Avoiding gain at the S shareholder level when a loan is repaid

Corporate repayment of loans owed to an S corporation shareholder reduces the shareholder’s basis in such loans. However, when basis in a shareholder’s loan has been reduced by passthrough losses, repayment of the loan is a taxable event to the extent full repayment exceeds the shareholder’s basis in the debt, or to the extent partial repayments exceed a pro rata portion of the basis in the debt (Rev. Ruls. 64-162 and 68-537).

This gain on the repayment of reduced-basis debt does not increase debt basis for purposes of using S corporation losses in the hands of that shareholder.

Recognition and character of gain on repayment of reduced-basis loan

Reductions in debt basis result in gain when the loan is partially or fully repaid. This is inevitable because corporate income increases debt basis to the extent debt basis was reduced by losses or deductions (Sec. 1367(b)(2)(B)).

The character of the gain depends on whether the debt is evidenced by a written note. If there is no note, as with an open account receivable, the gain is ordinary income (Rev. Rul. 68-537). If the indebtedness is evidenced by a written instrument, the repayment is treated as a sale or exchange of a capital asset (Rev. Rul. 64-162). Thus, the gain is long-term capital gain if the debt instrument has been held for more than 12 months, and it is short-term capital gain otherwise.

Example 1. Recognizing gain on repayment of reduced-basis note: P is the sole shareholder of N Inc., a calendar-year S corporation that has had a valid S corporation election in effect for all years it has existed. Five years ago, P loaned N $60,000. The loan was documented properly and pays interest at a fair market rate. A passthrough loss in the following year reduced the basis of the loan by $15,000, bringing P’s debt basis to $45,000.

At the beginning of the current year, P has stock basis of $29,000 and debt basis of $45,000.

N’s only passthrough item for the year is nonseparately stated trade or business income of $12,500. The corporation made distributions of $14,000 during the year. (Therefore, there is no “net increase” in basis for the year, and debt basis is not increased by the current year’s income items.)

The corporation has paid the interest annually. This year, P decides he would like to have N pay him the face amount of the note, $60,000, and tells his tax planner that he wants N to make a principal payment of at least $45,000. (The payments can be made from funds the corporation has on hand.) How can the tax effects of the loan repayment be minimized?

P must recognize gain if he receives payments on the note. Receipt of the face amount would result in gain of $15,000 ($60,000 payment − $45,000 basis).

P assumed that a repayment equal to his basis in the note, $45,000, would have no adverse tax effects. However, partial repayment of a shareholder loan that has been used as a basis for loss deductions represents income to the shareholder. Such income, computed on a pro rata basis, is $11,250, determined as follows: ([$60,000 face amount – $45,000 basis] ÷ $60,000 face amount) × $45,000 repayment = $11,250.

P has a long-term capital gain because he held the note for more than 12 months. Thus, the repayment is made up of a long-term capital gain of $11,250 and a nontaxable return of basis of $33,750. The note’s balance and P’s basis in the note at year end are shown in the table “Note Balance and P’s Basis in Example 1″ (below).

Example 2. Increasing debt basis by passthrough income when debt is repaid during the year: P is the sole shareholder of N Inc., a calendar-year S corporation. Two years ago, P loaned N $60,000. The following year, a passthrough loss reduced the basis of the loan by $15,000, bringing P’s debt basis to $45,000. On Jan. 1 of the current year, P’s stock basis is zero and his debt basis is $45,000. On July 1 of the current year, the corporation pays him $60,000 in full satisfaction of the note. At year end, the corporation passes through $65,000 of nonseparately stated income, and no distributions are made to P during the year. Is P’s basis in the note increased at year end, even though the loan was paid off?

The $65,000 net increase is first applied to increase P’s debt basis to the extent it was reduced by post-1982 losses. The remaining $50,000 ($65,000 − $15,000) of net increase is applied to increase P’s stock basis. His stock and debt basis is determined as shown in the table “P’s Stock and Debt Basis in Example 2″ (below). The passthrough income increases P’s debt basis, so there is no gain on the repayment of the note. Passthrough income increases the basis of reduced-basis debt. Losses, however, do not reduce debt basis if the loan has been repaid during the year.

Example 3. Making a partial payment in following year: Assume the same facts as in Example 1, except that the corporation makes a payment of $7,500 in the following year. The income from the repayment is $1,875, calculated as follows:([$15,000 face amount – $11,250 basis] ÷ $15,000 face amount) × $7,500 repayment = $1,875. The repayment is made up of a long-term capital gain of $1,875 and a nontaxable return of basis of $5,625. The note’s balance and P’s basis in the note at year end are as shown in the table “Note Balance and P’s Basis in Example 3″ (below).

Tax planning strategies to avoid gain on repayment of reduced-basis note

One tax planning strategy to avoid the tax on the gain from repayment of a reduced-basis written note is to offset the capital gain with capital losses. Disposition of personal or corporate assets that would generate capital losses, or capital loss carryovers from previous years, can be used to offset the capital gain generated by repayment of the shareholder note. The timing of the note payments can also be an effective tax planning tool. For instance, the practitioner may recommend the note payments be delayed until a year when there are capital losses to offset the gain.

If the purpose of the loan repayment is for the shareholder to receive funds from the corporation, other means might be used. For instance, if the gain could not be offset by losses, the practitioner might recommend that no loan payments be made and a distribution be made instead. But that is not always practical because distributions may be taxable also.

Another tax planning strategy that can mitigate the gain generated from repayment of a reduced-basis loan involves the investment interest expense deduction limitations in the shareholder’s return. Capital gain arising from a debt repayment may be treated as investment income to the shareholder, thereby enhancing the deductibility of investment interest. Conversely, had the shareholder received a distribution (rather than a loan repayment), the character of capital gain recognized on the distribution may be passive, active, or portfolio income, depending on the taxpayer’s participation in the operations of the business and the nature of the corporation’s activities.

Caution: Interest expense properly allocable to a trade or business is potentially subject to a limitation under Sec. 163(j). Investment interest expense should be reviewed to determine if it qualifies as business interest if none of the exceptions to the limitation exist.

Consideration should be given to making a debt-for-stock swap to eliminate the debt and thereby remove the threat of gain on repayment. However, certain requirements and formalities must be met to implement the swap.  

This case study has been adapted from PPC’s Tax Planning Guide: S Corporations, 34th edition (March 2020), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).