How to determine if debt might create basis for an S corporation shareholder
New proposed regulations may create opportunities for shareholders who can establish that their debt is bona fide.
June 28, 2012
The IRS recently issued proposed regulations on the contentious subject of when an S corporation shareholder can increase his or her basis in the S corporation’s stock, based on loans to the corporation, and thereby increase the amount of the corporation’s losses and deductions the shareholder can recognize (REG-134042-07).
S corporation shareholders, unlike partners, generally are not permitted to increase their basis by guaranteeing a loan made by a third party to the corporation until they actually have to make payments on the guarantee. They are also not allocated basis from their allocable share of the entity’s debt, as a partner is for the partnership’s debt. As a result, S corporation shareholders often construct elaborate loan transactions to create basis that will allow them to deduct losses.
The proposed regulations provide that, to increase a shareholder’s basis in indebtedness, a loan must represent the S corporation’s “bona fide indebtedness” that runs directly to the shareholder. “Bona fide indebtedness” is not defined in the regulations; rather, general federal tax principles determine if a debt is bona fide. The proposed regulations continue to deny basis from a shareholder’s guarantee, or surety, or similar arrangement unless the shareholder actually performs under the arrangement (REG-134042-07 preamble; Prop. Regs. Sec. 1.1366-2(a)(2)(iii), Example 2).
As for loans running directly to the shareholder, the proposed regulations address loans made under what the IRS calls the “incorporated pocketbook” theory, in which a shareholder claims that a loan to an S corporation from an entity related to the S corporation shareholder is in substance a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corporation. Under the proposed regulations, these types of transactions would increase basis only when there is a bona fide creditor/debtor relationship between the shareholder and the S corporation (REG-134042-07 preamble; Prop. Regs. Sec. 1.1366-2(a)(2)(iii), Example 3). Therefore, if the loan is a bona fide debt in such a transaction, the actual economic outlay doctrine does not have to be satisfied (REG-134042-07 preamble).
The proposed regulations provide four examples of loan transactions that may create basis for taxpayers. Examining those examples, together with case law on the issue, can help taxpayers determine whether their particular arrangement may be respected as bona fide debt from the S corporation to the shareholder.
Basic shareholder loan
The first example is a straightforward loan from a shareholder to his wholly owned S corporation. To establish whether the loan is a bona fide debt is determined, according to the regulations, under general federal tax principles and depends on all the facts and circumstances. To determine this, the preamble cites a number of cases, including Geftman, 154 F.3d 61 (3d Cir. 1998). In that case, the court discussed the following attributes that support a bona fide loan:
Shareholders should be certain to document the loan transaction with notes executed at the time the loan is made and make sure the corporation abides by the repayment schedule. Any other documentation, such as entries on the books that treat the transaction as a loan, is also helpful.
The second example involves a shareholder guarantee of a loan from a bank to an S corporation, which the bank required before it would make the loan. The guarantee itself does not create basis, and the IRS has most of the case law on its side on this issue. The major case in which a shareholder was granted basis from her guarantee, Selfe,778 F.2d 769 (11th Cir. 1985), had, as the IRS notes, “unique and limited circumstances.” The Eleventh Circuit refused to find those same circumstances in a later case (see Sleiman, 187 F.3d 1352 (11th Cir. 1999)). The example, however, involves a shareholder’s being called upon by the bank to repay the loan, and those payments do create basis.
The third example involves a sole shareholder of two S corporations, S1 and S2. S1 loans $200,000 to the shareholder who then lends the money to S2. Under the regulations, if the loan from the shareholder is bona fide indebtedness, then the money will increase the shareholder’s basis. The attributes for a bona fide loan discussed above apply in this situation as well, and the shareholder and S corporation should ensure that the normal formalities of making a loan (e.g., executing a note payable, making payments, etc.) are followed to help ensure the loan is treated as bona fide. Note that the IRS is not requiring the shareholder to make an actual economic outlay in these circumstances.
The fourth example also involves a sole shareholder of two S corporations, S1 and S2. S1 loaned money to S2 in March. In December, S1 assigned its creditor position on the note to the shareholder, which, under local law, caused S2 to be directly liable to the shareholder. Whether S2 is indebted to the shareholder is also determined by examining the bona fide loan factors discussed above. And, again, the IRS is not requiring that the shareholder make an actual economic outlay provided the debt is otherwise bona fide.
These regulations are, of course, only proposed and will apply only to transactions entered into on or after they are finalized. In addition, the IRS has scheduled a public hearing for Oct. 8, 2012, and the regulations may be changed as a result of public comments. Nonetheless, these proposed regulations give taxpayers guidance on how the IRS views S corporation basis and shareholder debt, and taxpayers can take note and structure their transactions accordingly.
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Sally P. Sch reiber, J.D., is a senior editor with the AICPA’s Magazines and Newsletters team. She contributes to The Tax Adviser and Journal of Accountancy as well as the Corporate Taxation Insider and Tax Insider newsletters.