A practitioner should take special care in advising clients on shareholder loans to an S corporation. Repayment of the loans by the corporation has the potential to generate unexpected taxable income to the shareholder.
First, a quick review of the mechanics of S corporation loans. An S corporation shareholder in a closely held corporation might make loans to the company to improve liquidity and to provide working capital. The face amount of the loan becomes the shareholder's initial basis in the loan. The S corporation might also pass through losses to its owners, which can be deducted by the shareholders to the extent of their adjusted stock and loan basis (Sec. 1366(d)).
If a passthrough loss exceeds a shareholder's stock basis, the excess loss then reduces the shareholder's loan basis, but not below zero (Regs. Sec. 1.1367- 2(b)(1)). When the corporation passes through net income in a subsequent year, the loan basis is increased first, but only to the extent of the indebtedness at the beginning of that tax year. Any excess net income is next used to increase the shareholder's stock basis (Regs. Sec. 1.1367-2(c)(1)).
Special rules apply in cases of multiple indebtedness—i.e., if a shareholder has multiple loans to the corporation that are each evidenced by separate notes. This item will deal only with single loans, with or without written notes. If there is no note, the loan is considered open account debt, which is defined in Regs. Sec. 1.1367-2(a) as "shareholder advances not evidenced by separate written instruments and repayments on the advances."
Full or partial cash repayment of the debt by the corporation reduces the shareholder's loan basis. (Repayment with property other than cash is beyond the scope of this item.) If the debt basis has previously been reduced to zero, all the subsequent repayment is treated as taxable income to the shareholder. In the case of a reduced loan basis, each repayment is allocated between return of basis and income (Rev. Rul. 68-537).
The character of the income is determined by whether or not the loan is evidenced by a written note. Generally, repayment of a loan is not considered to be the sale or exchange of a capital asset, and thus produces ordinary income. However, if the loan is evidenced by a written note, income from the repayment is capital gain, because the note itself is considered a capital asset in the shareholder's hands (Rev. Rul. 64-162). The usual rules apply in determining whether the capital gain is long term or short term.
Example: P Corp. requires a large infusion of cash to pay bonuses and other expenses at the end of year 1. The shareholder intends to have P borrow the money from outside sources but is too busy to complete the loan process during the last few days of December. In order to make life easier, the shareholder advances the money personally, expecting P to finalize the outside loan and repay the shareholder advance within a few days. There is no note, so the loan is open account debt. The outside loan is finalized on the first business day of year 2, and P repays the shareholder advance.As noted above, the shareholder's loan basis would be increased for income passed through at the end of year 2, to the extent of the loan balance at the beginning of year 2. Unfortunately, year 2 shows a loss in excess of the combined stock basis and loan basis. Therefore, the loan basis is reduced to zero at the end of year 2, and the entire loan repayment is income to the shareholder. Because the loan is open account debt, the income is ordinary—not a good result.
Practitioners can help clients achieve better results. First, consider advising clients to set up notes for their open account debt so that any subsequent repayment income would be capital gain, rather than ordinary. Second, discuss the circumstances of repayment with clients. If P had waited to repay the shareholder debt until a year with net income, some or all of the loan basis would have been restored, and there would have been that much less income to recognize. In the alternative, the shareholder could have taken out a personal loan (separate from the business) to avoid repayment from P in a loss year.
In addition, practitioners need to be aware of a potential change in the definition of open account debt. The IRS has issued proposed regulations (REG-144859- 04) that would modify the use of open account debt if it exceeds $10,000 during the tax year. If made final, these new rules would further complicate the computation of loan basis and repayment income. (For more on these proposed regulations, see Sobochan, "Open Account Debt for S Shareholders," Tax Clinic, 38 The Tax Adviser 451 (August 2007).)
ConclusionClients do not always make their tax adviser aware of shareholder loan advances and repayments until after they have taken place. Clients should be frequently reminded to consult with their adviser prior to taking either action so that the adviser can help protect them from adverse tax affects.
Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or firstname.lastname@example.org.