The most misunderstood tax concept for business owners is the concept of basis. Basis refers to an owner’s investment in a particular business, and basis must be tracked accurately for annual tax reporting. When an owner sells his or her business interest, the profit on the sale is calculated as (sales proceeds received) less (basis).
Here’s an example of calculating basis:
- Bob invests $50,000 in cash and $10,000 in furniture and fixtures into Openmeadow Gifts. The equity section of the company’s balance sheet will list $60,000 in capital contributed by Bob, which is his basis of ownership.
- An owner’s share of company profits increases basis. Think about basis as a bucket: Bob put money into the bucket when he contributed cash and other assets into the business. Assume that Bob’s share of profits for the first month is $5,000. Bob will be taxed on his share of the profits, but that $5,000 also increases his basis to $65,000.
- An owner’s share of company losses decreases basis, along with any withdrawals. Assume that the company loses money in month two, and Bob’s share of the loss is $3,000. During month two, Bob also takes a withdrawal of $5,000. His basis declines to ($65,000 – $3,000 losses – $5,000 withdrawal) = $77,000.
Basis is most important when an owner decides to sell all or part of a business interest. Basis in a business interest is similar to cost basis for an investment. If you were selling 100 shares of IBM stock at $50 per share, for example, you’d need to know that your cost basis is $30 per share to calculate a $20 gain per share.
In the same way, Bob cannot calculate his gain or loss on the sale of his business interest if he doesn’t know his basis. In many instances, a company will not keep close track of an owner’s basis, and the business must catch up its accounting records to compute an owner’s gain or loss on a sale.