S corporation basis rules: Reform is sorely needed
Treating S corporations and partnerships differently when it comes to debt makes no sense.
August 29, 2013
On June 17, the Tax Court reminded all practitioners that the debt basis rules for S corporations are rigid and fairly unforgiving. In Montgomery, T.C. Memo. 2013-151, the Tax Court ruled against the taxpayer’s purported increase in tax basis by denying an increase in tax basis for the amount of a loan to the S corporation from a third-party that was in turn guaranteed by the taxpayer. This case reinforces the notion that S corporation shareholders only obtain an increase in tax basis for a guaranteed corporate debt if and when the shareholders actually pay the loan.
Although the facts of the case were complicated, the result was rather basic: A loan to an S corporation gives rise to tax debt basis for the shareholder only if the loan is made directly by the shareholder to the corporation or if the shareholder actually advances the funds to pay the debt. Of further complication is that the shareholder generally must loan the money directly; not even another entity controlled or wholly owned by the shareholder will satisfy the demands of the provision.
This treatment of debt is, of course, generally different if the entity is taxed as a partnership instead of as an S corporation. The slight difference in statutory language for partnership debt versus S corporation debt has dramatic implications in terms of business transactions, flow of documents, proceeds, and, of course, the eventual taxation of the operations of the entity. Although there are some technical reasons that would support treating a partnership differently from an S corporation, there are other times where those differences should not matter as a practical matter because of the implications. This is one of those areas.
For years, the debt basis area has been a trap for unsuspecting S corporation shareholders and their advisers. Under Sec. 1366(d), S corporation shareholders can deduct only their allocable share of losses to the extent of:
Unfortunately, neither the Code nor the regulations define the phrase in the second requirement, and the definition has been left to the courts. The courts have established that corporate debt must generally meet two requirements to give rise to an increase in shareholder basis:
This treatment is distinctly different from partnership taxation, which provides under Sec. 752 and its accompanying regulations that partnership-level debt generally creates partnership outside basis without the need for a direct indebtedness between the partnership and partner.
Thus, if a partnership borrows money from a third-party bank and the partner then guarantees the debt as a condition of the loan, under Sec 752, that arrangement would give rise to an increase in partnership liabilities and, as a result, increase the outside debt basis of the individual partners.
Clearly, a corporation is different legally from a partnership and as a result carries with it a different set of issues. However, the argument that that difference would produce a different result from that seen in the Montgomery case based strictly upon entity passthrough-type seems unwise.
By speaking to any practitioner who works in this area, a CPA will discover that many S corporations and their shareholders often fail to structure third-party and normal self-funded debt properly and thereby limit the ability to recognize real economic losses in a timely manner. These revelations usually occur when it is too late to restructure the debt to achieve the desired tax result.
The current method of producing the desired S corporation debt basis involves a small change in the direction of the loan paperwork with very little economic consequence. Instead of having the S corporation borrow from the bank and the shareholder guarantee the debt, the shareholder instead borrows the funds from the bank and loans the funds to the S corporation personally, with the S corporation being required to guarantee the shareholder’s debt.
Perhaps, if there are multiple owners of the S corporation, and only a few of them are required to guarantee the debt, then the distinction in the form of the loan is significant, economically speaking. However, a sizable number of S corporations are wholly owned. Thus the argument that these two types of loans should be treated differently is not persuasive. Prior to June 2012 when proposed regulations were issued, taxpayers were attempting to structure their affairs in this manner to satisfy the first debt basis requirement, but in the process they were often not satisfying the hotly contested second requirement of being compelled to make an economic outlay.
On June 12, 2012, Treasury published Prop. Regs. Sec. 1.1366-2, which among other things, made it clearer what type of so-called back-to-back loans would provide debt basis to S corporation shareholders under Sec. 1366(d)(1)(B). The preamble to those regulations more than hinted that as long as the debt was “bona fide,” it would give rise to basis increases for the shareholders under Sec. 1366(d)(1)(B), thereby arguably replacing the “economic outlay” requirement. Others have argued convincingly that Treasury should amend the regulations so that this intent is clearly stated in the regulations themselves (see Letter From ABA Tax Section to the Senate Finance Committee and House Committee on Ways and Means, item 4 (April 10, 2013)). Treasury’s attempt to provide practical reasoning in this area should be applauded.
However, even when the economic outlay concerns are resolved, cases like Montgomery are troubling. There is a difference between the corporate and partnership form of business entity: A corporation prohibits an “aggregate” entity approach on many key tax issues. But from a policy perspective, it is hard to justify why two similarly situated businesses otherwise identical in every regard but for passthrough entity type (partnership vs. S corporation) should yield such a difference in terms of outside tax basis attributable to debt.
One can argue that with the economic outlay issue being resolved, practitioners can just continue to structure loans so that they always first go to the shareholder with an immediate loan from the shareholder to the corporation. The bank will likely require the corporation to also guarantee the original third-party debt to the shareholder. This solution contributes to the appearance that form triumphs over substance—a concept that fuels much skepticism about the U.S. tax system.
Explaining to a client why a loan to an S corporation from a bank that is subsequently guaranteed by the shareholder can yield a completely different result than a loan from the bank to the shareholder followed by a loan from the shareholder to the S corporation that guarantees the bank debt is difficult at best and embarrassing at worst.
The House Committee on Ways and Means should be congratulated for addressing this issue with a proposal for meaningful reform in the Small Business Tax Reform Discussion Draft submitted by Rep. David Camp, R-Mich. However, a unified passthrough-entity approach may not be proper or wise. For that reason, Option 2 in the House’s tax reform proposal, which proposes eliminating the separate tax regimes for partnerships and S corporations and creating one system for passthrough entities, goes too far. Nonetheless, some of the issues raised in this process should be discussed and answered. Sec. 752 and Sec. 1366(d)(1)(B) should be harmonized.
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Troy K. Lewis, CPA, M. Acc., is a vice president at Heritage Bank in St. George, Utah, an adjunct professor of accounting and taxation at Brigham Young University in Provo, Utah, and a member of the AICPA S Corporation Taxation Technical Resource Panel.