S shareholder's note payable and note receivable as two separate items.
The answer is an unequivocal maybe.
This situation is occasionally seen after a C corporation makes an S election. The scenario often develops as follows.
A C corporation shareholder withdraws funds from the corporation in the form of a loan. This is usually done to avoid or delay taxation of what would otherwise be wages or dividends. The C corporation then makes an S election. The S corporation suffers losses, and either requires capital or the shareholder needs additional basis to deduct losses on his Form 1040. The shareholder contributes funds to the corporation in the form of a loan.
The issue is whether to net the receivable against the payable or to leave them as two separate items on the balance sheet. If the amounts are netted against each other, the loan to the corporation is in effect treated as a repayment of the receivable from the shareholder. The shareholder's contribution of capital to the corporation will not result in additional basis against which the shareholder can deduct S losses on his Form 1040.
However, if the items remain segregated and are treated as two separate items on the balance sheet, the taxpayer may be able to claim the basis created by the shareholder loan to the corporation. This allows the shareholder to use flowthrough losses that would otherwise be in excess of basis.
There is very little guidance in this area, with the subject not addressed in the Code or the regulations. The answer must be found by looking at the law in other areas and then reasoning by analogy to arrive at the proper conclusion.
The IRS often takes the position that economic reality determines how an issue should be resolved. What "economic reality" is can be determined by looking at the treatment of debt with regard to a partner's basis in a partnership. In the partnership area, the regulations stipulate that regardless of what the books say, there is a valid debt if the partner faces a risk of loss, i.e., if the partner may be required to pay the liability.
When an S shareholder has both a receivable and a payable, the economic reality is that the shareholder can be forced to pay the debt owed to the S corporation while receiving nothing on the receivable. When there is both a payable and a receivable, the shareholder is put in the position of being both a debtor to and a creditor of the corporation.
If the S corporation was to go into bankruptcy, the shareholder is in the same position as any other creditor. At the same time, the receivable from the shareholder will be treated just like any other corporate asset. If the corporation does not have sufficient assets to pay its liabilities, the creditors--including the shareholder--will only receive a portion of the amount owed. It is also possible, if the remaining assets have been used as security for loans, that the shareholder (as a general unsecured creditor) will not receive anything at all. At the same time, the other creditors will either try to force the shareholder to pay the debt owed to the corporation or, alternatively, distribute the note receivable to one of the creditors (who will then try to collect on the note). Therefore, the economic reality is that the shareholder is faced with a risk of loss equal to the entire amount of the loan to the corporation.
This scenario makes a number of assumptions, most importantly that both the loan and the receivable are legally enforceable obligations. This brings into play state law issues (such as the statute of limitations for enforcing debt obligations). This situation also assumes that notes exist for all relevant loans. The issue of documentation is very important in numerous tax areas. It must be taken for granted that proper documentation would also be extremely important in this area. Also, proper authorization must exist for the corporation to create both the payable and the receivable. If there is only documentation to support making the loan to the shareholder, subsequent loans by the shareholder to the corporation might be looked on as nothing more than loan repayments to the corporation. If the company went bankrupt, the shareholder would certainly attempt to make exactly that argument.
It is important to note that taking an advance from an S corporation and then immediately lending it back to the corporation in order to generate a loan from the shareholder could easily be struck down by the IRS. The maneuver lacks a valid business purpose and would be attacked as nothing more than a tax-avoidance scheme. Also, a similar maneuver exists in the payment of expenses by a cash-basis taxpayer. A cashbasis taxpayer cannot borrow money from a creditor, immediately return the cash to the lender as payment for a previously owed business-related expense, and then claim a deduction for the payment of a business expense. The courts treat this transaction as if nothing at all occurred; the taxpayer personally is in the same position both before and after the transaction.
Also, to illustrate the requirement that the shareholder change position by giving up something when making a loan to a corporation, note the treatment given to the following situation. An S corporation owes money to a brother/sister corporation. The brother/sister corporation distributes the receivable from the S corporation to their mutual stockholder. Now the S corporation owes the debt to the shareholder. The courts have held that this has not created valid debt basis for taking flowthrough losses, since, throughout the entire transaction, the shareholder never gives up anything out of his own pocket.
However, all of these contrary examples can be distinguished from the issue at hand. When the shareholder receivable and payable are separately and legitimately created, the shareholder gives up an amount of money out of his own pocket. Therefore, the shareholder has changed his position because of the loan to the corporation. Also, if the receivable and payable are created for legitimate business purposes (i.e., other than tax avoidance), creating the two separate items is not open to attack for lacking a valid business purpose.
All of the preceding arguments support treating the two items as separate. However, due to the scarcity of influential authority, the Service may conclude differently. Also, tax advisers must consider what the results would be to a client if the two separate accounts were established and the corporations were subsequently to go into bankruptcy. Of course, competent legal advice would be required, especially if substantial dollar amounts are involved.
All that aside, however, an aggressive tax return preparer should definitely keep the concept in mind. More conservative preparers should consider that in light of the probable bankruptcy consequences, netting the receivable and the payable in order to arrive at the loan basis for deducting losses could actually be doing an injustice to the shareholder.