S corporation shareholders confront limitations in the amount of passthrough entity losses they may deduct from income. Understanding how basis is accurately calculated and what qualifies as shareholder basis against which to deduct passthrough losses is integral to preparing an accurate tax return that will pass the scrutiny of an IRS audit.
S corp. basis and why it is important
S corporations are considered passthrough entities that pass the income and losses earned from the business to the shareholders, who are taxed on the business's income and losses on their individual income tax returns. However, an S corporation shareholder cannot automatically assume that a loss passed through from the company is deductible on his or her individual income tax return. The first step is to determine whether the shareholder has sufficient basis in the entity to deduct the loss.
A shareholder acquires S corporation basis through the original purchase of stock; additional equity contributions; and cumulative net income, less distributions passed through to the shareholder during the time the stock is owned. Additionally, a shareholder acquires debt basis from loans made to the S corporation. It is important to note that nondividend distributions (distributions other than from accumulated earnings and profits) reduce stock basis but do not reduce debt basis. Sec. 1366(d)(1) provides that deductible passthrough losses to a shareholder cannot exceed the shareholder's adjusted basis of stock in the S corporation plus the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder.
Basis is important because it is the first test to determine whether the shareholder has a deductible loss from the company. Shareholders must also pass the at-risk and passive activity loss tests before reporting the loss on their tax return. Sec. 1366(d)(2) provides that the passthrough loss can be carried forward indefinitely if the taxpayer lacks sufficient basis to deduct the loss in the current tax year. However, the taxpayer may lose the ability to deduct the loss in future years if sufficient basis is not created or restored before the company is sold or shut down.
What qualifies as debt basis?
Debt must meet two requirements to qualify as S corporation basis. First, the debt must run directly from the shareholder to the S corporation. Second, under Regs. Sec. 1.1366-2(a)(2), the indebtedness must be bona fide. Whether indebtedness to a shareholder is bona fide is determined under general federal tax principles and depends upon all the facts and circumstances.
The IRS adopted these "bona fide debt" provisions on July 23, 2014, when it issued final regulations providing guidance regarding basis for S corporation loans (T.D. 9682). The new provisions replace the judicially created standard requiring an "actual economic outlay" that leaves the shareholder "poorer in a material sense" that was previously used to determine whether a shareholder is entitled to debt basis under Sec. 1366(d)(1)(B).
Bona fide debt
Regs. Sec. 1.166-1(c) defines a bona fide debt as arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money. Courts have looked to the intent of the parties at the time the loan is made to verify a debtor-creditor relationship. The shareholder must have a real expectation of repayment and intent to enforce collection efforts against the S corporation in the event of a default on the loan.
The definition of bona fide debt is met without a doubt when the source of the funds is an unrelated third party such as a bank. If the shareholder borrows funds from a bank and lends the cash to the S corporation, the bank will hold the shareholder to repayment terms. The conclusion is less certain when the loan is made between related parties or between the shareholder and entities with common ownership. In these situations, it is important to document the intent of the parties by characterizing the transaction as a loan in the corporate resolutions and accounting records. The parties should maintain written notes with a fixed repayment schedule and a fair market rate of interest at least equal to the applicable federal rate, similar to what a shareholder would execute with unrelated parties.
Courts will evaluate the financial condition of the S corporation debtor when the loan was made, to see that it supports an expectation of repayment on the part of the shareholder and an intent to create a valid debtor-creditor relationship. The courts have also found it important that the shareholder collateralize the loan with his or her personal property.
Circular loans are a flow of funds creating loans between parties, with the cash beginning and ending with the original lender. The intent of such loans is to create debt basis that shareholders then use to deduct passthrough losses on their individual income tax returns.
In Oren, T.C. Memo. 2002-172, the Tax Court held that husband and wife taxpayers did not have sufficient loan basis under Sec. 1366(d) to deduct passthrough losses from their S corporations. The tax adviser of the husband, Donald Oren, assisted with creating loans between Oren and his commonly owned S corporations to create basis to deduct losses. Oren's S corporation, Dart Transit Co., loaned $4 million to Oren. Oren lent the funds to Highway Leasing (HL), a second S corporation in which he had common ownership. HL then lent the funds back to Dart. Oren executed the series of loan transactions all on the same date. The loans were evidenced by notes that provided that principal was due 375 days following demand, with annual interest due at a rate of 7%. Oren used the debt basis created in HL to deduct passthrough losses from the S corporation on his individual income tax return.
The court focused on the fact that the taxpayer was not poorer in any material sense after the loans were made and that he did not have an economic outlay, concluding that the loans did not qualify as additional S corporation basis to allow Oren to deduct losses on his tax return. The court found that the loan transactions resulted in nothing more than offsetting bookkeeping entries because the loan proceeds originated and ended with the S corporation, Dart, with no change in the parties' economic position. HL did not need to retain the loan proceeds for its business operations because the business loss was generated by depreciation deductions, and, therefore, it returned the cash to Dart.
If HL had retained the funds, then the transaction would not have been circular, and the court may have held that the loan proceeds in HL increased Oren's debt basis. This distinction is helpful for taxpayers who can prevent a circular transaction and avoid scrutiny of the debt basis issue upon an IRS audit.
The court noted that the terms of the promissory notes were not the equivalent of terms that might appear in notes executed for the benefit of unrelated third parties, especially considering the significant sum of the loans. Further, the loans were unsecured and were in the form of demand notes. Additionally, Oren, the majority or sole owner of both the obligor and obligee of the notes, controlled when a demand for payment on the notes would be made.
Also, when repayments were made on the notes, they did not comply with the notes' terms, which provided for payment 375 days after demand. Rather, the repayments of both principal and interest occurred contemporaneously in a circular transaction, which led to the court's holding that the debt was not bona fide. The court also believed that it was highly improbable that Dart would have demanded that Oren repay his loans from Dart out of his personal assets. Assuming there was a demand for payment, the chain of events to repay the loans would have an offset, leaving the parties in the exact same position where they started.
In cases such as Oren that occurred before the final regulations were issued in July 2014, the courts viewed circular loans as lacking economic substance and failing the economic-outlay and poorer-in-a-material-sense tests. However, the final regulations have opened the door to reconsidering circular loans as a viable option to create S corporation debt basis as long as the loan is considered bona fide debt. If Oren were brought to court today under the final regulations, the focus would be on the definition of a bona fide debt. What the IRS and the courts will consider a bona fide debt is somewhat unclear at this point, but a change in the economic position of the parties might not be required. Oren would have a stronger argument for proving that the S corporation debt increased his basis if he structured the notes with terms similar to those found between third parties; included a fixed schedule for repayment, rather than as demand notes; and collateralized the debt between the parties. A history of principal and interest payments over time would lend further support to the creation of a bona fide debt.
Regs. Sec. 1.1366-2(a)(2)(ii) provides that the shareholder does not have basis in a loan that is merely guaranteed, unless the shareholder actually pays on the guarantee.
In Phillips,T.C. Memo. 2017-61, the Tax Court recently reiterated and expanded the application of the law to hold that judgments and liens against an S corporation shareholder do not increase basis. In this case, Sandra Phillips was a 50% owner in an S corporation engaged in developing and selling real estate. The S corporation relied heavily on financing. The bank loaned the funds directly to the S corporation, with the shareholders as guarantors on the loans. In 2006, during the real estate market downturn, the S corporation defaulted on the bank loans. The lenders sued the S corporation and the guarantors and sought enforcement of the personal guaranties to satisfy the judgment.
Phillips took the position that she was entitled to an increase in her S corporation basis even though she had not remitted any amounts toward the court judgment or made direct payments to the lenders. Phillips presented a "substance versus form" argument, stating that the guaranteeing shareholder had in substance borrowed the funds directly from the lender and transferred the proceeds to the S corporation as a contribution to capital or a back-to-back loan. However, Phillips did not produce any additional evidence that the lending banks looked to her, as the shareholder of the S corporation, as the primary obligor on the loan.
The Tax Court held that Phillips was not entitled to a basis increase for the loan guaranties or judgments against her. To identify the true obligor of the debt, it is necessary to examine the lender's intentions when the loan originated. A court's entry of a deficiency judgment against a guarantor many years after the loan default is not relevant in determining whether the lender looked to the shareholder as the primary source of repayment on the loan. The court further held that Phillips could increase her S corporation basis only by making payments toward the judgment.
With proper planning, Phillips would have been able to establish basis in the bank loans. Phillips should have structured the loans so that she was the primary obligor, with the S corporation as the guarantor. Because the loan amounts were substantial and Phillips would have been unable to obtain the loan based on her assets only, she could have pledged the S corporation stock as collateral to receive bank approval for the loan.
The flow of funds is also critical to establishing basis. The bank should have distributed the loan proceeds to Phillips personally, and she should have loaned the money directly to the S corporation. This back-to-back loan structure is sufficient to prove that the lender intended to make the loan to the S corporation shareholder, and would have prevented Phillips from needing to make payments on the judgment to establish S corporation basis.
Taxpayers can successfully restructure an S corporation third-party note payable using a note payable directly to the shareholder. In Gilday, T.C. Memo. 1982-242, the S corporation had a bank note payable, which was guaranteed by the shareholders. Motivated by tax planning, the shareholders gave the bank a personal note for the entire balance due, and the bank canceled the note payable with the S corporation.
The court stated that the shareholders did not have basis in the earlier note, when they were merely its guarantors. However, the restructuring of the debt moved the shareholders from the position of guarantors to primary obligors, which gave them basis to deduct the S corporation passthrough losses.
If shareholders are required to pledge assets in addition to signing a bank promissory note, they should make sure that assets to secure the bank loan are not pledged directly by the S corporation. Assets pledged directly by the S corporation do not provide debt basis for the shareholder. In Bolding, 117 F.3d 270 (5th Cir. 1997), the taxpayer provided the bank with a security interest in cattle that were to be acquired with the funds from the bank line of credit. The Uniform Commercial Code financing statement, which provided notice that the bank had a security interest in the cattle, was signed by the shareholder and not the S corporation. In determining that the shareholder had debt basis in the line of credit, the court noted that it was important that the shareholder, rather than the S corporation, was the party assigning the security interest to the bank.
The parties should make sure to respect the loan structure and meet the definition of a bona fide debt by having the corporation make payments on the loans from the shareholder directly to the shareholder. The shareholder should personally make the payment on the bank debt. This important planning tool will support the debt as basis for the shareholder to use to deduct passthrough losses on his or her individual tax return.
Emphasis on loan structuring
An understanding of S corporation basis rules enables practitioners to assist clients in taking advantage of planning opportunities aimed at maximizing deductible passthrough losses and lowering the shareholder's tax liability. Additionally, thoughtful and careful loan structuring will allow shareholders to currently use passthrough losses rather than suspending their use to future years.
Michael D. Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
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