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Using S losses to generate future capital gains - planning opportunities available for shareholders with capital losses.

It is not uncommon for an S shareholder with zero stock basis to loan money to the S corporation to use either current year or suspended losses. The debt basis is reduced by the used losses, resulting in "reduced-basis" debt. If the reduced-basis debt is repaid before its basis is restored by future S income, the shareholder recognizes income on otherwise tax-free principal repayments (usually an unfavorable result). But what may be surprising to some - and may present at least one planning opportunity - is that this income is considered capital in nature as long as the debt is evidenced by a note and is a capital asset in the shareholder's hands. (Note: The following discussion does not deal with any interest income paid on the note, which is always ordinary income.)

The use and benefit of current S losses at the cost of incurring a future year capital gain from the debt repayment may nevertheless result in a benefit to the shareholder, by allowing the use of capital losses he would not otherwise be using in the foreseeable future (besides the allowable $3,000 a year deduction). In effect, the shareholder can trade capital losses (i.e., by offsetting debt repayment capital gain) for the acceleration of S losses. And the shareholder can structure the loan to be made at or near year-end, with repayment early in the subsequent year, resulting in minimal economic loan costs to the shareholder (the shareholder can use his own cash or borrow the funds to loan to the S corporation for a short period of time). In any event, any loan costs may be partially or completely offset by interest income on the loan from the S corporation. Caution: It is necessary to "run the numbers" to determine the benefits and costs of using this strategy before entering into this type of transaction.

Capital gain treatment from

repayment of debt evidenced

by a note

Rev. Rul. 64-162 provided that if a shareholder-creditor has reduced-basis debt from the use of S losses and deductions, the retirement of the debt is considered to be an amount received in exchange for a capital asset when a note was issued to the shareholder-creditor and such note is a capital asset in the shareholder's hands. (See also Letter Ruling (TAM) 9304004, which follows Rev. Rul. 64-162 in its conclusion.) Installments received in retirement of the note must be allocated in part to a return of the shareholder's basis in the loan and in part to income capital gain income if a capital asset).

Ordinary gain treatment

from repayment

of "open account" debt

Rev. Rul. 68-537 provided that a shareholder-creditor of an S corporation derives ordinary income from the repayment of reduced-basis "open account" debt; open account debt is, not evidenced by a note and therefore the repayment is not considered an exchange of a capital asset. However, open account debt should qualify for capital gain treatment if the shareholder obtains a note from the S corporation.

Tax ramifications and planning

for shareholder loan

and repayment

The results from currently using S losses by a shareholder loan and subsequent year repayment for the shareholder with other capital losses are:

* A current ordinary tax deduction for the S losses (current or suspended).

* A subsequent year capital gain offset by the shareholder's capital losses - no tax cost (assuming sufficient capital losses).

* If structured properly, the shareholder is only "out" cash from the loan for a short period of time, resulting in little or no economic loan costs to the shareholder (after taking loan interest income into account).

If there is an actual net increase (or expected net increase) in basis items during the year the loan is to be repaid, careful planning to sustain the capital gain on shareholder reduced - basis debt repayment may be necessary; otherwise, the shareholder may end up with restored debt basis and no debt repayment income capital gain), which might be an undesired result. (See basis restoration rules under recently issued Sec. 1367 final regulations.)

Example 1: S corporation S incurred an ordinary trade or business loss of $100,000 in 1993; 1994 net income is expected to be breakeven and 1995 net income is expected to be $100,000. The sole shareholder, T, had zero stock basis in 1993 and loaned $100,000 to S late in 1993 to use S's loss against other ordinary income. T also has a capital loss carryover from a prior year of $150,000, which he does not expect to use in 1994 or in the foreseeable future. The 1993 shareholder loan is completely repaid early in 1994 so T is "out" the cash for only a short period of time.

The result: a 1993 ordinary loss deduction of $100,000 with a corresponding reduction in T's loan basis to zero. The 1994 loan repayment therefore results in a $100,000 capital gain, which is completely offset by the capital loss carryforward with no resulting tax. The 1995 net income of $100,000 is taxed to T and also increases his stock basis by a like amount. Without the shareholder loan the 1993 loss would have been suspended and would offset the net income in 1995, resulting in no taxable net income in 1995, no increase to the stock basis and a capital loss carryforward.

The example illustrates how the short-term shareholder loan accelerated the use of the 1993 loss at no tax cost to the shareholder from its repayment. The shareholder effectively traded his capital losses for the acceleration of the S losses. Also, S income has increased stock basis instead of restoring debt basis.

In contrast, Example 2 illustrates when such a transaction may not produce any benefit to the shareholder.

Example 2: Assume the same facts as in Example 1, except that T does not have a capital loss carryover and the loan is outstanding for more than one year before its repayment in 1994. The 1994 capital gain from the loan repayment is fully taxable at the lesser of T's maximum tax rate or 28% long-term capital gain rate.

Although it may first appear that the shareholder may enjoy a rate benefit between the maximum ordinary rate of 39.6% from the 1993 losses and the long-term capital gain rate of 28% from the 1994 debt repayment, this rate "benefit" is effectively eliminated, because the S corporation's 1995 net income is fully taxable to the shareholder. In other words, over the period 1993 through 1995, the shareholder paid an additional capital gain tax (even if only at 28%) from the debt repayment that would not have been paid if the loan was never made. It would be advisable in this situation to repay the debt in 1995 after its basis is completely restored, resulting in no debt repayment income while still enjoying the acceleration of the 1993 ordinary loss deduction.

When structuring a shareholder loan, allow flexibility in timing its repayment to a particular year to when it is most beneficial. Obviously, not repaying the reduced-basis debt or repayment after the debt basis is restored by S income in a subsequent year will avoid current income.

Caution: Both the S corporation's and each shareholder's particular facts and circumstances in the current year as well as in future years (to the extent possible) must be carefully analyzed to determine whether a shareholder loan and the repayment of reduced-basis debt is beneficial. Again, it is necessary to "run the numbers" of the benefits and costs (i.e., debt repayment income).

Note: In the absence of a capital loss, this technique should be considered only if there is a high degree of certainty that the S corporation will have no income for many years - an unlikely event.
COPYRIGHT 1994 American Institute of CPA's
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Article Details
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Author:Terry, Steve
Publication:The Tax Adviser
Date:Jul 1, 1994
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