On April 12, 2007, the Service issued proposed amendments to Regs. Sec. 1.1367-2 and -3 (REG-144859-04), to address concerns about the treatment of S shareholders’ open account debt.
Regs. Sec. 1.1367-2(a) states that open account debt is a shareholder advance that is not evidenced by a note. Typically, open account debt refers to a situation in which multiple loans are historically made from a shareholder to a corporation throughout the year.
Repayments and advances are treated differently for open account debt than for a shareholder loan evidenced by a note. For debt evidenced by a note, additional advances made by shareholders constitute new loans. Advances for loans considered open account debt are treated as additions to the existing open account debt.
Similarly, loan repayments for debt evidenced by a note are applied to the specific loans for which the payments are made. Loan repayments on open account debt are applied to all such debt.
The debt basis calculation also differs. For shareholder loans evidenced by a note, additional advances do not restore or prevent income recapture to zero- or low-basis loans repaid during the year. Because additional advances are deemed new loans, they provide the shareholder with additional basis for deducting additional losses, but do not prevent income recapture for the zero- or low-basis loans repaid during the period.
However, for open account debt, additional advances restore zero-basis loans repaid during the year. Under Regs. Sec. 1.1367-2(b)(1), basis for open account debt is determined at the close of the year. Thus, advances and repayments are netted throughout the year; the final determination of debt basis for open account debt is determined at the close of the year. This provision allows S shareholders time to make corrective loans before the end of the year to restore debt basis.
This is a very important distinction, because income recapture can occur when debt basis is used to deduct corporate losses. When debt basis is reduced to zero due to corporate losses, and payments are made against the zero-basis loans, income recapture may occur.
The proposed regulations
were issued in response to the decision in Brooks, TC
Memo 2005-204. There, S shareholders advanced money to their S
corporation in one year and used the advances to deduct
corporate losses. In the subsequent year, the corporation repaid
the loans, then the shareholders made additional loans to
restore debt basis. This situation continued over several years,
allowing the shareholders to defer in-
come recognition indefinitely.
In Cornelius, 494 F2d 465 (5th Cir. 1974), aff’g 58 TC 417 (1972), the IRS took the position that loans were separate transactions, not open account debt. The taxpayer contended that the loans were always treated as open account debt, but the Tax Court and Fifth Circuit rejected this.
The Service felt that the intended concept of open account debt was to provide administrative simplicity, not indefinite deferral of income. This distinction brought about the issuance of the proposed regulations.
The proposed regulations change the definition of open account debt. Prop. Regs. Sec. 1.1367-2(a)(2)(i) defines open account debt as shareholder advances not evidenced by separate written instruments for which the aggregate outstanding principal amount (net of repayments on the advances) does not exceed $10,000 at the close of any day during the S corporation’s tax year.
Under Prop. Regs. Sec. 1.1367-2(a)(2)(ii), the shareholder must maintain a daily running log to account for the open account debt. If, at any point during the S corporation’s tax year, the aggregate balance of the open account debt exceeds $10,000, it is treated in the same way as debt evidenced by a note. The resulting debt repayments are treated in this manner for the loan’s remaining life; see Prop. Regs. Sec. 1.1367-2(d)(2)(ii).
Effect on open account debt: By limiting the definition of open account debt, the proposed regulations minimize S shareholders’ ability to defer income recognition. Shareholders now must bear the administrative burden of maintaining a daily log to record advances and repayments on open account debt.
This log will not only provide substantiation in determining if a given debt is considered open account debt, but will also establish the cutoff point for when it is no longer deemed open account debt. Once debt is no longer considered open account debt, that particular debt balance can never be treated as open account debt in the future. If the debt is no longer deemed an open account debt and the debt basis has been reduced, future repayments on the debt are treated in the same way as debt evidenced by a note, with the potential for income to the shareholder on repayment due to zero/low basis.
Another effect of the proposed regulations is the need to more closely track the corporation’s profit or loss. Under Prop. Regs. Sec. 1.1367-2(c)(2), when multiple debts exist (i.e., when there is both open account debt and debt evidenced by a note), net increases in basis apply first to restore the reduction of basis in any debt repaid in the tax year to the extent needed to offset any gain that would otherwise be realized on repayment. So, when debt is no longer considered open account debt, it will be important to track the corporation’s profitability to determine whether future repayments will trigger income recapture.
Below is a list of options that taxpayers can use in light of the proposed regulations:
Treat all advances as capital, rather than debt. Under this strategy, the shareholder treats advances as additional paid-in capital, rather than debt. This allows the shareholder to avoid the open account debt rules. The shareholder can take repayments in the form of distributions, then simply contribute additional funds to the corporation to avoid distributions in excess of basis at year-end. However, if the corporation has undistributed C corporation earnings and profits and an insufficient S corporation accumulated adjustments account (AAA), the income potential will continue to exist for distributions in excess of the AAA.
Keep open account debt balances under $10,000. This may seem to be more trouble than it is worth, but by reclassifying shareholder distributions to reduce the balance of the open account debt, a shareholder may be able to circumvent the $10,000 de minimis rule. Those looking to continue to use open account debt must keep a daily log, so there will be no more expended effort to track the account balance.
Set up a formal note for open account debt exceeding $10,000. The IRS has not clarified whether debt repayments on zero- or low-basis open account debt will be treated as ordinary income recapture or receive capital gain treatment similar to that afforded loans evidenced by a note. To ensure capital gain treatment, set up a formal note for any debt that no longer qualifies for open account treatment.
Use outside loans to increase the $10,000 limit. For S corporations with multiple shareholders, use outside loans between shareholders to circumvent the $10,000 limit.
Example: J and B own X Corp., an S corporation. B has a zero-basis open account loan to X and would like to forward additional funds to it on a short-term basis.
Under the proposed regulations, any additional funds that B forwards to the corporation would change the treatment of the open account debt. Further, when B is repaid, he will have income due to the recapture of his reduced basis.
Instead of forwarding funds to the corporation, B could loan the additional funds to J, who then repays him when X’s cashflow has improved. Under this strategy, additional funds are forwarded to X, but B does not experience income recapture.
Use multiple small loans evidenced by a formal note. Under the existing regulations, income earned by an S corporation in any year will first restore the basis in zero- or low-basis loans, before it increases shareholder stock basis. If a loan with reduced basis is repaid during a year in which net income is recognized by the S corporation, the income is first applied to restore the basis of the loan that is partially or fully repaid. By using multiple small notes, a taxpayer can more easily control income recognition on repayment of a zero- or low-basis loan.