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IRS final regs limit S corporation open account debt

October 21, 2008

The Treasury last week issued the long-awaited, or long-dreaded, final regulations (TD 9428) on advances to S corporations by their shareholders. While the final regs are less severe than their original proposal, they still promise plenty of unhappy surprises to S corporation owners. To understand why, let's review how debt enables S corp owners to deduct corporate losses.

S corporations generally pay no income tax on their own income. Instead, income and loss items pass through to the owners' 1040s. If the S corporation has losses, they might be deductible on the owners' returns if the owner has basis in their stock of the S corporation or in loans they have made to the S corporation. If there is no basis, the loss carries over until there is new basis.

Basis in stock starts with your purchase price; your basis increases by your share of S corp income and by contributions to corporation. It goes down by losses and by distributions.

If you have no basis in your stock, losses then reduce your basis in any loans made to the S corporation; corporate income restores debt basis before it restores stock basis.

This creates obvious tax planning opportunities for making big loans on December 31 of year 1 to give you basis to take losses, taking the money back on January 3, year 2, and then putting it back as needed the following December. The owners of Brooks AG, an Alabama S corporation, did this to the tune of hundreds of thousands of dollars, and the Tax Court upheld their deductions. The new regs are the overkill response.

If you have separate written loan instruments, the tax law tracks their basis separately. If the Brooks AG owners had written loans, they would have had income when they repaid the loan in year 2. If you have open account debt without a written debt instrument, like they actually did have, only the year-end balances matter.

The new regs place a $25,000 limit on the amount of year-end open account debt; it the year-end balance exceeds $25,000, it is considered a written loan, rather than open account debt, and future advances are considered a new loan.

EXAMPLE: Joe owns all of Joe Inc., an S corporation. He is out of stock basis at the end of 2008, so he loans the company $30,000 at the end of 2008 to to enable him to deduct $25,000 of corporate losses on his 1040. That leaves him a $5,000 basis is his open account loan.

In January 2009, a customer pays an overdue bill, enabling Joe to pay back his $30,000 advance. The company breaks even in 2009, and Joe loans the $30,000 back on open account in December 2009.

Unfortunately for Joe, he has $25,000 gain on the repayment in January; because the corporation had no taxable income, Joe's basis wasn't restored before repayment. The year-end advance is considered a different loan. Under the old rules, the 2009 repayment would not have triggered 2009 income if the loan were renewed by the end of 2009; this trick could still work, however, if the open account debt did not exceed $25,000.

So what should S corporation owners do now? The new regs apply to loans made starting this week. Loans outstanding over $25,000 at October 19 are not affected, but any new advances will not be part of their old loans, even if they are "topping off" a prior balance.

If you own all of an S corporation, the obvious route is to make contributions to capital, rather than loans. The advantages of having a loan, rather than equity, for a 100% owner are usually more theoretical than real. Just be sure that your accounting records reflect the contributions as capital, rather than debt, and any withdrawals as distributions, rather than loan repayments; also be sure that your corporate minutes note the capital contributions and distributions. As stock basis generally only is measured at year-end, this is a much more forgiving way to fund corporate losses.

If the S corporation has multiple owners, capital contributions may be hard to work, as they need to be pro-rata to ownership. Loans don't have to be pro-rata, but they're much more likely to trigger income.

The bottom line: if you need to loan over $25,000 to finance your S corporation losses at year end, be prepared to leave the funds in until future income restores your basis in the loan; otherwise, the new rules are likely to leave you with some unwanted taxable income when you repay the loan.

Remember: basis is only the first limit that applies to losses. You also have to get by the at-risk rules and the passive loss rules.

Related: IRS LOOKS TO TIGHTEN RULES ON S CORPORATION ADVANCES

Tags: basis.S corporations.

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