Direct shareholder loans to an S corporation can be very important tools for tax planning. Unlike a partner, an S corporation shareholder does not increase basis by a ratable share of corporate indebtedness to third parties. This is because a shareholder generally is not liable for the corporation's obligations.
To obtain basis, the debt must be owed by the corporation directly to the shareholder (Sec. 1366(d)(1)(B); Regs. Sec. 1.1366-2(a)(2)(i)). The shareholder's personal guarantee of the corporation's obligations to third parties does not create basis (Regs. Sec. 1.1366-2(a)(2)(ii); Rev. Ruls. 70-50 and 71-288).Passthrough Losses Can Reduce Debt Basis
Once a shareholder's basis in S corporation stock has been reduced to zero, passthrough losses and deductions still can be deducted to the extent the shareholder has debt basis (i.e., basis in direct loans from the shareholder to the S corporation) (Sec. 1367(b)(2)(A); Regs. Sec. 1.1367-2).
If the shareholder holds more than one debt at the end of the corporation's year, the basis reduction applies to each debt in the same proportion that the basis of each debt bears to the aggregate bases of all debt (Regs. Sec. 1.1367-2(b)(3)).
Debt basis is not reduced by passthrough losses or deductions if the debt has been satisfied, disposed of, or forgiven during the corporation's tax year (Regs. Sec. 1.1367-2(b)). (Even though debt basis cannot be decreased if the loan was fully repaid during the year, it can be increased by the corporation's income under certain conditions.)Increasing Previously Reduced Debt Basis by Corporate Income
When debt basis has been reduced by passthrough losses in a year after 1982, passthrough items of income or gain generally increase debt basis. However, the items of income, gain, loss, and deduction must first be netted, along with the nondividend distributions. (Nondividend distributions are distributions other than those made from accumulated earnings and profits.) If the result is a positive amount (income and gain amounts exceed losses, deductions, and nondividend distributions), there is a net increase, and debt basis is increased by the net increase to the extent debt basis has been reduced by post-1982 losses (Sec. 1367(b)(2)(B)). Debt basis is increased only up to the outstanding balance on the note at the beginning of the year (Regs. Sec. 1.1367-2(c)(1)). After the net increase has been applied against debt basis, any remaining net increase is used to increase stock basis.
Planning tip: If there is a "net increase" because passthrough income and gains exceed losses, deductions, and nondividend distributions, the nondividend distributions are not taxable, even though the shareholder has no stock basis.
Example 1. Increasing previously reduced debt basis by corporate income: G Inc. is an S corporation that incorporated and simultaneously elected S status 11 years ago. At the beginning of the current tax year, P, the sole shareholder, has no stock basis and a debt basis of $33,000. (The note to P has a face value of $50,000, and his debt basis has been reduced $17,000 by losses in excess of stock basis.) P's Schedule K-1 shows the items in Exhibit 1. What are P's stock basis and debt basis at the end of the current year?
The practitioner must first determine whether there was a net increase during the year by netting the items of income, gain, loss, and deduction, and nondividend distributions. The net increase in this case is $22,000 ($41,500 + $4,500 − $6,000 − $18,000). Thus, P's debt basis is increased by $17,000, the amount it has been reduced by post-1982 losses. The remaining $5,000 of net increase is used to increase stock basis. His stock and debt basis are determined as shown in Exhibit 2.
P includes the $41,500 nonseparately stated income and $4,500 long-term capital gain in his gross income and deducts the $6,000 Sec. 1231 loss on his Form 1040, U.S. Individual Income Tax Return. All $18,000 of the distribution is nontaxable.
Debt basis that has previously been reduced by passthrough losses is reinstated by the current year's "net increase." The net increase is the amount that the current year's passthrough income and gains exceed losses, deductions, and nondividend distributions (Sec. 1367(b)(2)(B)). Capital contributions by the shareholder to the corporation are not included as items of income used in calculating the net increase (Nathel,131 T.C. 262 (2008)).
If the netting of items of income, gain, loss, deduction, and nondividend distributions results in a negative number, debt basis is not increased by passthrough items of income and gain. Rather, stock basis is increased by income and gain items and reduced by nondividend distributions. Stock basis is then reduced by loss and deduction items. Once the loss and deduction items have reduced stock basis to zero, they reduce debt basis (but not below zero). The loss and deduction items are deductible on the shareholder's personal return to the extent they have reduced either stock or debt basis (and to the extent they are otherwise deductible).
Example 2. Adjusting stock and debt basis when net amount is negative: Assume the same facts as in Example 1, except the distributions totaled $48,000 instead of $18,000. The netting process would result in a negative amount of $8,000, and P's stock and debt basis would be calculated as in Exhibit 3.
The distribution is nontaxable to the extent of stock basis ($46,000), and the remainder ($2,000) is taxable to P as long-term capital gain. P includes the $41,500 nonseparately stated income and $4,500 long-term capital gain in his gross income and deducts the $6,000 Sec. 1231 loss on his Form 1040.
Example 3. Distributions do not reduce debt basis: T owns all of the shares of S Corp. an S corporation that incorporated and simultaneously became an S corporation 11 years ago. At the beginning of the current tax year, his stock basis is $10,000 and his debt basis is $50,000. The debt basis has not previously been reduced by passthrough losses. S distributes $23,000 to T on July 1. At year end, T's Schedule K-1 shows nonseparately stated income of $2,000. His stock and debt basis are determined as shown in Exhibit 4.
Distributions do not reduce debt basis. Distributions from an S corporation that does not have AE&P are nontaxable to the extent of stock basis and are capital gain to the extent they exceed stock basis (Sec. 1368(b)). Thus, the distributions to T are $12,000 nontaxable and $11,000 capital gain. The capital gain is long-term because T held the shares more than 12 months.
Example 4. Avoiding shareholder gain by making corporate payments on debt: Assume the same facts as in Example 3. The $11,000 of long-term capital gain would be avoided if the corporation had made a $23,000 payment on the debt, rather than making a distribution to T. The loan payment would reduce his debt basis from $50,000 to $27,000, and his stock basis at the end of the year would be $12,000. The transaction should be clearly documented in the minutes and other corporate records as a loan repayment to avoid an IRS argument that the $23,000 payment was a distribution instead of debt reduction.
Planning tip: Alternatively, the payment could be treated as a note receivable from the shareholder. The corporation can have loans receivable from and payable to the shareholder. Again, the loan should be evidenced by a written note, bear a market rate of interest, and be clearly documented in the corporate records to verify that the debt is bona fide.
This case study has been adapted from PPC's Tax Planning Guide: S Corporations, 29th edition, by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.