Accounting Principles.
When an investor or owner contributes money into a business the transaction is considered tax-free under Section 351 (corporation) or Section 721 (partnership) depending on the entity’s legal form. There are rules involved if tangible property is donated and another set of rules for intangible property or services rendered (Section 83).
Basis is used to calculate ordinary and capital gains which are taxed at different rates. This is why it is essential for accountants to track all forms of basis in an investment in business (outside basis) and any entity investments (inside basis). Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.