Revisiting "Avoiding Shareholder Gain When Reduced-Basis Loan Is Repaid." (response to The Tax Advisor, p. 322, May 1992)
Paul, sole shareholder of S corporation New Leaf, loaned $60,000 to the corporation and received a $60,000 note bearing fair market interest. Thereafter, the basis of the note was reduced to $45,000 by a passthrough loss. Under the facts in the May Study, the reduction in debt basis occurred prior to 1983 and therefore debt basis would not be restored by subsequent corporate income inasmuch as Sec. 1367(b)(2))(B)permits increases in debt basis only for reductions occurring in tax years beginning after 1982.
Full repayment will result in income to the shareholder to the extent it exceeds his basis According to the IRS, even a partial repayment will result in income to the shareholder because each dollar of repayment must be allocated pro rata to income and basis. Under the facts as presented, a $45,000 repayment would be deemed to be made up of a $33,750 nontaxable return of basis and $11,250 of gain. 554
Various strategies for offsetting the assumed income were discussed in the May Study. One approach not discussed is a method for completely avoiding income or gain to the shareholder for a distribution of an amount equal to the face value of the note, even though such face value exceeds the basis to the shareholder.
If Paul contributes the note to New Leaf as a contribution to capital, the basis of his stock will be increased by his basis for the note. In all likelihood (since the corporation is able to repay the debt), it will have an accumulated adjustment account in such amount. Also, New Leaf may have no earnings and profits inasmuch as it is an S corporation. In either event, a distribution not in excess of the stock basis will be nontaxable to the shareholder and merely reduce the basis of his stock.
Sec. 108(e)(6)provides that, for purposes of determining income of a debtor from discharge of indebtedness, if a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, Sec. 118 will not apply, but the corporation will be treated as having satisfied the indebtedness with an amount of money equal to the shareholder's adjusted basis in the indebtedness. If such provision were applicable without exception or limitation, the contribution to capital of the note would result in income from discharge of indebtedness. However, Sec. 108(d)(7)(C)provides an exception to the general rule of Sec. 108(e)(6). A shareholder's adjusted basis in indebtedness of an S corporation will be determined without regard to any adjustments made under Sec. 1367(b)(2), which contains the provisions for adjustments to the basis of indebtedness. Therefore, the corporation will have no income from discharge of indebtedness. In addition, if an unrelated distribution is made, the shareholder is able to receive a nontaxable distribution of all or even a portion of the amount previously evidenced by the debt to the extent of his full enhanced basis for the stock. Although the form of the transaction should be respected (and the IRS National Office has informally indicated it would respect the form selected by the taxpayer), it would be prudent to arrange the timing and amount of distributions so as to avoid any attempt by the Service to treat the contribution and distributions as a "step transaction" and mere repayment of debt.
If Paul contributes the note to New Leaf as a contribution to capital, he should be able to completely avoid any income or gain.