Proposed Regs. on Basis for S Corporation Shareholders From Bona Fide Indebtedness

On June 11, the IRS issued proposed regulations on the contentious subject of when an S corporation shareholder can increase his or her basis in the S corporation’s stock, based on loans to the corporation, and thereby increase the amount of the corporation’s losses and deductions the shareholder can recognize (REG-134042-07).

S corporation shareholders, unlike partners, generally are not permitted to increase their basis by guaranteeing a loan made by a third party to the corporation until they actually have to make payments on the guarantee. They are also not allocated basis from their allocable share of the entity’s debt, as a partner is for the partnership’s debt. As a result, S corporation shareholders spend a lot of time trying to avoid these rules and create basis that will allow them to deduct losses.

The proposed regulations provide that, to increase a shareholder’s basis in indebtedness, a loan must represent the S corporation’s “bona fide indebtedness” that runs directly to the shareholder. “Bona fide indebtedness” is not defined in the regulations; rather general federal tax principles determine if a debt is bona fide. And the proposed regulations continue to deny basis from a shareholder’s guarantee, or surety, or similar arrangement unless the shareholder actually performs under the arrangement (REG-134042-07 preamble; Prop. Regs. Sec. 1.1366-2(iii), Example (2)).

As for loans running directly to the shareholder, the proposed regulations address loans made under what the IRS calls the “incorporated pocketbook” theory, in which a shareholder claims that a loan to an S corporation from an entity related to the S corporation shareholder is in substance a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corporation. Under the proposed regulations, these types of transactions would increase basis only when there is a bona fide creditor/debtor relationship between the shareholder and the S corporation (REG-134042-07 preamble; Prop. Regs. Sec. 1.1366-2(iii), Example (3)).

The proposed regulations do not address whether a shareholder’s contribution of his or her own unsecured promissory note increases the shareholder’s stock basis, leaving unchanged the conclusion in published guidance and case law that it will not increase basis (see, e.g., Rev. Rul. 81-187). According to the IRS, a similar rule applies to partners who give unsecured promissory notes to their partnerships. The IRS has requested comments on its proposal to allow S corporation shareholders to increase their basis in their stock when the S corporation disposes of the note or the shareholder makes principal payments on the note.

Taxpayers may submit written or electronic comments on the regulations, and/or request to speak at the public hearing scheduled for Oct. 8, 2012, in Washington. Comments and requests to speak must be received by Sept. 10, 2012. The regulations would apply to loan transactions entered into on or after the final regulations are published in the Federal Register.