Economic Outlay Revisited
The economic outlay doctrine is a barrier for S corporation shareholders attempting to create debt basis. While not impenetrable, it requires analysis and forethought for the shareholders to break through.
Under Sec. 1366(d)(1), the deductibility of subchapter S losses is limited to the shareholder’s stock and debt basis. If the corporation’s current-year loss exceeds the shareholder’s basis, Sec. 1366(d)(2) provides that this loss may be carried forward indefinitely. This carryforward provides some relief from a temporary lack of basis, but planning opportunities and pitfalls exist, particularly when shareholders own stock in multiple passthrough entities with varying degrees of profitability and the shareholders have varying degrees of basis in those entities.
Shareholders can create stock basis by making capital contributions; however, shareholders often prefer to create debt basis. To avoid expending their personal funds in a direct loan to an S corporation, shareholders have tried to create debt basis in a number of other ways, including: (1) guaranteeing the S corporation’s note, (2) obtaining a loan from an unrelated or a related party and lending the loan proceeds to the S corporation (back-to-back loan), and (3) substituting a shareholder’s personal note for the corporation’s note to an unrelated third party. The IRS and the courts have used the economic outlay doctrine to analyze whether shareholders of S corporations actually create debt basis. Briefly stated, that requires an actual cash investment by the shareholder. This article specifically focuses on how to create debt basis and how to structure debt so that it meets the economic outlay doctrine.
Note: The IRS has put a back-to-back loan project on its current business plan.
This article has been excerpted from The Tax Adviser. Read the full article here (PDF).