Earlier this week, the IRS released proposed regulations that would seem to liberalize a shareholder’s ability to increase debt basis in an S corporation. Specifically, it appears that recharacterizing a situation whereby a related party owned by the shareholder had been loaning amounts to the S corporation into a loan owed directly from the S corporation to the shareholder through a distribution or other legitimate transaction would now create the desired basis. Let’s go straight to the Q&A:
Q: Why do we care about a shareholder’s basis in his S corporation?
A: Because Section 1366(d)(1) provides that a shareholder can only utilize a loss passed through to him from the S corporation to the extent of:
1. the adjusted basis of the shareholder’s stock, and
2. the adjusted basis of any indebtedness of the S corporation to the shareholder.
Q: So there are two different types of basis?
A: Absolutely. A shareholder’s basis in stock and his basis in debt are separately maintained and subject to different rules. For example, an S corporation distribution is tax-free to the extent of the shareholder’s stock basis; the shareholder’s debt basis is not included in this amount.
Q: How is stock basis computed?
A: Because of the flow-through nature of an S corporation (the entity rarely pays corporate level tax[i]), in order to preserve a single level of taxation the shareholders must constantly adjust their basis in the corporate stock to reflect the items of income or loss passed through to them.
To illustrate, assume A contributes $100 to a wholly-owned S corporation. If the S corporation invests the $100 and earns $10 in interest, presumably the value of the S corporation increases to $110. The $10 of interest income flows through to A and is taxed on his Form 1040. If A does not adjust his basis to account for the interest income and he sells the S corporation’s stock for $110, he will recognize an additional $10 of gain ($110-$100). Thus, A will have paid tax on the same $10 twice, which runs contrary to the purpose of an S corporation.
In general, the starting basis is either what the shareholder paid for the stock[ii] or the basis of assets contributed to the corporation in a I.R.C. § 351 exchange[iii]. From that point on, stock basis is adjusted each year in the following order[iv]
1. Capital contributions
2. Items of income (including tax-exempt income)
2. Non-deductible expenses[v]
Q: Fair enough. Now how does a shareholder get debt basis?
A: The most important thing to understand is the difference between debt basis in an S corporation as compared to a partnership. In a partnership, a partner gets basis under I.R.C. § 704 for his share of all of the partnership’s debt.[vi] To the contrary, a shareholder in an S corporation has basis in an S corporation’s debt only to the extent that debt is owed directly to the shareholder. In other words, the shareholder must generally loan amounts directly to the S corporation in order to have basis in that liability.
To illustrate, if A loans $500 to his wholly-owned S corporation, A has $500 of basis in the debt of his S corporation that may be used to offset losses passed through to A. Assuming A also had stock basis of $200 at the end of 2011 and the S corporation generates a $400 loss during the year, A will reduce his stock basis from $200 to $0 to account for the first $200 of loss, and then will reduce his debt basis from $500 to $300 to account for the remaining $200 loss. Because of the debt basis, A may utilize the entire $400 loss, subject to other restrictions.
Q: That seems easy enough. So where does the confusion come in?
A: Taxpayers are creative creatures. And unfortunately, neither the statute nor the regulations do much to clarify what constitutes a valid loan from a shareholder to an S corporation for purposes of creating debt basis. Thus, over the years, S corporation shareholders have tried any number of ways to claim debt basis for the purposes of absorbing losses. Typically, these attempts satisfy the form required by the regulations — the S corporation ends up owing a liability directly to a shareholder — but they often fail to meet the substance of what the IRS is looking for.
Q: Is that where these new proposed regulations come in?
A: Yup. These new regulations are nothing earth shattering, as they merely incorporate requirements that have been established time and time again by the courts. But they should go a long way towards ending needless litigation.
Q: So what do the proposed regulations say? I’m far too lazy to read them myself, and you seem to enjoy an abundance of free time.
A: Thank you, I think. The regulations would put an end to two common shareholder attempts to create debt basis without the required substance:
1. Typically, the courts have established that in order to generate debt basis, a shareholder must make an actual “economic outlay” to the S corporation that leaves the shareholder “poorer in a material sense.”[vii] While this requirement at times has caused the IRS or the courts to rule that legitimate transactions have not created debt basis (see below), in other situations they are necessary to prevent basis being created in a situation where the shareholder hasn’t actually done anything.
To illustrate, imagine a situation where an S corporation owes a bank $1,000. To create debt basis, A may “guarantee” the loan from the S corporation to the bank. Throughout the years, a litany of cases have concluded that this does not create debt basis, as the requisite economic outlay is missing, and the proposed regulations would formalize that conclusion as follows:
Guarantees. A shareholder does not obtain basis of indebtedness in the S corporation merely by guaranteeing a loan or acting as a surety, accommodation party, or in any similar capacity relating to a loan. When a shareholder makes a payment on bona fide indebtedness for which the shareholder has acted as guarantor or in a similar capacity, based on the facts and circumstances, the shareholder may increase its basis of indebtedness to the extent of that payment.
2. Additionally, many shareholders have claimed debt basis for loans made from a related entity owned by the shareholder to the S corporation. In two cases (Culnen and Yates), taxpayers have successfully argued that because these related parties were essentially “incorporated pocketbooks” the loan was in substance made directly from the shareholder. In the overwhelming majority of cases, however, the courts have held that a related party loan to the S corporation does NOT satisfy the requirement that the loan be made directly from the shareholder to the S corporation, and thus an increase to debt basis is not warranted.[viii]
Under these proposed regulations, a loan from a related party to the S corporation would NOT create debt basis for the S corporation shareholder, because it does not create a “bona fide creditor-debtor relationship between the shareholder and the borrowing S corporation.”
However, the regulations would provide that in the event a related party loan is converted into a loan between the shareholder and the S corporation — for example, where the related party distributes the receivable to the shareholder — if the transaction creates bona fide indebtedness between the shareholder and the S corporation then the transaction would create loan basis to the shareholder. The regulation include the following example:
Example 4. Loan restructuring through distributions. A is the sole shareholder of two S corporations, S1 and S2. In March 2013, S1 made a loan to S2. In December 2013, S1 assigned its creditor position in the note to A by making a distribution to A of the note. Under local law, after S1 distributed the note to A, S2 was relieved of its liability to S1 and was directly liable to A. Whether S2 is indebted to A rather than S1 is determined under general Federal tax principles and depends upon all of the facts and circumstances. See paragraph (a)(2)(i) of this section. If the note constitutes bona fide indebtedness from S2 to A, the note increases A’s basis of indebtedness in S2 under paragraph (a)(2)(i) of this section.
Q: Great. But what is “bona fide indebtedness?”
A: Actually, that’s kind of the main thrust of the proposed regulations. The regulations were hopeful to put an end to taxpayer disputes, but unfortunately, they incorporate the dreaded “facts and circumstances” test, providing:
Whether indebtedness is bona fide indebtedness to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.
While this may appear frustrating, it actually should be taxpayer friendly. What this is really saying is that if a transaction creates a bona fide creditor-debtor relationship, then an “economic outlay” is not required. This should result in the creation of valid debt basis in transactions such as the one seen in the above example as well as last week in Maguire v. Commissioner, in which a shareholder does not actually go out-of-pocket with any cash, but rather reconfigures previous debt in a manner that creates a legitimate debt between the S corporation and the shareholder.
This is a good thing. Previously, where taxpayers have indulged in poor planning and had their related party entities fund the operations of a loss S corporation through loans, it has been difficult for the shareholder to recharacterize the loan into one owed directly from the S corporation to the shareholder without running afoul of the economic outlay requirement. The proposed regulations would appear to do away with the requirement that the shareholder part with cash, so long as the restructuring of the loans results in a situation where the debt owed from the S corporation to the shareholder is bona fide.
Q: When would these proposed regulations become effective?
A: When the regulations become final.
Q: This was thorough and excellent, but shouldn’t you be watching Italy-Croatia right now?
A: Yes. Yes I should.
[i] But see I.R.C. § 1374 and I.R.C. § 1375
[ii] I.R.C. § 1012
[iii] I.R.C. § 358
[iv] Treas. Reg. §1.1367-1(f).
[v] Note, there is an election under Treas. Reg. §1.1367-1(g) that can be made to reverse this order and deduct losses prior to non-deductible expenses
[vi] See I.R.C. § 752. That’s not to say the partner is “at-risk” for the debt, however.
[vii] See, for example, Oren v. Comm’r,357 F.3d 854, 857-859 (8th Cir. 2004); Bergman v. U.S., 174 F.3d 928, 932 (8th Cir. 1999).
[viii] See Yates v. Comm’r, T.C. Memo. 2001-280; Culnen v. Comm’r, T.C. Memo. 2000-139.