Partnership Basis vs S Corporation Basis: The Debt Rule That Separates Them

A partner who contributes 50,000 to a partnership that then borrows 100,000 has a basis of 100,000. An S corporation shareholder who contributes 50,000 to a corporation that then borrows 100,000 has a basis of 50,000, and personally guaranteeing the loan does not change that number by a single dollar. Both entities pass their income and losses through to their owners, both track an owner's basis to limit those losses and to tax distributions, and on this one rule they part company completely.

REG examines the two basis computations more than any other pass-through topic, usually as a sequence: start with the contribution, add the year's income, subtract the distribution, apply the loss, report the ending basis or the deductible loss. The sequence is different for the two entities, and the traps are at the steps where a candidate applies one entity's rule to the other. This article runs both computations on parallel facts so the difference is visible at every line.

Why basis matters

Basis does three jobs for an owner of a pass-through entity. It caps the losses the owner may deduct: a loss allocated in excess of basis is suspended and carried forward until basis is restored. It determines whether a distribution is tax-free: a distribution is a return of basis until basis is exhausted, and gain after that. And it fixes the gain or loss when the interest is sold. Every question on the topic is one of those three, asked after a series of adjustments.

The two computations, side by side

Step	Partnership: partner's outside basis	S corporation: shareholder's stock basis
Starting point	Cash plus the adjusted basis of property contributed	Cash plus the adjusted basis of property contributed
Entity-level debt	Added: the partner's share of partnership liabilities is treated as a contribution of money	Ignored: corporate debt never enters stock basis
Owner's own loan to the entity	Included through the liability share, like any other partnership debt	Creates a separate debt basis, only for a direct loan from the shareholder
Owner's guarantee of entity debt	Can shift the allocation of recourse debt toward the guarantor	Creates nothing until the shareholder actually pays
Income, including tax-exempt income	Increases basis	Increases basis
Distributions	Decrease basis; cash in excess of basis is gain	Decrease basis; cash in excess of stock basis is gain, and debt basis is not used
Decrease in the owner's share of debt	Treated as a cash distribution	Not applicable
Losses and nondeductible expenses	Decrease basis after distributions; deductible only to the extent of basis	Decrease basis after distributions; deductible to the extent of stock basis, then debt basis
Basis below zero	Never; excess loss is suspended	Never; excess loss is suspended

The partnership, worked

Partner A contributes 50,000 cash for a 50% interest. The partnership borrows 100,000 on a recourse basis, shared equally, so A's basis is 100,000. During the year A is allocated 30,000 of ordinary income and 2,000 of tax-exempt interest, receives a cash distribution of 20,000, and A's share of the liabilities falls by 5,000 as the loan is repaid. The partnership then allocates A a loss of 120,000 from a bad year in its main business.

Step	Amount	Basis
Contribution	50,000	50,000
Share of liabilities	50,000	100,000
Ordinary income	30,000	130,000
Tax-exempt income	2,000	132,000
Cash distribution	(20,000)	112,000
Decrease in liability share, a deemed distribution	(5,000)	107,000
Loss allocated 120,000, deductible to basis	(107,000)	0

A deducts 107,000, suspends 13,000, and ends the year with a basis of zero. Three points in that table are the ones questions turn on. The liabilities went in at the start and their reduction came out as a distribution. The tax-exempt income raised basis even though it was never taxed, because otherwise it would be taxed on the way out. And the distribution reduced basis before the loss was applied, which is the ordering rule that decides how much of the loss survives.

Which partners get which debt is its own rule. Recourse debt is allocated to the partners who bear the economic risk of loss, which is why a guarantee can shift it; nonrecourse debt is generally allocated by the partners' profit-sharing ratios. A limited partner who bears no risk on a recourse loan gets none of it.

The S corporation, worked

Shareholder B contributes 50,000 cash for 50% of an S corporation. The corporation borrows 100,000 from a bank and B guarantees the loan. B also lends the corporation 20,000 directly. During the year B is allocated 30,000 of ordinary income and 2,000 of tax-exempt interest, receives a cash distribution of 20,000, and is then allocated a loss of 90,000.

Step	Stock basis	Debt basis
Contribution	50,000
Bank loan, guaranteed by B	50,000, no change	0, no change
Direct loan from B	50,000	20,000
Ordinary income 30,000 and tax-exempt income 2,000	82,000	20,000
Cash distribution 20,000	62,000	20,000
Loss 90,000: first against stock, then debt	0	0

B deducts 82,000 and suspends 8,000. The guaranteed bank loan did nothing. The direct loan created 20,000 of debt basis, which absorbed the loss only after the stock basis was gone. Had B instead borrowed the 20,000 personally and contributed it as capital, it would have been stock basis and the result would be the same 82,000 of deductible loss; the form matters for what happens next, not for this year's number.

What happens next is the part of the S corporation rule that surprises. Debt basis reduced by losses is restored by later net income before stock basis is increased, so that the shareholder's loan is made whole first. Distributions, on the other hand, never touch debt basis: a distribution in excess of stock basis is a capital gain even if the shareholder has debt basis to spare. And if the corporation repays a loan whose basis has been reduced, the shareholder recognises income on the repayment to the extent the amount received exceeds the reduced basis.

The ordering rules

Both entities apply adjustments in a fixed order, and the order is examined.

Order	Partnership	S corporation
1	Increase for income items and increases in liability share	Increase for income items
2	Decrease for distributions and decreases in liability share	Decrease for distributions
3	Decrease for losses and nondeductible expenses	Decrease for nondeductible, noncapital expenses
4		Decrease for losses and deductions; a shareholder may elect to take losses before nondeductible expenses

Distributions before losses, in both. A candidate who applies the loss first and then treats the distribution as gain has inverted the rule and will get both numbers wrong.

Property distributions

The entities differ here too. A partnership distributing property generally recognises no gain, and the partner takes the property at the partnership's basis, limited to the partner's remaining outside basis. An S corporation distributing appreciated property is treated as having sold it at fair value: the corporation recognises the gain, which passes through to the shareholders and raises their basis, and the shareholder takes the property at fair value. The partnership rule defers; the S corporation rule accelerates.

What sits on top of basis

Basis is the first of three limits on a pass-through loss, not the only one. The at-risk rules then limit the loss to amounts the owner could actually lose, which removes most nonrecourse debt from the partnership figure. The passive activity rules then limit losses from activities in which the owner does not materially participate to passive income. REG tests the basis limit and expects a candidate to know the other two exist; the interaction of all three is examined in more depth in TCP, along with the entity-choice decisions that turn on it. The TCP study guide maps where.

How REG asks

Question pattern	Answer
Partner's basis after the partnership borrows	Add the partner's share of the liability
Shareholder guarantees the S corporation's bank loan	No basis until the shareholder pays
Loss exceeds basis	Deduct to basis; suspend the excess; carry forward
Cash distribution exceeds partner's basis	Gain for the excess, usually capital
Cash distribution exceeds S shareholder's stock basis, debt basis remains	Gain for the excess; debt basis is not used
Tax-exempt income	Increases basis in both
Loan repaid to the partnership's lender	Partner's share of the decrease is a deemed distribution
S corporation income in a year after debt basis was reduced	Restores debt basis first

Where to practise this

Basis is a procedure, and it is learned by running twenty fact patterns for each entity until the ordering is automatic. Prepito's REG course covers partnership and S corporation formation, basis, distributions and loss limitations with practice questions and simulations that show the basis roll-forward line by line, and the TCP course takes the same computations into the at-risk and passive rules. For the approach to US entity tax as a whole from outside the US, see How to Study REG When You Have Never Filed a US Tax Return and the REG study guide.

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Sources: IRS Publication 541, Partnerships, IRS, S Corporation Stock and Debt Basis, AICPA CPA Exam Blueprints. The worked figures are illustrative and ignore the at-risk and passive activity limits; the Internal Revenue Code and IRS guidance change, so confirm the current rules for a specific case.