Your initial investment in an S corporation is both a capital cost and a basis cost. For the corporation, the amount is capital cost and used to determine the percentage of the company that you own. This percentage is used to determine income and loss passed through to the shareholder for tax purposes. For the shareholder, the amount is basis cost and must be adjusted every year after the initial investment.
An S corporation's profit and loss are treated as part of its owners' personal income. That is, a loss from an S corporation can be used to offset income gains from other sources. This "pass-through" is the key feature of an S corporation. You can deduct S corporation results from your personal taxes each year only to the same dollar figure as your adjusted basis in the company.
If, at startup, your S corporation has five equal shareholders and a value of $100,000, you would own $20,000 or 20 percent of it. If you invest an additional $50,000, you own $70,000 of a $150,000 business, or 46.67 percent. It is also possible to structure a $50,000 investment as a loan to the company. You would have a debt basis of $50,000 in the company and a stock basis of $20,000. You would still own 46.67 percent of the company at startup, but as the company repays the loan, your debt basis would decrease.
Although the word "basis" is used along with both dollar figures and percentage figures, basis is actually the dollar figure. That figure changes regularly from year to year as the business posts gains or losses. You calculate basis, and thus the company's impact on your personal taxes, from the K-1 form that the Internal Revenue Service requires an S corporation to issue each year. The calculation is the company's reported profit or loss (in dollars) multiplied by your percentage of ownership in the company. If the S corporation loses $50,000 in a year and you own 46.67 percent, you can deduct $23,335 from your taxable income.
You may have to pay capital gains tax if the corporation makes distributions or changes ownership. For example, suppose that after a few years the business is worth $500,000 and it makes a one-time distribution of 50 percent of its value. Let's also say that your basis is entirely in assets -- that is, your startup basis didn't involve a loan. Your 46.67 percent of the distribution is $116,675 and your new basis is $166,675. You realize $46,675 in capital gains -- $166,675 minus your $70,000 startup basis -- and you pay income taxes on $116,675.