Only Bona Fide Shareholder Loans Can Create S Corp Basis

Posted on Wednesday, July 11, 2012

The IRS has issued new regulations that address when S Corp shareholders may increase their adjusted basis because of "indebtedness" of the S corp to them.  The shareholder may increase the adjusted basis only if the indebtedness is bona fide.  The new rules that elaborate on this basis principle are intended to assist S corp shareholders in determining whether their arrangement with the S corp creates basis of indebtedness.  They are also intended to reign in some otherwise legitimate tax strategies.  Although these new rules have been issued as proposed regulations that will not formally apply until, on, or after the date the regs are finalized, it is clear that the rules generally represent the IRS's current position and should be ignored only at an S corporation owner's risk.

Background

Code Sec. 1366(d)(1) generally provides that the aggregate amount of losses and deductions that a shareholder has taken into account for any tax year cannot exceed the sum of that shareholder's adjusted basis in stock and adjusted basis of any indebtedness of the S corp to that shareholder.  The IRS explained that the Tax Code does not define "basis of indebtedness."  However, courts have interpreted Code Sec. 1366 to mean that an investment in the S corp that constitutes an actual economic outlay by the shareholder creates basis of indebtedness.  According to the IRS, these cases have generated disputes over when a back-to-back loan gives rise to an actual economic outlay.  The proposed regs require that loan transactions represent bona fide indebtedness of the S corp to the shareholder to increase basis in indebtedness.  As a bit of good news in otherwise more demanding rules, however, the new rules provide that an S corporation shareholder need not otherwise satisfy the "actual economic outlay" doctrine for these purposes.

Proposed regs

Although the IRS expressly did not provide a different standard for what constitutes bona fide indebtedness under Code Sec. 1366, general federal tax principles and facts and circumstances determine whether indebtedness is bona fide.  The regs do state, however, that an S corp shareholder that merely acts as a guarantor or in a similar capacity has not created basis of indebtedness unless the shareholder actually made a payment. In such cases, basis is limited to the extent of the payment.

The IRS explained that an S corp shareholder may attempt to obtain basis of indebtedness by borrowing from another person, such as a related entity, and subsequently lending the proceeds to the S corp (a back-to-back loan transaction).  Alternatively, an S corp shareholder may seek to restructure an existing loan of the S corp as a back-to-back loan by assuming the S corp's liability on the loan and creating a commensurate obligation from the S corp to the shareholder.  According to the IRS, the shareholder can obtain basis only if there is bona fide debt of the S corp that runs directly to the shareholder.

Some S corp shareholders have used what is called the "incorporated pocketbook" theory to claim an increase in basis of indebtedness in circumstances that involve a loan directly to the S corp from an entity related to the S corp shareholder.  The arrangement involves an S corp shareholder that claims that a transfer from the related entity directly to the shareholder's S corp was made on the shareholder's behalf and was, in substance, a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corp.  The new regs clarify that an incorporated pocketbook transaction may increase basis of indebtedness only where the transaction creates a bona fide creditor-debtor relationship between the shareholder and the borrowing S corp.

Posted in Tax And Accounting Topics For Business

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