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IRS LOOKS TO TIGHTEN RULES ON S CORPORATION ADVANCES

May 08, 2007

Back in 2005 we noted an unusual Tax Court case. The owners of Brooks AG Company had made year-end advances to their S corporation in 1999 to enable them to take losses, withdrew the cash shortly after year-end, and then loaned the funds back to the company in December 2000 to enable them to take more losses.

The Tax Court, to our surprise, said this worked. They said only the debt balances at year-end mattered, and the withdrawal of funds during the year didn't cause trouble.

The IRS so disliked this result that it has proposed new regulations that would undo the result. They came out April 12, and are open for comment until July 11 at www.regulations.gov.

BACKGROUND

When a corporation elects to be an S corporation, it generally is no longer a taxable entity; its taxable income and loss henceforth hits the returns of the owners.

If the S corporation has a loss, owners can deduct the losses on their reutrns, but only to the extent of their basis in S corporation stock and in loans they have made to the S corporation. S corporation losses first reduce the shareholders basis in his stock, and then in his debt. Future earnings restore the basis in the debt, and then increase stock basis.

If a shareholder loan is repaid before its basis is restored, the payment triggers income. The Tax Court in Brooks said that all cash advances are one loan, and only the balances at year-end matter in determining whether there is gain.

When S corporation shareholder loans are evidenced by notes -- in contrast to open account advances -- their basis is separately tracked. If one note is paid off during the year and another is created before year-end, the results can differ from open account debt. The basis of a note that is paid off in March can't be restored by another made in December.

WHAT THE PROPOSED REGULATIONS SAY

The proposed regulations would split open account debt into multiple loans if the balance of open account debt exceeded $10,000 during the year. The open account debt on the books would be treated as a loan under a note at the time it went over $10,000, and any additional advances would be treated as a separate loan.

HOW THAT WOULD WORK

If these rules had applied in the Brooks AG case, the results would have been dramatically different. Instead of having one loan with balances measured at the end of each year, there would have been two loans - an $800,000 loan paid off in 2000 and a $1,100,000 made at the end of 2000.

The results are compared below side-by-side.

Analysis of debt in Brooks AG case as issued and under proposed regulations:

(Click for enlarged chart)

Under the proposed rules, the Brooks AG shareholders would have deducted all of their losses, but they would have also had a $441,293 gain on the repayment of the "deemed" separate debt paid off during 2000 - in effect, recapturing the 1999 loss that the 1999 year-end loan enabled them to take.

If this rule goes through, and I think it will, S corporation shareholders will need to take even more care in deducting losses using year-end loans.

And remember: basis is only the first hurdle for S corporation shareholders to cross in deducting their losses. They also need to get by the "at-risk rules" and the "passive loss" rules.

Links:

Brooks v. Commissioner, T.C. Memo 2005-204

YEAR-END PLANNING FOR S CORPORATIONS: BEWARE OF BASIS!

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