09 Jul 2012 Proposed Regulations Broaden the S Corporation “Debt Basis” Definition
In June 2012 the IRS issued REG-134042-07, containing proposed regulations that would clarify the basis of indebtedness of S corporations to their shareholders. The proposed regulations would allow some taxpayers to take greater deductions on the losses of debt-financed S corporations.
When a shareholder loans money to her S corporation, she must track both stock basis and debt basis in venture. Stock basis is required to calculate taxability on a distribution. Debt basis is required to calculate how much of an S corporation’s passthrough losses a shareholder may utilize as tax deductions.
When an S corporation-borrower passes a loss to its shareholder-lender and the shareholder seeks to deduct the loss, the shareholder must decrease her stock basis to match the deduction. Once her stock basis has reached zero, the shareholder must begin decreasing her debt basis in the same manner. Once debt basis has reached zero, the shareholder can utilize no more of the S corporation’s passthrough losses. Internal Revenue Code (“IRC”) §1366(d)(1); Treas. Reg. §1.1366-2(a)(1). (The shareholder must satisfy the usual at-risk limitation and passive activity loss limitation before utilizing the deduction.) Shareholders generally attempt to maintain high debt bases and thus utilize more losses.
Debt basis is created when a shareholder lends money to an S corporation, and is reduced as the S corporation passes losses through to its shareholder or repays the debt. If the S corporation repays the note when the debt basis is zero, the shareholder will recognize gain on the full amount of the repayment. If the shareholder’s debt basis had only decreased by 50% when repayment occurs, then 50% of the repayment would be treated as taxable income, and so on.
Unlike partnership principles, see IRC §704, under current S corporation rules shareholders do not receive basis for debts owed by the S corporation to third parties; the S corporation’s debt must be a direct loan from the shareholder or the result of some arrangement whereby the shareholder has become “poorer in a material sense.” Bergman v. U.S., 174 F.3d 928, 932 (8th Cir. 1999) (citing Perry v. Comr, 54 T.C. 1293, 1295–96 (1970)); see generally Treas. Reg. §1.1366-1–2. Personal guarantees and co-borrowing structures do not generate debt basis. However, debt basis is generally created when a shareholder borrows money and re-lends it to the corporation.
The proposed IRC §1366 regulations generally broaden the definition of debt basis by stating that “in order to increase a shareholder’s basis of indebtedness, a loan must represent bona fide indebtedness of the S corporation that runs directly to the shareholder.” The proposed regulations inform three scenarios:
- Scenario 1: A shareholder guarantees the S corporation’s obligation to a third party.
- Result: Debt basis is not created.
- Scenario 2: A shareholder makes a payment on the S corporation’s obligation to a third party.
- Result: Debt basis is created.
- Scenario 3: A shareholder owns two entities, one of which has loaned money to the other. The borrower is an S corporation. The related party distributes or otherwise transfers the promissory note to its shareholder.
- Result: Debt basis is created if the transaction results in a “bona fide indebtedness” (a facts and circumstances standard well established outside IRC §1366) between the S corporation and its shareholder.
The proposed regulations would likely reduce litigation by clarifying the types of non-direct-lending scenarios which may generate debt basis. The proposed regulations reaffirm Congress’s intent “to limit the loss that a shareholder takes into account to that shareholder’s investment in the corporation” while reducing barriers to the free movement of assets between ventures and aiding taxpayers by broadening the definition of debt basis.
IRS REG-134042-07 is open for comment until September 10, 2012.
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