Corporate losses and deductions that can pass-through and be deducted by a shareholder are limited by I.R.C. §1366(d)(1). This limit is the shareholder’s total adjusted basis in the corporation’s stock and debt. If a shareholder’s share of losses and deductions exceeds such basis, the excess losses are suspended and can be carried over indefinitely. If the shareholder can increase his or her basis in later years, a deduction will result to the extent of the basis. A shareholder may increase his loan basis under I.R.C. §1366(d)(1) by lending money to the S corporation. Sometimes a shareholder may not have cash to lend to the corporation. If a shareholder borrows $100 from XYZ Bank in return for the shareholder’s personal note and then lends $100 to S corporation and receives the S corporation’s note, then the shareholder should have basis in his or her loan.
Shareholders have frequently borrowed money from an entity in which they owned an interest and then relent the money to the S corporation (a “back-to-back” loan). The IRS and the courts have held that such loans do not result in an increase in basis to the shareholder-lender in the S corporation debt. The courts have stated that I.R.C. §1366(d)(1)(e) refers to “indebtedness of the S corporation to the shareholder” and that those words require a direct indebtedness to the shareholder. The courts have held that in such a “back-to-back” loan situation, there has not been an “actual economic outlay” by the shareholder. The courts framed the test as being one of whether the shareholder because of the loan is “poorer in a material sense.” This test has made no sense because even if a shareholder lends his own money to the corporation, the shareholder is not poorer in a material sense because he has replaced his cash with an obligation of the S corporation.
The IRS has issued final regulations involving the circumstances in which a shareholder’s loan will cause basis against which losses can be taken. The regulations abandon the “economic outlay” concept and replace it with the principle that a shareholder that owns an S corporation will create basis if the debt runs directly between the S corporation and the shareholder and the debt is bona fide as determined under general federal tax principles.
The IRS has stated that taxpayers may rely on these final regulations regarding indebtedness between an S corporation and a shareholder that resulted from any transaction that occurred in a year to which the period of limitations on assessment of the tax has not expired before July 23, 2014.
Bona Fide Indebtedness Section 1.1366-2(a)(2) states that the shareholder’s adjusted basis includes any bona fide indebtedness of the S corporation that runs directly to the shareholder. Whether the indebtedness is bona fide is determined under general federal tax principles and depends on all the facts and circumstances. This test replaces the “economic outlay test” that had been developed under case law. Commentators had requested the IRS affirmatively state that the economic outlay test is no longer relevant, but the IRS declined stating that the regulations clarify that that is the case.
While the final regulations issue no guidance on what constitutes a bona fide loan, the loan should create a binding obligation of the corporation to its shareholder. Also, consider satisfying the following “safe harbor straight debt” requirements of I.R.C. §1361(c)(5)(B):
- The debt must be in writing.
- It must represent unconditional promise to pay on demand or on a specified date a sum certain in money.
- The interest rates (and interest payment dates) must not be contingent upon profits, the borrower’s discretion or similar factors.
- The debt must not be directly or indirectly convertible into stock.
While these factors may not be required or conclusive, they will be helpful in an audit situation.
Formalities. Proper structure is important and at least three steps should be taken to ensure the integrity of back-to-back loans. First, there should be separate sets of loan documents covering (i) the loan from the third party to the shareholder and (ii) the loan from the shareholder to the S corporation. Second, the loan proceeds from the third party to the shareholder should be placed in the shareholder’s bank account and transferred to the S corporation. The funds should not be transferred directly from the third party to the corporation. Third, repayment should be made by the corporation to the shareholder and then to the third party lender. Repayment should not be made directly from the S corporation to the third party.
Example 1. Shareholder loan transaction. A is the sole shareholder of S, an S corporation. S received a loan from A. Whether the loan from A to S constitute bona fide indebtedness from S to A is determined under general federal tax principles and depends upon all of the facts and circumstances. If the loan constitutes bona fide indebtedness from S to A, A’s loan to S increases A’s basis of indebtedness. The result is the same if A made the loan to S through an entity disregarded as an entity separate from A under §301.7701-3.
Example 2. Back-back loan transaction. A is the sole shareholder of two S corporations, S1 and S2. S1 loaned $200,000 to A. A then loaned $200,000 to S2. Whether the loan from A to S2 constitutes bona fide indebtedness from S2 to A is determined under general federal tax principles and depends upon all of the facts and circumstances. If A’s loan to S2 constitutes bona fide indebtedness from S2 to A, A’s back-to-back loan increases A’s basis of indebtedness in S2.
Example 3. Loan restructuring through distributions. A is the sole shareholder of two S corporations, S1 and S2. In May, 2014, S1 made a loan to S2. In December, 2014, S1 assigned its creditor position in the note to A by making a distribution to A of the note. Under local law, after S1 distributed the note to A, S2 was relieved of its liability to S1 and was directly liable to A. Whether S2 is indebted to A rather than S1 is determined under general federal tax principles and depends upon all of the facts and circumstances. If the note constitutes bona fide indebtedness from S2 to A, the note increased A’s basis of indebtedness in S2.
Example 4. Guarantee. A is a shareholder of S, an S corporation. In 2014, S received a loan from Bank. Bank required A’s guarantee as a condition of making the loan to S. Beginning in 2015, S could no longer make payments on the loan and A made payments directly to Bank from A’s personal funds until the loan obligation was satisfied. For each payment A made on the note, A obtains basis of indebtedness. A’s basis of indebtedness is increased during 2015 for A’s payments to Bank under the guarantee agreement.
Shareholder Guarantees. The final regulations retain case law and the IRS position that a shareholder does not obtain basis for indebtedness in the S corporation merely by guaranteeing a loan or acting as a surety accommodation party, or any similar capacity relating to the loan. However, if a shareholder individually makes a payment on the bona fide indebtedness of the S corporation, the shareholder’s basis is increased by the payment.
Contributing Shareholder’s Own Note. If a shareholder contributes his or her own note to the corporation, the IRS and case law has held that the shareholder has no basis in that note for purposes of pass-through of losses and deductions. The regulations do not change the law in this regard. A shareholder does not obtain basis by contributing his or her own note to the corporation.
Passive Loss Rules.
These passive loss rules were enacted via I.R.C. §465 in 1976 to curb the use of nonrecourse debt to increase its basis. For a shareholder to be able to deduct pass-through losses and deductions from an S corporation, the shareholder must have sufficient amounts at risk. In general, an S corporation shareholder may not include amounts as at risk unless he is personally liable to the borrowed funds and has secured the borrowed amounts with property not used in the activity. A taxpayer’s amount at risk rarely includes any amount borrowed from a person that holds an interest in the activity (other than interest as a creditor or a person related to a person holding such an interest in the activity). If X owned 50% of S Corporation and Y owned the other 50%, if X borrows money from Y and loans it to S Corporation then X may have basis in his loan for purposes for Section 1366. However, the amount would not considered at risk and X may not count the loan for at risk purposes.