The Service has issued final regulations (T.D. 9428) amending the definition of open account debt, which may significantly affect when an S corporation shareholder recognizes gain on the repayment of such debt.
Under Sec. 1366(d)(1), the aggregate amount of passthrough losses and deductions that an S corporation shareholder may take into account for any tax year cannot exceed the shareholder’s adjusted basis in the corporation’s stock and loans made by the shareholder to the corporation.
Under Sec. 1367(a)(2), the basis of each shareholder’s stock in an S corporation is decreased (but not below zero) by, among other things, the shareholder’s pro-rata share of the corporation’s losses, deductions, and nondeductible, noncapital expenses. If these items reducing basis exceed the amount that reduces the shareholder’s stock basis to zero, such excess losses and deductions are applied to reduce (but not below zero) the shareholder’s basis in any indebtedness of the S corporation to the shareholder (Sec. 1367(b)(2)).
If an S corporation repays a loan from a shareholder in which the shareholder’s basis has been reduced under Sec. 1367(a)(2), the shareholder recognizes gain on the repayment.
Final regulations issued in 1994 (T.D. 8508) provided that shareholder advances not evidenced by separate written instruments and repayments on the advances (open account debt) are treated as a single indebtedness. Under these rules, a shareholder would compare the amount of open account indebtedness outstanding at the beginning of the year with the amount of such indebtedness at the close of the year to determine if there was a net repayment for which gain might be recognized.
In Brooks, T.C. Memo. 2005-204, the taxpayer took advantage of these rules by making a large unwritten advance at the end of the tax year (year 1) against which he claimed passthrough losses; the S corporation repaid the loan shortly after the beginning of the following tax year (year 2). Shortly before the close of year 2, the taxpayer made another large unwritten advance. As a result of the advance made at the close of year 2, there was no net repayment of the open account debt for the year; accordingly, the taxpayer avoided recognizing gain on the repayment of the year 1 advance.
The taxpayer continued this pattern of making a loan at the close of one year, repaying the loan at the beginning of the following year, and making another loan just prior to the close of the following year for several years. This allowed the taxpayer to claim losses flowing through from the S corporation without having his cash invested in the S corporation for any real period of time.
The Tax Court sided with the taxpayer, agreeing that under the Sec. 1367 regulations there is a repayment on open account debt to which gain might be recognized only if there is a net decrease in the amount of such indebtedness for the year, determined by comparing the amounts outstanding at the beginning and end of the tax year.
In response to the Tax Court’s decision in Brooks, in 2007 the IRS issued proposed regulations modifying the definition of open account debt (REG-144859-04). These proposed regulations defined “open account debt” as shareholder advances not evidenced by separate written instruments for which the principal amount of the aggregate advances (net of repayments on advances) did not exceed $10,000 per shareholder at the close of any day during the S corporation’s tax year.
Accordingly, under these regulations, shareholders would be required to determine for open account debt purposes whether shareholder advances and repayments on the advances exceeded the $10,000 aggregate principal threshold on any day during the S corporation’s tax year. This meant that shareholders would be required to maintain a daily “running balance” of shareholder advances and repayment on advances and the outstanding principal amount of the open account debt.
Final Regulation Changes
On October 20, 2008, the IRS issued final regulations on open account debt. The regulations define the term “open account debt” as shareholder advances not evidenced by separate written instruments and repayments on the advances, the aggregate outstanding principal of which does not exceed $25,000 of S corporation indebtedness to the shareholder at the close of the S corporation’s tax year. The regulations also provide that advances and repayments on open account debt are treated as a single indebtedness.
More significantly, the final regulations eliminate the requirement to maintain a daily running balance; instead, under the final regulations the determination of whether the threshold balance of $25,000 is exceeded will generally be made at the end of the tax year of the S corporation. However, if all or part of the open account debt is disposed of before then, the final regulations require the determination to be made immediately before the disposition of the debt during that tax year. Similarly, if a shareholder with open account debt is no longer a shareholder at the end of the S corporation’s tax year, the final regulations require the determination to be made immediately before the shareholder’s interest in the S corporation is terminated.
The new regulations are effective October 20, 2008, and apply to shareholder advances and corresponding repayments made on or after that date. They do not apply to open account debt that is outstanding prior to October 20, 2008, or to corresponding repayments on that debt. To illustrate how the October 20, 2008, effective date affects outstanding open account debt, the preamble includes an example.
Implications As a result of the modification to the definition of open account debt provided in the final regulations, the tax-planning opportunity that the taxpayer used in Brooks is no longer available (other than for amounts of $25,000 or less). However, the final regulations are a significant improvement over the proposed regulations because they eliminate the requirement to maintain a daily running balance.
The final regulations do not address the character of gain on the repayment of unwritten advances that do not qualify as open account debt under the regulations. However, it appears that the treatment of unwritten advances exceeding $25,000 as being evidenced by a separate written instrument is only for purposes of determining the timing and amount of gain recognized on repayment. Accordingly, it is likely that gain recognized on the repayment of such debt will be ordinary. Shareholders should consider evidencing all loans made to their S corporations in writing; gain on the repayment of a debt that is evidenced by a written instrument should generally be capital gain.
David Kautter is a partner with Ernst & Young LLP in Washington, DC.
Contributors are members of or associated with Ernst & Young LLP.
For additional information about these items, contact Mr. Kautter at (202) 327-8878 or firstname.lastname@example.org.