S Corp. Shareholder Basis for Circular or Certain Back-to-Back Loans

By Carl Dolson, CPA, and James Sansone, CPA, Chicago, IL

Editor: Rick Klahsen, CPA

Practitioners routinely face the challenge of helping S corporation shareholders increase their basis for purposes of deducting passthrough losses under Sec. 1366(d) (1). Often, planning to increase basis will result in shareholders making loans to the S corporation at year end. With regard to shareholder loans to S corporations facilitated by borrowings from a related entity, back-to-back, and circular loans, three Tax Court decisions, including one in 2009, continue the court-imposed requirement that shareholders make an “economic outlay” to acquire basis and demonstrate why practitioners need to exercise care in the construction of shareholder loans to S corporations to provide the best opportunity for increasing basis for deduction of losses.

Back-to-Back Loans

In Ruckriegel, T.C. Memo. 2006-78, two 50% shareholders in an S corporation that incurred losses were also 50% partners in a partnership. Upon the advice of the businesses’ outside CPA, the partnership advanced funds directly and indirectly, through the S corporation’s shareholders, to the S corporation. Certain of the direct loans were recorded through year-end adjusting journal entries as shareholder loans. Shareholder loans were evidenced by promissory notes, although the shareholders had no clear recollection of when the notes were executed, and were documented in the S corporation’s board of directors’ meeting minutes.

The Tax Court looked at several factors in ruling that the S corporation’s shareholders acquired no basis in the partnership’s payments directly to the S corporation but did acquire basis in the back-to-back loans the partnership made to the S corporation’s shareholders that were then loaned by the shareholders to the S corporation.

With regard to the taxpayers’ arguments that the direct payments from the partnership to the S corporation were essentially back-to-back loans through the S corporation’s shareholders, the court considered the limited history of the partnership’s directly paying expenses on behalf of its partners. The court also considered the advice of the outside CPA to the S corporation’s shareholders who, following a disallowance of basis in shareholder loans in a previous IRS examination, believed he had structured the subsequent partnership advances to the S corporation in a manner intended to constitute bona fide back-to-back loans, as evidenced by the promissory notes, corporate minutes, and accounting for the partnership advances. It was apparent that the promissory notes, minutes, and accounting were done after the fact or at year end, not as the partnership made direct payments to the S corporation. The court also found significance in the treatment of some, but not all, of the partnership direct advances as shareholder loans. Certain direct payments were treated as being from the partnership instead of the shareholders.

Short-Term Back-to-Back Loans

In Russell, T.C. Memo. 2008-246, short-term loans to an S corporation were originally made by a partnership owned by the S corporation’s two shareholders and recorded on the S corporation’s books as notes payable to the partnership. At the end of the S corporation’s August 31 tax year, an adjusting journal entry reclassified the notes payable to the partnership as notes payable to the S corporation’s two shareholders. On September 3, immediately following its August 31 fiscal year, the S corporation repaid the short-term debt with interest directly to the partnership. Even though the S corporation properly accounted for the debt as shareholder loans, the shareholders did not report interest income received from the S corporation or interest expense paid to the partnership on the short-term debt on their individual tax returns. Notes were prepared documenting the loans from the partnership to shareholders and from shareholders to the S corporation.

The Tax Court denied any tax basis for the loans arising from the partnership, agreeing with the IRS that the loans should be classified as a direct loan from the partnership. First, the court found that the S corporation’s shareholders made no economic outlay that left them poorer in a material sense. Second, it found that the S corporation’s indebtedness ran to the partnership, not to the S corporation’s shareholders, and that indirect borrowing, such as a guaranty, surety, accommodation, co-making, or otherwise, gives rise to indebtedness only when the shareholders pay part or all of the existing obligation.

Circular Loans

In Kerzner, T.C. Memo. 2009-76, the Tax Court analyzed a situation involving circular loans. Husband and wife each owned 50% of a partnership and an S corporation. Each year, the partnership loaned money to the owners, who used the borrowed funds for loans to the S corporation of an identical amount. The S corporation then paid rent to the partnership of an equivalent amount.

The Tax Court again examined whether the S corporation’s shareholders made an economic outlay that rendered them poorer in a material sense. The court saw a circular flow of cash beginning and ending with the partnership. Kerzner argued that he bore an economic outlay because of the risk that the S corporation would not be able to repay him. The Tax Court, citing other cases involving a circular flow of funds (Oren, T.C. Memo. 2002-172, aff’d 357 F.3d 854 (8th Cir. 2004);Kaplan, T.C. Memo. 2005-218), found an inherent lack of substance in the loans and ruled that the S corporation’s shareholders did not make an economic outlay.


Practitioners advising on proper methods to use for shareholders to acquire basis in loans made to S corporations incurring losses can take away several points from these court decisions:

  • Identify S corporations with basis limitation issues as soon as possible to emphasize to shareholders the importance of structuring S corporation loans as coming directly from shareholders and to minimize last-minute recharacterization of advances from related entities as back-to-back loans from shareholders.
  • Properly document, through interest-bearing promissory notes and contemporaneous corporate minutes, shareholder loans to S corporations. Have shareholders report interest income from these loans and interest expense on money borrowed to make loans to S corporations.
  • If the source of shareholder funds for S corporation loans is coming from a commonly controlled passthrough entity, consider taking the funds as a distribution from the entity rather than as a loan from the entity. While backto-back loans have stood up in a few court decisions (such as in Ruckriegel), they certainly draw greater attention from the IRS.
  • For back-to-back loans, have all payments to make and repay loans go to and from the S corporation and shareholder, not directly to or from the S corporation and the related entity.
  • Circular loans are risky. As the Kerz ner case demonstrates, if funds for the shareholder loan to the S corporation begin and end with the same entity, the shareholder will not likely be considered to have made an economic outlay, which is essential for a shareholder to acquire basis in a loan to the S corporation.


Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or rick.klahsen@rsmi.com.

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