Shareholders of S corporations are restricted in the amount of passthrough entity losses they can deduct from their income. For the purpose of preparing an accurate tax return that will withstand the scrutiny of an IRS audit, it is essential to comprehend how basis is accurately calculated and what counts as shareholder basis against which to deduct passthrough losses.
S corp. basis and why it is important
S corporations are thought of as passthrough entities because they distribute the profits and losses made by the company to the shareholders, who must pay taxes on those profits and losses on their personal income tax returns. An S corporation shareholder, however, should be aware that a loss passed through from the business is not necessarily deductible on the shareholder’s personal income tax return. Determine whether the shareholder has a sufficient basis in the entity to offset the loss as a first step.
S corporation basis is acquired by a shareholder through the initial stock purchase, additional equity contributions, cumulative net income, less distributions made to the shareholder while the stock is held, and other similar transactions. In addition, loans made to the S corporation give a shareholder debt basis. Note that nondividend distributions (distributions other than from accumulated earnings and profits) lower the basis of the stock but do not lower the basis of the debt. Sec. According to 1366(d)(1), a shareholder’s deductible passthrough losses cannot be greater than their adjusted basis in S corporation stock plus their adjusted basis in any debt the S corporation owes to them.
Basis is crucial because it is the initial inquiry into whether the shareholder has a loss that the company will deduct from their compensation. Before claiming a loss on their tax return, shareholders must also pass the tests for at-risk and passive activity losses. Sec. If the taxpayer doesn’t have enough basis to deduct the loss in the current tax year, 1366(d)(2) states that the passthrough loss may be carried forward indefinitely. However, if sufficient basis is not created or restored prior to the company being sold or shut down, the taxpayer might no longer be able to deduct the loss in subsequent years.
What qualifies as debt basis?
Debt must satisfy two conditions in order to be used as an S corporation basis. The debt must initially be owed by the S corporation directly from the shareholder. Second, under Regs. Sec. 1. 1366-2(a)(2), the indebtedness must be bona fide. According to general federal tax principles, the determination of whether debt owed to a shareholder is bona fide depends on all relevant facts and circumstances.
These “bona fide debt” provisions were adopted by the IRS on July 23, 2014, when it released final regulations outlining the basis for S corporation loans (T D. 9682). The new provisions take the place of the judicially established standard, which called for an “actual economic outlay” that makes the shareholder “poorer in a material sense” and was previously applied to determine whether a shareholder was entitled to debt basis under Sec. 1366(d)(1)(B).
Bona fide debt
Regs. Sec. 1. According to 166-1(c), a bona fide debt is one that results from a debtor-creditor relationship and is based on an actual, enforceable obligation to pay a certain amount of money. Courts have used the parties’ intentions at the time the loan was made to determine whether there is a debtor-creditor relationship. In the event of a loan default, the shareholder must have a genuine expectation of repayment and the intention to pursue legal action against the S corporation.
When a bank or other unrelated third party is the source of the funds, the definition of “bona fide debt” is unquestionably satisfied. The bank will hold the shareholder accountable for repayment terms if the shareholder takes out a loan from it and lends the money to the S corporation. When the loan is made between related parties or between the shareholder and entities with common ownership, the conclusion is less certain. It is crucial to record the parties’ intentions in these circumstances by classifying the transaction as a loan in the corporate resolutions and accounting records. The parties should continue to have written notes, similar to what a shareholder would execute with unrelated parties, with a fixed repayment schedule and a fair market interest rate that is at least equal to the applicable federal rate.
The financial standing of the S corporation debtor at the time the loan was made will be considered by the courts to determine whether it supports the shareholder’s expectation of repayment and their intention to establish a legitimate debtor-creditor relationship. The shareholder must pledge personal property as collateral for the loan, according to the courts.
Circular loans are a flow of money that results in loans between parties, with the initial lender serving as both the start and the end of the money flow. Such loans are made with the intention of establishing debt basis, which shareholders will use to offset passthrough losses on their individual income tax returns.
In Oren, T. C. Memo. The Tax Court ruled in Tax Case 2002-172 that husband and wife taxpayers did not have enough loan basis under Section 1366(d) to deduct passthrough losses from their S corporations. Donald Oren, the husband’s tax advisor, helped the couple by establishing loans between Oren and their jointly owned S corporations in order to establish basis for loss deductions. Orens S corporation, Dart Transit Co. , loaned $4 million to Oren. Highway Leasing (HL), a second S corporation in which Oren shared ownership, was given the money by Oren. HL then lent the funds back to Dart. On the same day, Oren carried out a number of loan transactions. The loans were evidenced by notes that stated the annual interest rate was 7% and that the principal was due 375 days after demand. On his personal income tax return, Oren deducted passthrough losses from the S corporation using the debt basis established in HL.
The court came to the conclusion that the loans did not qualify as additional S corporation basis to allow Oren to deduct losses on his tax return by focusing on the fact that the taxpayer was not materially poorer after the loans were made and that he had made no economic outlay. The loan proceeds originated and ended with the S corporation, Dart, with no change in the parties’ financial situation, according to the court, which determined that the loan transactions amounted to nothing more than offsetting bookkeeping entries. Due to the fact that the business loss was caused by depreciation deductions, HL did not need to keep the loan proceeds for its business operations and returned the money to Dart.
The transaction would not have been circular if HL had retained the funds, and the court might have determined that the loan proceeds in HL increased Oren’s debt basis. For taxpayers who can use this distinction to avoid a circular transaction and scrutiny of the debt basis issue during an IRS audit.
The court noted that, particularly in light of the sizeable amount of the loans, the terms of the promissory notes were not equivalent to those that might be found in notes executed for the benefit of unaffiliated third parties. Furthermore, the loans were made in the form of demand notes and were unsecured. Oren additionally had control over when a demand for payment on the notes would be made. Oren was the majority or sole owner of both the obligor and obligee of the notes.
Additionally, the terms of the notes, which required payment 375 days after demand, were not followed when repayments on the notes were made. Instead, the principal and interest repayments happened simultaneously in a circular transaction, which led the courts to rule that the debt was not legitimate. Additionally, the court thought it was highly unlikely that Dart would have required Oren to repay his loans from Dart using his personal assets. Assuming there was a demand for payment, the series of events leading to the loans’ repayment would have an offset, putting the parties back where they had been before.
In cases such as Oren that occurred before the final regulations were issued in July 2014, the courts viewed circular loans as lacking economic substance and failing the economic-outlay and poorer-in-a-material-sense tests However, the final regulations have made it possible to take another look at circular loans as a potential way to establish S corporation debt basis, provided that the loan is regarded as bona fide debt. The definition of a bona fide debt would be the main topic if Oren were to be prosecuted in court today in accordance with the final regulations. Although it is currently unclear what the IRS and the courts will deem to be a bona fide debt, it may not be necessary for the parties’ financial circumstances to change. If Oren structured the notes with terms similar to those found between third parties, included a fixed schedule for repayment instead of demand notes, and collateralized the debt between the parties, he would have a stronger case for demonstrating that the S corporation debt increased his basis. A track record of principal and interest payments over time would provide additional evidence that a debt is legitimate.
Regs. Sec. 1. Unless the shareholder actually pays on the guarantee, according to 1366-2(a)(2)(ii), the shareholder has no basis in a loan that is only guaranteed.
In Phillips,T. C. Memo. In its recent decision 2017-61, the Tax Court reaffirmed and broadened the law’s application, holding that liens and judgments against S corporation shareholders do not raise basis. In this instance, Sandra Phillips owned 50% of an S corporation involved in real estate development and sales. The S corporation relied heavily on financing. The shareholders served as guarantors on the loans that the bank made directly to the S corporation. The S corporation fell behind on the bank loans in 2006, at the height of the downturn in the real estate market. The lenders sued the S corporation and the guarantors and sought enforcement of the personal guaranties to satisfy the judgment
Phillips asserted that she was qualified for an increase in her S corporation basis even though she hadn’t paid anything toward the court order or to the lenders directly. The guaranteeing shareholder had in fact borrowed the money directly from the lender and transferred it to the S corporation as a capital contribution or a back-to-back loan, according to Phillips’ “substance versus form” argument. However, Phillips did not provide any additional proof that the lending banks viewed her as the primary obligor on the loan because she was the shareholder of the S corporation.
According to the Tax Court, Phillips was not entitled to an increase in basis for the loan guaranties or judgments against her. Examining the lender’s intentions at the time the loan was made is necessary to determine who is the actual debtor. If a lender considered the shareholder to be the main source of loan repayment, the court’s entry of a deficiency judgment against a guarantor years after the loan default is irrelevant. Additionally, the court ruled that Phillips could only raise her S corporation basis by paying the judgment.
If Phillips had planned properly, he could have established a foundation for the bank loans. Phillips ought to have set up the loans so that the S corporation served as a guarantor and she was the primary obligor. Phillips could have used the S corporation stock as collateral to get the loan approved by the bank because the loan amounts were significant and she couldn’t have done so using just her assets.
The flow of funds is also critical to establishing basis. The bank ought to have given Phillips the loan proceeds personally, and she ought to have lent the money to the S corporation directly. This back-to-back loan structure would have spared Phillips from having to make payments on the judgment to establish S corporation basis and would have been sufficient to demonstrate that the lender intended to make the loan to the S corporation shareholder.
A note payable directly to the shareholder can be used to successfully restructure an S corporation third-party note payable. In Gilday, T. C. Memo. In 1982-242, the shareholders of the S corporation guaranteed a bank note payable. The shareholders provided a personal note to the bank for the entire amount owed, motivated by tax planning, and the bank cancelled the note payable with the S corporation.
The court ruled that because the shareholders were only its guarantors on the earlier note, they had no basis for doing so. However, due to the debt’s restructuring, the shareholders were no longer guarantors but rather primary obligors, which allowed them to write off their S corporation passthrough losses.
Shareholders should make sure that assets to secure the bank loan are not pledged directly by the S corporation if they are required to pledge assets in addition to signing a bank promissory note. The S corporation’s direct pledged assets do not give the shareholder a debt basis. In Bolding, 117 F. 3d 270 (5th Cir. 1997, the taxpayer granted a security interest to the bank in cattle that were intended to be purchased using the money from the bank line of credit. The shareholder, not the S corporation, signed the Uniform Commercial Code financing statement that disclosed the bank’s security interest in the cattle. The court noted that it was crucial that the shareholder, and not the S corporation, was the one assigning the security interest to the bank in determining that the shareholder had debt basis in the line of credit.
The parties should have the corporation pay the shareholder’s loans directly to the shareholder in order to uphold the loan structure and comply with the definition of a bona fide debt. The shareholder should pay the bank debt in full personally. This crucial planning tool will back up the shareholder’s use of the debt as basis to offset passthrough losses on his or her individual tax return.
Emphasis on loan structuring
Understanding S corporation basis rules enables professionals to help clients take advantage of planning opportunities aimed at maximizing deductibility of passthrough losses and minimizing shareholders’ tax obligations. Furthermore, careful and thoughtful loan structuring will permit shareholders to utilize passthrough losses now rather than deferring their application to future years.
EditorNotes
Michael D. Koppel, a retired partner with the Canton, Massachusetts law firm Gray, Gray & Gray LLP
For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas. com.
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FAQ
Can an S corp loan money to a shareholder?
Yes, a shareholder can receive a loan from an S corporation.
Does a loan to shareholder reduce basis?
An S corporation shareholder’s basis in loans that are repaid by the corporation is decreased.
Is a loan to a shareholder taxable?
The $2,000 must be reported as income if the shareholder made the loan without a debt agreement in place, and the lender must pay income tax on the repayment. The $2,000 repayment may be regarded as capital gains if the loan was made with a debt agreement in place, which is taxed at a lower rate than income tax.
What are the treatments for loans to shareholders when dissolving an S Corp?
The shareholder will have to report the loan as ordinary income because S corporations typically pass corporate profits and losses through to shareholders, who then report on their personal tax returns.