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EITHER A BORROWER OR A LENDER BE - BUT NOT BOTH

May 15, 2006

One benefit of having an S corporation is the ability to deduct corporate losses on your personal return. S corporation income and loss aren't taxed on the corporate return; instead they pass to the owners' 1040s. In a startup business such losses can generate tax refunds and much needed cash.

Of course, the tax law restricts your ability to use S corporation losses. The most basic restriction is that you can only deduct losses to the extent of your basis in S corporation stock and your loans to the S corporation. But you have to be careful; if the IRS thinks you are playing games with your basis, they won't hesitate to call you on it.

Basis starts with what you pay for the S corporation stock. It is increased by your share of S corporation income and by any contributions you make to its capital. It's reduced by your share of losses and distributions.

WILL THE CIRCLE BE UNBROKEN? NOT IF IRS CAN HELP IT.

One strategy the IRS dislikes is "circular" arrangements, where taxpayers borrow money from one business they own, loan it to the S corporation to create basis, and then have the S corporation "loan" the money back to where it started. A new "Technical Advice Memorandum" shows how the IRS fights these deals.

A married couple owned a partnership and an S corporation; each spouse owned 50% of the partnership and the S corporation. The partnership loaned money to the S corporation, which was a tenant of the building owned by the partnership. The money loaned by the partners to the corporation returned to the partnership as rent payments.

There were some other facts that didn't help. These loans were made over a series of years, and all of them were made right before year-end - clearly with taxes in mind. Not all of the loans had a fixed interest rate, and only one partial principal payment - and no interest payments - were ever made. The IRS decided that there wasn't enough to these "loans" to recognize them as giving the owners basis to take losses:

As a result of the circular route of funds, the economic insignificance of the terms of the notes, the lack of repayment on the notes, and the limits imposed on the Taxpayers ultimate liability to [the partnership], it is clear that no actual economic outlay that left the Taxpayers poorer in the material sense occurred. Therefore, the loans... did not give rise to basis in indebtedness within the meaning of � 1366.

BUT WHAT IF THE YEAR IS CLOSED?

By the time the IRS found out about the circular cash flows, some of the years were closed by the three-year statute of limitations. The IRS couldn't recapture the taxes from those years, so it set up a "suspense account" arrangement. No additional losses for the S corporation will be allowed until the "excess" losses that shouldn't have been disallowed are made up, either by S corporation income or cash contributions.

THE MORAL? If you need basis in your S corporation and you don't have cash to contribute yourself, it's best to borrow from a third-party lender, like a bank. If you need to get the funds from a related entity, like another corporation or partnership, take the funds as a distribution, rather than a loan, and don't let the S corporation send the money right back to where it started.