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Reinforce your understanding of frequently used principles and receive a wealth of tax planning tips and strategies. Learn how to apply the latest changes when preparing federal income tax returns and advise clients on new developments and tax-saving ideas for S Corps and other pass-through entities. Many key tax return issues are covered in this course.
Objectives:
TOC from previous edition. Please check back for updates.
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Excerpt from previous edition. Please check back for updates.
S Corporation Pass-Through Treatment
Shareholder Guarantee of Corporate Debt
An S corporation shareholder's basis is not increased by third-party loans made to the corporation. This applies even if the loan is personally guaranteed by the shareholder [Goatcher, 91-2 USTC ¶50,450, 944 F2d 747 (CA-11, 1991); Richard Salem v. Comm., 99-2 USTC ¶50,898, CA-11, 9/16/99; Sleiman, 99-2 USTC ¶50,828, CA-11, 9/10/99]. The Fourth, Fifth, Sixth, and Eleventh Circuits agree, as does the Tax Court in numerous opinions.
Observation: In several recent decisions, the courts have continued to support the IRS position on the issue of whether an S shareholder achieves stock basis for the personal guarantee of corporate-level debt (Estate of Alton Bean v. Comm., 2001-2 USTC ¶50,669, CA-8, 10/1/2001, aff'g. TC Memo 2000-355; Grojean v. Comm., 2001-1 USTC ¶50,355, CA-7, 4/13/2001; Luiz v. Comm., TC Memo 2004-21, 1/29/2004; Maloof v. Comm., 2006-2 USTC ¶50,443, CA-7, 8/4/2006, aff'g TC Memo 2005-75).
However, the shareholder's basis will be increased if the third-party loan is restructured so that the S corporation becomes indebted directly to the shareholder-guarantor (PLRs 9811016-19). Similarly, if the S shareholder actually satisfies the debt of the corporation, or if the shareholder gives a personal note to the lender in full satisfaction of the corporate liability, the S shareholder will achieve tax basis (Rev. Rul. 70-50, 1970-1 CB 178; Rev. Rul. 75-144, 1975-1 CB 277).
v Development: The Tax Court has confirmed that an S corporation shareholder has achieved basis where that shareholder gave his full recourse note to a bank to replace a loan that the bank had previously made to his S corporation. The court based its conclusion on the principles of Rev. Rul. 75-144, which held that the execution of a note by a shareholder created basis for the shareholder when the bank accepted the shareholder's note in replacement of a corporate debt (Miller v. Comm., TC Memo 2006-125, 6/15/2006).
Related Company Loans
In many cases, an S corporation is controlled by a shareholder who also owns other entities (e.g., other S corporations, C corporations, or partnerships). When a new S corporation is formed by such an individual, it is common to find that a large portion of the capitalization of the new S corporation arose from direct loans from these related companies (inter-company loans). This can result in insufficient tax basis on the part of the individual shareholder, such that the S losses are in excess of the shareholder's basis. There have been mixed opinions in the courts on whether an S corporation shareholder can achieve basis in connection with related entity loans.
IRS Victories
A long line of court cases have held that these loans do not serve to increase S shareholder basis, even where the loans have been supported by year-end adjusting entries to treat the loans first as distributions from the related company to the shareholder, followed by a shareholder contribution of capital or a loan to the S corporation (Shebester, TC Memo 1987-246; Wilson, TC Memo 1991-544; Bhatia, TC Memo 1996-429; Spencer v. Comm., 110 TC No. 7, 2/9/98; Jerry L. Thomas, TC Memo 2002-108, 4/30/2002). An Eighth Circuit decision held that loans to an S corporation from related entities did not increase the shareholder's basis. This conclusion was reached even though, prior to year-end, the S corporation had repaid the inter-company loan, followed by the related company moving the funds to the shareholder, who then subsequently loaned the funds directly to the S corporation. The Eighth Circuit viewed this year-end repositioning of funds as lacking economic substance, noting that the shareholder had not incurred an actual economic outlay of funds into the S corporation (Bergman v. U.S., 99-1 USTC ¶50,475, CA-8, 4/19/99, rev'g unreported D.C.).
In a case with facts and an outcome nearly identical to the Bergman decision, the Eighth Circuit affirmed the Tax Court by holding that a shareholder lacked basis. In Oren, an individual controlled three S corporations, one of which was profitable while two were incurring losses in excess of shareholder basis. Each year, to cure the basis shortfall, the profitable corporation loaned several million dollars to the shareholder, who on the same day loaned the money to a loss S corporation, which then immediately returned the money via loan to the profitable corporation. The Eighth Circuit concluded that the shareholder had not made an actual economic outlay because of the circular nature of these loans, and denied losses to the shareholder both for lack of regular income tax basis under ~§~1366 and for at-risk basis under ~§~465 (D. G. Oren, 2004- 1 USTC ¶50,165, CA-8, 2/12/2004, aff'g. TC Memo 2002-172).
v Development: In a recent case, the Tax Court did not allow S corporation shareholders to receive basis for direct loans that were made by the taxpayers' general partnership to their S corporation. The funds had moved directly from the partnership to the S corporation, and subsequent board meeting minutes and adjusting entries were insufficient to treat the loans as coming from the shareholders individually (Ruckriegel v. Comm., TC Memo 2006-78, 4/18/2006).
Taxpayer Victories
In 2000, the Tax Court issued an opinion that represented the first taxpayer victory in a related company loan situation. The court allowed an S shareholder to achieve basis for loans made by a controlled entity to the S corporation. The court accepted testimony from accountants and bookkeepers that all advances from the shareholder's profitable corporation to the S corporation were actually loans to the shareholder. This in turn allowed the shareholder to receive basis for the infusion of those funds into the S corporation (Daniel Culnen, TC Memo 2000-139, 4/13/2000).
Another favorable Tax Court opinion involved the sole shareholder of a profitable S corporation conducting mining activities, where that shareholder also owned an S corporation conducting a farming activity with losses. The IRS asserted that transfers of funds from the profitable mining corporation to the farming entity did not increase shareholder tax basis in the farming S corporation. However, the court agreed with the taxpayer's position that the transfers, in substance, were distributions or loans from the mining S corporation to the shareholder, followed by subsequent contributions to capital or loans from the shareholder to the farming S corporation. Further, in years where ownership of the farming corporation was transferred from husband to wife, the court allowed a deemed gift to be inserted in this assumed process of fund transfers (Charles and Jacquelyn Yates, TC Memo 2001-280, 10/11/2001).
Observation: In view of the substantial number of cases that have sided with the IRS on the issue of achieving basis via related company loans, individuals who form new S corporations should be advised to personally inject all capital and all loans into the S corporation, rather than allowing third-party loans from banks or related corporations. To the extent bank financing or funding from related companies is required, and the shareholder would have to guarantee the debt to obtain the loan, the individual shareholder should personally borrow those funds, followed by a transfer of those funds from the shareholder to the new S corporation. This will assure that any losses generated by the S corporation in its early years are fully deductible by the shareholder without encountering a basis limit. As an alternative strategy, if the existing profitable entity that will provide the capital to the new S corporation is also an S corporation, the new entity could be formed as a QSub (a 100%-owned subsidiary of the existing S corporation). (In those rare cases in which the S corporation can borrow directly from the bank without a shareholder guarantee, the shareholder will have to evaluate the trade-off of creating basis with the risk of possibly having to pay the loan off from personal funds if the business is unsuccessful.)
Shareholder Open-Account Debt
v Development: In response to the Tax Court's decision in Brooks, TC Memo 2005-204, the IRS has issued proposed regulations to amend Reg. ~§~1.1367-2 regarding the definition of open account debt and adjustments in the basis of indebtedness for shareholder advances and repayments on advances of open account debt. Under the proposed regulations, open account indebtedness would generally be limited to shareholder advances, net of repayments, of $10,000 at the close of any day during the S corporation's taxable year. The proposed regulations are to be effective for shareholder advances, and repayments on those advances, made on or after the date the final regulations are published in the Federal Register [NPRM REG-144859-04 (4/12/2007), corrected 5/8/2007].
Treatment of Distributions
The amount of any distribution to an S shareholder is the amount of cash distributed plus the fair market value of any property distributed. An S distribution represents a dividend under state law, and accordingly should represent a proportional payment to all S shareholders. A distribution to an S shareholder will generally be tax-free, to the extent the distribution is made from the current or previously undistributed net income of the S corporation and can be offset by tax basis in the hands of the recipient shareholder. The rules governing S distributions are found in ~§~1368.
The tax status of a distribution from an S corporation depends upon the existence of earnings and profits within the S corporation.
Impact of Earnings and Profits
The distribution rules of ~§~1368 divide S corporations into two groups: Those without accumulated earnings and profits (AE&P) and those with accumulated earnings and profits.
Due to a law change in 1996, an S corporation can no longer generate earnings and profits in any year in which it was in S status. Accordingly, a corporation that has always operated in S status cannot have accumulated earnings and profits (unless it acquires a C corporation in a carryover basis transaction, such as a tax-free merger). Stated differently, an S corporation will normally only have accumulated earnings and profits if it previously operated as a C corporation and generated positive earnings and profits during its C corporation years.
v Development: A 2007 law change eliminates the requirement that an S corporation must have been an S corporation for its first tax year beginning after December 31, 1996, in order to eliminate its accumulated earnings and profits from pre-1983 years. Thus, effective May 25, 2007, an S corporation only accumulates earnings and profits in a post-1982 year or years when the corporation was not an S corporation [Act 8235 of the Small Business and Work Opportunity Tax Act of 2007].
Distributions by S Corporations without Accumulated Earnings and Profits The amount of a distribution by a corporation without accumulated earnings and profits is taxfree to the extent of the shareholders' basis in the S corporation stock. The distribution is first applied to reduce a shareholder's stock basis. To the extent the amount of the distribution exceeds the basis, the excess is taxed as a capital gain [~§~1368(b)].
Observation: In the case of an S corporation without former C corporation earnings and profits, the tax treatment of a distribution is entirely determined by each shareholder at the shareholder level. Even though the corporation will maintain a record of an Accumulated Adjustments Account on the Form 1120S, this account is meaningless for the determination of distributions during S years. The accumulated adjustments account potentially can be meaningful, however, during the post-termination transition period following a termination of S status.
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