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.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
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