Sec. 465 Traps for the Unsuspecting S Corporation Shareholder

When an S corporation has losses, one concern is whether the shareholders have basis in the stock or debt in order to use this loss on their tax returns. The basis issue was discussed in depth last month.1 However, an issue often overlooked by shareholders and tax practitioners is whether shareholders have a sufficient amount at risk with regard to the investment in the S corporation. The at-risk rules are set out in Sec. 465. This article will address those rules, which without proper planning can limit the amount of deductible losses.

Congress originally enacted the at-risk rules in the Tax Reform Act of 19762 to curb tax shelters that gave taxpayers deductions for nonrecourse debt. However, the scope of the rules has been continually broadened.

The most inclusive provision of Sec. 465 is found in Sec. 465(c)(3), which states that for tax years beginning after December 31, 1978, the section applies to each activity engaged in by a taxpayer in carrying on a trade or business. Therefore, in the context of S corporations, the rules apply to any S corporation shareholder engaged in a trade or business. Often practitioners do not give the application of the rules to S corporations sufficient consideration because they incorrectly presume the concept applies predominantly to partnerships.

Contribution of Cash or Other Property

Sec. 465 starts simply enough by stating that a taxpayer is at risk for an activity for the amount of money and the adjusted basis of other property contributed to the activity. What if a shareholder contributes property that is subject to a debt? The amount at risk depends upon whether the shareholder is personally liable for the debt. If so, the shareholder’s amount at risk is increased by the full amount of the property’s adjusted basis. If the shareholder is not personally liable for the repayment of the loan, the amount at risk is increased by the adjusted basis of the property contributed and decreased by the nonrecourse debt.3

Is the Shareholder at Risk for Borrowed Amounts?

A very significant difference between a shareholder’s basis and at-risk amount may arise with regard to loans made by a shareholder to an S corporation. Under Secs. 1366 and 1367(b) and the applicable regulations, a shareholder’s basis is increased by loans made to the S corporation. However, under Sec. 465, such loans might not increase the shareholder’s at-risk amount. Specifically, Sec. 465(b)(2) states that an S corporation shareholder is at risk only with respect to amounts borrowed for use in the corporation to the extent that the shareholder:

(A) is personally liable for the repayment of such amounts; or (B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the fair market value of the taxpayer’s interest in such property).

Therefore, under (A) above, if a shareholder borrows funds from a bank and subsequently lends those funds to the S corporation, the terms of the note between the bank and the shareholder will determine the shareholder’s liability. However, in the case of money borrowed from a related party as opposed to from a bank, the substance of the transaction, and not the form, will govern whether the S corporation shareholder is at risk.4

Another frequently overlooked at-risk issue occurs under (B) above when a shareholder borrows money from an unrelated party, pledges the property of an S corporation as security, and lends the funds to the S corporation. This loan from the shareholder to the S corporation gives the shareholder basis in debt but does not increase his or her at-risk amount. The effect is seen in Example 1.

Example 1: E is a 100% shareholder of an S corporation. The corporation is in need of cash. E borrows $50,000 from a bank on a nonrecourse basis and pledges the S corporation’s assets to secure the loan. E subsequently loans these funds to the S corporation. Prior to making the loans to the S corporation, E’s basis and at-risk amount had been brought down to zero from losses of the entity. In the current year, the S corporation has an ordinary loss of $20,000.

The impact on E is as follows:

Impact on basis:

Impact on at-risk amount:

E must meet both tests in order to take the S corporation’s loss. Therefore, although E obtains basis in the debt, he cannot take the loss because he is not at risk for the loan obtained from the bank, which is secured by the company’s assets. This is not an uncommon situation; company assets are often security for a loan the shareholder takes out in order to loan funds to the S corporation. A guarantee by the shareholder of a loan made directly from the bank to the S corporation would not create basis.5 Therefore, the shareholders often use the back-to-back loan described above to create basis but neglect to consider the at-risk issue. Clearly, in order to avoid the trap of Sec. 465(b)(2)(B), collateral other than assets used by the activity must be put into place. It is important to note that the result would be the same if E pledged the S corporation stock as collateral for the loan from the bank.6

Exception for Qualified Nonrecourse Financing

The result above would be different in the case of qualified nonrecourse financing under Sec. 465(b)(6). A shareholder is at risk with regard to qualified nonrecourse financing that is:

• Borrowed with respect to the activity of holding real property;
• Borrowed from a qualified person;
• Financing for which no person is personally liable for repayment; or
• Not convertible debt.7

A qualified person is a person who is actively and regularly engaged in the business of lending money and not:

• A related person with respect to the shareholder or the corporation;
• A person from whom the S corporation acquired the property; or
• A person who receives a fee for the S corporation’s investment in the property.8

When qualified recourse financing is structured as a back-to-back loan or as a capital contribution to the S corporation, the shareholder can take advantage of Sec. 465(b)(6). More specifically, the S corporation shareholder will be at risk if the shareholder borrows money from a bank on a nonrecourse basis and loans the funds to the S corporation, which in turn uses the funds to purchase real estate for its activity of holding real estate. The loan is secured by the corporation’s real estate. Despite the fact that the loan is secured by assets used by the S corporation, the shareholder is at risk.

It is worthy of note that neither the statute nor the regulations define the term “activity.” However, the fact that a loan is secured by real property does not necessarily mean that the loan was secured as part of the activity of holding real property. For example, if a business purchases real estate to store rental equipment and takes out a loan secured by the real property, the loan would be considered to be made in connection with the activity of renting property, not the activity of holding real estate.

Amounts Borrowed from Persons Having an Interest in the Activity

S corporation shareholders also need to be aware that a shareholder is not at risk with regard to amounts borrowed from any person who has an interest in the activity or from a person who is related to a person with such an interest.9 Regs. Sec. 1.465-8 states that amounts borrowed from someone who has an interest other than as a creditor or who is related to an individual who has an interest other than as a creditor will not increase the shareholder’s amount at risk. The idea behind this limitation is that a creditor that has an additional financial interest in the activity other than as a creditor might not enforce his or her rights as a creditor if they conflict with other interests.

Under Regs. Sec. 1.465-8, even if an S corporation shareholder is personally liable for repayment of a loan for use in the S corporation, the shareholder will not be considered at risk if the money is borrowed from a person who has either a capital interest in the S corporation or an interest in the entity’s net profits. A shareholder of an S corporation is considered to have a capital interest in the entity. Therefore, an S corporation shareholder is not at risk for a loan from another shareholder of the same corporation, even if the shareholder is personally liable for the loan repayment.10

With regard to an “interest in the net profits” of the activity, an employee’s or independent contractor’s compensation that is in part or in full determined by the net profits of the activity will be a disqualifying interest.11 Therefore, a shareholder would not be at risk for money borrowed from an employee of the S corporation whose annual bonus was fixed as a percentage of the corporation’s net profits. The same at-risk trap exists if the S corporation shareholder borrows money from a creditor as described above if the loan is nonrecourse and secured by assets with a readily ascertainable fair market value.12

The S corporation shareholder needs to be aware that the rules for borrowing from such “disqualified interests” contain related-party provisions. Specifically, the shareholder would not be at risk for an amount borrowed from persons who are related to those who have disqualifying interests. A person is related for purposes of the at-risk rules if:

• The person is related under either Sec. 267(b) or Sec. 707(b)(1), substituting 10% for 50%; or
• The related person and the person with the disqualifying interest are engaged in trades or businesses under common control, within the meaning of subsections (a) and (b) of Sec. 52.13

Purchase of S Corporation Stock

Does the purchase of S corporation stock by an individual create an at-risk amount for the purchaser? Prop. Regs. Sec. 1.465-22(d) responds to this question by stating that the payments by a purchaser to a seller of the interest in an activity are treated as if the payments that were made to the seller were contributed to the S corporation. Therefore, if the purchaser pays for stock in cash from his or her personal funds, the amount at risk would equal the purchase price. However, if the purchased stock was financed with a nonrecourse loan secured by the stock purchased or the assets of the S corporation, the purchaser’s amount at risk would be zero under Sec. 465(b)(2)(B), as previously discussed.

Adjustments to the At-Risk Amount

Once a shareholder establishes an at-risk amount by virtue of a particular transaction or set of transactions, the individual must be aware of items that will increase or decrease that amount.

First, and similar to the computation of the shareholder’s basis, the pro-rata share of the S corporation’s items of income, including tax-exempt income, will increase the shareholder’s at-risk amount.14 Of course, a shareholder’s at-risk amount is increased by additional capital contributions of cash and property and also for shareholder loans made to the S corporation, subject to the previously discussed Sec. 465(b)(2).

Second, and also similar to the computation of the shareholder’s basis, a shareholder’s pro-rata share of the S corporation’s loss or deductions, including nondeductible expenses that are not capitalizable, will decrease the at-risk amount.15 In addition, the shareholder’s at-risk amount for debt is reduced by distributions of money as a loan repayment to the extent that the payment decreases the shareholder’s basis in the debt.16

It is well established that an S corporation shareholder cannot be at risk for a guarantee of S corporation debt. However, what if an S corporation shareholder repays part or all of the debt? Will the shareholder be entitled to an increase in the at-risk amount? The answer is a conditional “yes.” Specifically, the at-risk amount will increase only when the shareholder no longer has a legal right to seek indemnification from the primary obligor on the loan, that being either the S corporation or another shareholder.17

An earlier section addressed the at-risk implications when the S corporation shareholder borrows money from a bank on a recourse or a nonrecourse basis and contributes or loans these funds to the S corporation. What is the effect on the at-risk amount when the shareholder repays the creditor? The answer is different depending upon whether the loans are recourse or nonrecourse. In general, loan repayments on a recourse loan will not increase the shareholder’s at-risk amount. However, there are two situations in which these repayments will decrease a shareholder’s at-risk amount. First, if a shareholder repays the recourse debt with assets that are used in the corporation (which could be, for example, stock of the S corporation), the shareholder’s at-risk amount will decrease by the adjusted basis of the assets. Second, if an S corporation shareholder uses funds that would not increase the shareholder’s at-risk amount if contributed directly to the S corporation to repay the recourse debt, the shareholder’s at-risk amount is decreased by this repayment.18

Example 2: In 2008, Q, an individual calendar-year taxpayer, borrows $10,000 from a bank, assuming personal liability for repayment, for use in P, an S corporation of which she is the sole shareholder. At the close of 2008, Q’s amount at risk in the activity is $10,000. In December 2009, Q borrows $3,000 from another source for which she is not personally liable and that is secured by property used in the activity. She uses the funds to pay the bank. If no other factors occur during the year to affect Q’s at-risk amount in the activity, Q’s amount at risk will be decreased by the amount of the repayment because she used funds for the repayment that would not have increased her at-risk amount had they been contributed to the activity. Therefore, at the close of 2009 Q’s amount at risk is $7,000. The result would be the same if the $3,000 used for the repayment of the loan were withdrawn from P.

A different set of rules controls when an S corporation shareholder has incurred nonrecourse debt. Repayments may increase or decrease the amount at risk depending upon two key factors. Specifically:

• Did the nonrecourse debt increase the S corporation shareholder’s at-risk amount when the loan was incurred?
• Would the funds or property used to pay back the loan increase the shareholder’s at-risk amount if these were contributed directly to the corporation?

If the S corporation shareholder’s nonrecourse loan did not increase the shareholder’s amount at risk at the time the loan was incurred, repayments of it would result in an increase in the S corporation shareholder’s amount at risk (Prop. Regs. Sec. 1.465-25(b)(2)(i)). However, if the amounts used to repay the nonrecourse indebtedness would not have increased the S corporation shareholder’s amount at risk if contributed directly to the S corporation, the shareholder’s amount at risk is unaffected by the repayment. If the S corporation shareholder’s nonrecourse loan did increase the shareholder’s amount at risk at the time the loan was incurred, subsequent repayments will not increase the S corporation shareholder’s amount at risk.19 However, if the amount used to repay this type of nonrecourse loan would not increase the S corporation shareholder’s at-risk amount if contributed directly to the S corporation, the repayment would actually decrease the S corporation shareholder’s at-risk amount.

Part of the lesson from these details is that the impact on the amount at risk for S corporation shareholders’ repayments of loans, the proceeds of which were subsequently loaned to the corporation, depends on many circumstances surrounding the loans and the funds used for repayment. The result will typically be different than the impact of the basis computation; hence, another Sec. 465 trap lurks in these rules.

At-Risk Aggregation Rules

Congress originally enacted the at-risk rules to combat what was perceived to be an abusive tax shelter in which the investor’s goal was to obtain large deductions without actually being at risk of any loss from the investment. Along these lines, there was also concern that investors would invest in several different entities with several ventures and attempt to use losses from one activity to offset the income of another activity. As a result, Sec. 465(c)(2) contains rules that forbid such offsetting. These rules are not addressed here because this article deals with the at-risk rules as they pertain to operating businesses.

It is, however, worthy of note that Sec. 465(c)(3) does contain aggregation rules for activities that constitute a trade or business that is operated in an S corporation and owned by shareholders who are active in the business of the entity. Specifically, if an S corporation carries on a trade or business and at least 65% of any losses from the trade or business are allocable to individuals who actively participate in its management, all activities comprising the trade or business must be aggregated.20 If this allocation rule is met and, for example, an S corporation has both a shoe repair business and a seasonal accounting practice, the activities are combined in determining both the amount at risk and the amount of losses that can be taken on the shareholder’s returns.

However, if, in contrast, the S corporation has one owner and two activities, one in which the shareholder participates and the other in which the shareholder does not participate, it is possible that the amount at risk for each activity may be required to be separately computed, and the amount of income or loss from each activity is also separately computed. In order to determine the at-risk amount for each activity, the shareholder may be required to apply tracing rules (similar to the interest expense tracing rules of Sec. 163) for moneys invested and loaned to each activity. There is, however, no clear authority on the subject. This represents a significant difference from basis calculation, which determines one basis amount for each shareholder regardless of the number of activities.

Recapture of Losses Where Amount at Risk Is Less Than Zero

Losses cannot reduce the amount at risk to below zero. Once the at-risk amount is zero, losses are suspended. However, the amount at risk may go below zero by means of reductions of liabilities, distributions of cash, or the conversion of loans from recourse to nonrecourse. If a shareholder’s amount at risk is below zero at the end of a tax year, the shareholder recognizes income to the extent of the negative amount.21 It is as if the shareholder is recapturing prior losses. This amount of income becomes deductible once the shareholder is sufficiently at risk again. Example 3 illustrates the provision.

Example 3: M is an S corporation formed on January 1, 2008. J, the sole shareholder, invests $30,000 of cash in exchange for M stock. J also borrows $30,000 from a third party on a recourse basis. The lender is not an M shareholder and is not related to a shareholder. J loans the additional $30,000 to M. J’s at-risk amount is $60,000. In 2008 M has a net operating loss of $50,000. J can deduct the entire loss of $50,000. On January 1, 2009, J’s at-risk amount is $10,000 ($60,000 – $50,000). On December 31, 2009, the $30,000 that J borrowed is converted into a nonrecourse loan. As a result, the amount at risk is (–$20,000). J is required to include the negative at-risk amount in income. If in 2010 J’s amount at risk is increased by $20,000 or more, J can deduct the $20,000 included in gross income in 2009.

A question arises concerning the character of the income recognized when an at-risk amount becomes negative. Suppose an S corporation repays loans from shareholders that have basis lower than the face amount. Such payments could create negative at-risk amounts. Is the income to the shareholder ordinary or capital? Typically, the income resulting from repayment of a loan that is evidenced by a note is capital in nature (Sec. 1271(a)). However, should the income be considered ordinary because the deductions being recaptured were deducted as ordinary losses? There is no IRS guidance on this matter. Another consideration in such a situation is that if the at-risk and basis amounts are different, separate calculations of the impact will be required.

Conclusion

Got basis? That is not enough. Separate calculations are required to determine the at-risk amount of S corporation shareholders. This concept is often not considered in tax planning with regard to the taxable income and loss of an S corporation because the term “at risk” is often perceived to apply only to partnerships. But Sec. 465 contains many traps that will limit S corporation shareholders from deducting their pro-rata share of the company’s losses on their tax returns. Often the amount at risk is quite different from the shareholder’s basis in stock and/or debt. In fact, the at-risk amount is often less than the basis amount. Practitioners must be fully cognizant of the Sec. 465 rules in order to properly plan for the impact of the S corporation’s year-end results.

Editor’s Note: This article was named winner of The Tax Adviser’s 2010 Best Article Award by The Tax Adviser‘s Editorial Advisory Board.

Footnotes

¹ See Sullivan, “The Story of Basis,” 41 The Tax Adviser 398 (June 2010).

² Tax Reform Act of 1976, P.L. 94-455.

³ Prop. Regs. Sec. 1.465-23(a).

⁴ Riggs, T.C. Memo. 1992-323; Berger, T.C. Memo. 1994-298.

⁵ Perry, 47 T.C. 159 (1966), aff’d, 392 F.2d 458 (8th Cir. 1968); Raynor, 50 T.C. 762 (1968).

⁶ Prop. Regs. Sec. 1.465-25(b)(1)(i).

⁷ Sec. 465(b)(6)(B).

⁸ Sec. 465(b)(6)(D), referencing Sec. 49(a)(2)(D)(iv).

⁹ Sec. 465(b)(3).

¹⁰ Regs. Sec. 1.465-8(b)(2).

¹¹ Regs. Sec. 1.465-8(b)(3).

¹² Regs. Sec. 1.465-8(c).

¹³ Sec. 465(b)(3)(c).

¹⁴ Prop. Regs. Sec. 1.465-22(c)(1).

¹⁵ Prop. Regs. Sec. 1.465-22(c)(2).

¹⁶ Prop. Regs. Sec. 1.465-22(b).

¹⁷ Prop. Regs. Sec. 1.465-6(d).

¹⁸ Prop. Regs. Sec. 1.465-24(b).

¹⁹ Regs. Sec. 1.465-25(a)(2), referring to Regs. Sec. 1.465-24(b).

²⁰ Sec. 465(c)(3)(B).

²¹ Sec. 465(e)(1).

EditorNotes

Lewis Taub is a tax director with RSM McGladrey in New York, NY, and is a member of the AICPA’s S Corporation Technical Resource Panel. For more information on this article, contact Mr. Taub by telephone at (212) 372-1342 or by e-mail at lewis.taub@rsmi.com.