You are probably familiar with a tax concept called basis, even if you don’t know it by that name. It is a relatively simple concept that is extremely important for keeping track of your company’s taxes.

Say you buy a house for $200,000 and sell the house three years later for $300,000. When you make the sale, the IRS taxes you on the $100,000 appreciation in the house’s value as opposed to the total sale amount of $300,000. From the IRS’s perspective, you have already been taxed on the $200,000 that was used to buy the house.

The $200,000 is your basis in the house. Basis is a tax concept that helps ensure fair taxation on income. In this example, basis refers to how much you paid for the house — this is also sometimes referred to as cost basis.

Basis is used in other contexts as well. Let’s consider the formation of a company. Say Larry, Sergey, and Eric each contribute cash of $5,000 to a company they have formed, and each in return receives 50 shares of stock. Their initial balance sheet would look like this:

Their initial cost basis in the shares would be $5,000, the amount they paid for the shares.

Five years later, the company’s value has increased from $15,000 to $150,000. Larry, Sergey and Eric now hold shares worth $50,000 each. When they sell their shares, the amount they are taxed on is represented by the following formula:

Each founder will therefore have to pay tax on $45,000 when they sell their shares of stock.

There are a number of things that can make basis increase or decrease. For example, if a shareholder puts in more cash to the corporation, this increases his or her basis in the shares.

Say Larry decides to put another $5,000 into the corporation to keep the operations going in year 2 but does not receive more stock.

Now the balance sheet looks like this:

As a result, Larry’s basis — now called his adjusted basis (AB) — is equal to $10,000. In year 5, when the corporation is sold, Larry’s taxable gain is:

Even though Larry did not receive additional stock as a result of the second cash contribution to the corporation, his basis increases in his existing stock. As a result, Larry owes less tax on the sale of that stock. This is called a capital contribution and is one way to increase your basis in the stock.

Basis has many ways to go up or down, and it is very important to keep track of basis in your stock and/or your LLC interest, because this will determine how much tax you owe when you sell the stock or LLC interest. I will be writing more posts on different factors that can increase or decrease basis, but for now here is a summary list:

Increases basis

• Capital contributions (as in the example)
• Personally guaranteeing S Corporation loans (S Corporation only)
• Loans taken out by an LLC
• Paying tax on your share of the profits of an LLC or S Corporation

Decreases basis

• Depreciation (deducting the cost of assets over time)
• Amortization (deducting the cost of intangibles over time)
• Taking out your share of the profits of an S Corporation or LLC

And here are some transactions that transfer basis to new property:

• Transferring property to a corporation that qualifies under 351 of the I.R.C.
• Switching one piece of business property for another under 1031 of the I.R.C.