Tax & Business Insights

New Regulations for S Corporation Debt Basis

Volume 26 Issue 4 --July/August 2014

This summer, the IRS finalized updated regulations (“the Regulations”) on debt basis for S corporation shareholders. In some instances, the Regulations codify existing case law, but in at least one respect, the Regulations offer some new possibilities.

Shareholder debt basis is important if the losses have reduced the shareholder’s stock basis to zero. If so, debt basis can support additional loss deductions. While there are other rules that govern use and restoration of debt basis, this newsletter will focus on the creation of debt basis.

The Regulations confirm several existing rules, some of which have been developed in court decisions. To be included in debt basis, a loan must create bona fide indebtedness.

While the Regulations broadly incorporate general tax law principles to determine what constitutes bona fide debt, the Regulations offer no specific guidance on determining when debt is bona fide indebtedness. Fortunately, the Regulations are more specific in other areas.

First, the Regulations make clear that a shareholder’s guarantee of an S corporation’s debt does not create debt basis. Only when the shareholder actually makes payments under the guarantee is debt basis increased.

For example, suppose Biff is the sole shareholder of 2 S corporations — Biff’s Fine Furniture (BFF) and  Biff’s Auto Detailing (BAD). Suppose BAD borrows money from a bank and Biff personally guarantees the loan. That does not create debt basis for Biff in either BFF or BAD.

Second, to be included in debt basis, the loan must be owed directly by the S corporation to the shareholder. For example, if Biff caused BFF to make a loan to BAD, the loan would not count as debt basis for Biff. The debt obligation must run directly from BAD to Biff to be included in debt basis.

The Regulations permit BFF to distribute the BAD note to Biff and, if the debt were legally owed directly to Biff, it would still count.

The Regulations generally acknowledge the widely accepted treatment of back-to-back loans, where a shareholder borrows money from a third party and loans it to the S corporation. Assuming that this constitutes bona fide indebtedness, it will count as part of debt basis.

For example, if Biff borrows $50,000 from his own Bank and then loans that same amount to BAD, Biff’s debt basis in BAD is increased by $50,000.

One potentially significant change is that the  Regulations reject a doctrine developed in some court decisions that says only loans that involve  an actual capital outlay will be counted as part of debt basis. For example, suppose Biff borrowed money from BFF and then loaned that same amount to BAD. Under some court decisions, this might not count as debt basis because Biff has not made an actual outlay of capital. He merely loaned funds he received from a related source.

The Regulations reject that approach and provide that in such situations if the indebtedness from the S corporation to the shareholder is bona fide indebtedness under all the facts and circumstances, it counts as debt basis.

The Regulations apply to any transaction entered into after July 23, 2014, but shareholders may rely on the Regulations for earlier transactions provided the statute of limitations for the year of the transaction has not expired before July 23, 2014.

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