What does the shareholder stock and debt basis limitations tell the IRS?

[Plarka]

Are they taxing me on just the net profit for the year? What are they doing with the number which is this year's profit added to the previous years? Are they using this number to know what to tax me on?

If not, which question on Turbotax Business is telling them what I will report on my personal taxes to get taxed on? Distributions made to shareholders?

[KeshaH]

Stock and debt basis is used to calculate how much loss you can deduct on your personal return in years that your business reports a net loss. It's also used to determine how much of a capital gain you'd have if you sold the business.

Each year the business has a profit, you pay tax on your share - regardless of whether you took distributions or not. This increases your stock basis, which tracks your after tax investment in the business. You'll receive a Schedule K-1 which shows your share of the income and expense items of the business. The information from the Schedule K-1 is entered on your tax return and that's how that IRS will know what you're taxed on for the year.

[Plarka]

Thank you! This makes sense! 

Looking at my K-1 from last year, it looks like the ordinary business income is the amount we entered on our personal taxes from the K-1.  Is that correct?

I thought I had entered that as distributions, because I had taken all the money out of the business to pay off my house, but the distributions line 6 on 1120S is blank.  Since I took all the money out to my personal account and used it, shouldn't it be entered as distributions there?   I thought I told TurboTax it was distributions when answering all the questions. 

[KeshaH]

Yes, the ordinary income from Schedule K-1 is what is reported on your personal return. You'd also report any investment income (interest, dividends, capital gains/losses), net rental income, royalties, charitable contributions, and other items from your Schedule K-1, if any of the items are present. These other items are income and expense items from your business that are not included in ordinary income because they may have different tax treatment among different shareholders.

Yes, your Schedule M-2 should show your distributions. To reflect your distributions, you could amend your prior year 1120s to update the M-2 or you can make an adjustment to the beginning balance on the current year M-2. If you make the adjustment on the current year form, make sure you keep records of the calculation of the adjustment in case the IRS asks about it.