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You can't restore S corporation loan basis with a capital contribution

December 18, 2008

S corporation shareholders can only deduct losses if they have basis in either:

-Their stock, or

-Loans they have made (not guaranteed!) to the S corporation.

A big part of year-end planning for S corporation shareholders is making sure they have some basis. When you have multiple shareholders, loans are often preferred because each shareholder can choose whether or not to make the loan without disrupting the ownership percentages.

The danger with loans is that the losses reduce the shareholder-lender's basis in the loan; if it is repaid before enough S corporation income is earned to restore the loan's basis, the lender has a taxable gain. This is especially a problem under the new regulations that restrict "open account" S corporation loans. This problem snared S corporation owners with income on $1,622,050 in loan payments yesterday in Tax Court.

The Taxpayers, brothers Sheldon and Ira Nathan, loaned the funds to their S corporations, enabling them to deduct losses. In a series of transactions, they made capital contributions of over $1.4 million to the corporations and repaid the loans. The IRS said they had ordinary income on the loan repayment. The taxpayers tried to convince the court to allow them to increase the loan basis by treating the capital contributions as income, but the judge didn't go for it (my emphasis; copious citations omitted):

By attempting to treat petitioners' capital contributions to G&D and W&N CAL as income to G&D and W&N CAL, petitioners in effect seek to undermine three cardinal and longstanding principles of the tax law: First, that a shareholder's contributions to the capital of a corporation increase the basis of the shareholder's stock in the corporation; second, that equity (i.e., a shareholder's contribution to the capital of a corporation) and debt (i.e., a shareholder's loan to the corporation) are distinguishable and are treated differently by both the Code and the courts; and third, that contributions to the capital of a corporation do not constitute income to the corporation.

As you go about S corporation year-end planning, a few things to keep in mind:

- If you are looking at a loss, determine whether you have enough basis to deduct it. You need to take into account any current year loans and distributions to date.

- If you are considering year-end loans or contributions to capital, remember that basis is necessary to deduct losses, but it isn't sufficient; your basis has to be "at-risk" and you have to clear the maze of the "passive loss" rules.

- If you make a year-end loan to the S corporation to take losses, remember that the loan needs to stay in place until S corporation income has restored your loan basis; otherwise you will trigger income when you repay the loan.

- If you have repaid a loan already and now are facing taxable income as a result, don't count on restoring your basis with another loan or a capital contribution.

- Be extremely careful in using funds from another wholly-owned entity to finance a loan to the S corporation; if you circle the funds back to where they started, the IRS may strike down the loan as lacking substance.

Cite: Nathel, 131 T.C. No. 17.

Link: Tax Update 2008 year-end tax planning posts.

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