Using capital contributions and debt to increase the loss basis of S shareholders.
This article will discuss the requirements that must be met for shareholder capital contributions and loans to create tax basis; cover the proposed regulations as they pertain to adjustments to the basis of S corporation indebtedness to its shareholder; and delve into the very important and all too often neglected interaction between the Sec. 465 "at risk" rules and shareholder's basis in capital contributions and loans.
The Impact of Loans on Shareholder Basis
When a shareholder makes a direct loan to his S corporation, the shareholder acquires additional basis in his investment in the corporation that can be used to offset losses that flow through to the shareholder's return. The initial basis of each loan is the face amount of the loan (subsequently decreased by principal payments). Basis in the loan is reduced by any net losses allocated to a shareholder in excess of his basis in the corporation's stock. If a shareholder has made more than one loan to a small business corporation, the basis reduction is applied to each loan in the same proportion that the basis of each loan bears to the aggregate bases of the total indebtedness owed to the shareholder by the corporation.(3) To the extent that such losses exceed both the shareholder's stock and debt basis, they can be carried forward indefinitely and used in a later tax year when stock or debt basis is increased.(4)
If an S shareholder has insufficient stock basis to absorb his share of anticipated corporate losses and cannot (or will not) make additional capital contributions, serious consideration should be given to making a loan to the corporation before the close of its tax year. The failure to consummate such a loan will reduce the present value of the tax benefit stemming from the loss and, in the worst case scenario, the loss would never be used by the shareholder.
Treatment of Loss Carryforwards
Loss carryforwards are available for use only by the shareholder who owned the stock during the time period the losses were actually incurred.(5) They are not transferable when ownership of the S stock changes. Thus, unused loss carryforwards will be lost when stock is sold, given away or transferred by reason of death.
If an S corporation revokes its s election, loss carry forwards that have not been used by shareholders because of basis limitations can be taken during a one-year post-termination period. Shareholders have an opportunity during this time to restore basis through capital contributions (but not through additional loans to the corporation).(6) Any loss carryover that remains at the end of a one-year post-termination period is permanently lost. This final opportunity to make use of unused loss carryforwards can be used only in a revocation of S status; it is not available in a transfer of stock ownership. Since a shareholder's ability to quickly increase basis may be far from assured, an affected shareholder may want to increase his debt basis instead, to the extent necessary, before an S election is revoked, so that all current and carryforward losses can be fully used.
Increasing Stock Basis
Shareholders can increase their basis in S stock by making additional cash transfers to the corporation. In addition, shareholders can transfer other property to an S corporation in exchange for stock, tax free under Sec. 351(a), provided that an 80% post-transfer control requirement is met.(7) In this case, basis increases only to the extent of the basis of the property transferred.
This control requirement will often present income recognition problems for minority shareholders who transfer appreciated property to a corporation. If the control requirement cannot be met, gain is recognized to the extent that the fair market value (FMV) of the stock received is greater than the basis of the property transferred to the corporation.
In addition, if a shareholder contributes property in a Sec. 351 transaction that is encumbered by a liability the corporation assumes or takes subject to, any increase in stock basis is limited to the shareholder's basis in the property, reduced by the amount of the liability assumed.(8)
Furthermore, there must be an actual contribution of cash or property before stock basis is increased. The IRS stated in Rev. Rul. 81-187(9) that a shareholder's contribution of his demand note will not increase stock basis. Since the shareholder incurrred no cost in executing the note, his basis in the note is zero. The service has also held in Rev. Rul. 80-236(10) that a cash contribution by a shareholder in exchange for stock, followed by the shareholder's securing of a nonrecourse loan of an equal amount from a third-party lender (using the stock as collateral), will not increase stock basis.
Shareholder efforts to recast their loan guarantees as direct loans to them, rather than to the corporation, followed by additional capital contributions on their part, have also been unsuccessful. The Tenth Circuit has held that the form of the transaction governed its tax ramifications and that since no actual economic outlay has occurred in this situation, no basis increase took place.(11)
Creating Debt Basis
In many situations, additional capital contributions may not be feasible or shareholder may have no desire to permanently commit additional resources to the corporation. Perhaps the 80% control requirement cannot be met (in the case of appreciated property), or the shareholder is not willing or able to make additional contributions. Establishing or increasing basis in debt may be the only way for an S shareholder to obtain a basis increase.
The most obvious way for a shareholder to create or increase debt basis is to loan additional cash directly to the S corporation. The debt can either be formalized by having the corporation issue a promissory note or it can be handled simply as an open account receivable.
However, in many cases, a lack of liquidity may make a direct cash transfer impossible. In this regard, a shareholder's mere guarantee of a corporate debt in and of itself does not create debt basis.(12) This result has held true even though loans were made primarily on the strength of a shareholder's personal financial net worth and, subsequently, the shareholder suffered substantial financial detriment because the guarantees forced him into personal bankruptcy.(13) However, a shareholder's subsequent payment of the indebtedness under the guarantee will produce a basis increase. Under the doctrine of subrogation, the payment made creates a direct indebtedness of the corporation to the shareholder.(14)
Until recently, the Service's position has been that payment under the guarantee is considered to have been made when the shareholder gives his personal note to the creditor in full satisfaction of the corporate liability even though no note payments are actually made until a subsequent tax year.(15) Insufficient corporate revenues to service the shareholder guaranteed debt are not a prerequisite to the shareholder obtaining a basis increase if he substitutes his personal note for the corporate obligation.(16) Thus, if a creditor will accept this arrangement, the shareholder, who may already bear the ultimate responsibility for the debt repayment, appears to have at his disposal a financially painless means of increasing his debt basis.
Unfortunately, the Service has more recently changed its position and the loan substitution approach has been judicially rejected. The Tax Court denied a taxpayer a basis increase when he substituted his personal note for corporate indebtedness, and held that a basis increase can be attained only if the shareholder makes a cash or property transfer to the corporation.(17) The Tax Court also recently held that the distribution of an S corporation debt obligation by a corporate creditor to its controlling shareholder, who was also a shareholder in the S corporation, did not give rise to debt basis for the shareholder, in spite of the shareholder's post-distribution creditor status.(18)
In light of the Service's present position of denying a basis increase if a shareholder's notes are subtituted for a corporate obligation, socalled back-to-back loans are a preferred vehicle for establishing debt basis. Under this approach, a shareholder borrows from the financial institution, loans the proceeds to the S corporation and has the corporation directly or indirectly pay off the debt obligation.(19)
The tax consequences of corporate repayment of shareholder debt depends on whether debt basis, previously used to absorb loss passthroughs, has been restored. Generally, debt basis is increased, but not above its face amount, by a shareholder's allocable portion of the corporation's net income for the tax year.(20) A shareholder's portion of net income is used first to fully reinstate the debt basis of any of the shareholder's loans outstanding at the beginning of the tax year (before it is used to increase stock basis).(21) According to the regulations, the basis increase is first applied to restore the prior basis reduction in any indebtedness that is repaid in whole or part during the tax year.(22) Any residual increase is used to restore the basis of any other outstanding shareholder loans in proportion to the amount that the basis of such loans has been reduced but not yet restored.(23)
Example1: X has made three loans to an S corporation in which he is a majority shareholder. The loans were made over a period of years in the amounts of $5,000, $8,000 and $7,000. X subsequently received the benefit of $10,000 of loss passthroughs, which he used to reduce other income. The loans have a tax basis of $2,500, $4,999 and $3,500, respectively. During the year, the S corporation repaid $4,000 of the first loan. At the end of the year, X's share of income from the S corporation was $8,000. This amount is first allocated to the loan that was partially repaid ($2,000).* The remaining $6,000 is allocated proportionately to the remaining loans, $375, $3,000 and $2,625, respectively.
*$2,000 = $4,000 loan repayment [divided by] $5,000 loan face amount X $2,500 (basis reduction of $5,000 - $2,500).
If a shareholder's debt basis has not been fully restored at the time of debt repayment, the shareholder will recognize income in an amount equal to the difference between the amount of the debt repayment and the loan's adjusted basis. If a loan is evidenced by the issuance of a corporate note, capital gain equal to the difference between the amount repaid and the basis of the note will result.(24) In the absence of a note, a shareholder must report ordinary income. Each repayment is prorated between its loan repayment portion and its gain portion.(25)
Example 2: Y loans $10,000 to his S corporation in order to take advantage of a $10,000 loss passthrough. The loan is evidenced by a note that bears interest. At the end of the next tax year, Y's pro rata share of income is $2,000 and the S corporation repays $4,000 of the loan plus interest of $600. The interest is taxable as ordinary investment income. The $2,000 basis in debt must be allocated over the entire $10,000 face amount of the note. Capital gain will be recognized in the amount of $3,200 ($4,000 - (4/10 X $2,000)).
However, there is no requirement that debt repayments made to a shareholder be allocated ratably to all shareholder loans that may be outstanding. Consequently, taxable income may be minimized in a given tax year by repaying those loans with the highest basis first.(26)
Example 3: Y has made several loans to his S corporation in order to take advantage of certain loss passthroughs. The loans and adjusted basis are $10,000 (adjusted basis, $2,000) and $5,000 (adjusted basis, $1,000). During the year he makes an additional loan of $20,000 to allow the S corporation to take advantage of an investment opportunity. In the next year the S corporation experiences good cash flow and repays $15,000 of the outstanding loans. The $15,000 can all be allocated to the $20,000 so that no gain need be recognized on the transaction.
Normally, it is advisable for a corporation to issue a note to its shareholder to document a loan so that any gain recognized on repayment will be capital in nature. The presence of a note with a stated market rate of interest and actual note repayments also serves as important evidence that the funds transferred by the shareholder were a valid loan. Otherwise, it is possible that the loan could be reclassified by the Service as a capital contribution and loan repayments treated as corporate distributions, taxable as dividend distributions.(27)
Application of the At-Risk Rules
Losses are allowed to be taken by an S shareholder only to the extent to which the shareholder is at risk with respect to his investment in the corporation.(28) A shareholder is considered at risk in an activity with respect to the amount of money he contributed and the adjusted basis of other property contributed to the activity by him, as well as certain amounts borrowed with respect to the activity.(29) The amount for which a shareholder is at risk is determined at the close of the tax year. Thus, the amount at risk may vary during the year, but only the amount at risk at the close of the year is determinative.
A shareholder is considered at risk with respect to amounts borrowed for use in an activity to the extent that the shareholder is personally liable for repayment of the loan. Even if the S corporation agrees to make regular payments to the shareholder in satisfaction of the shareholder's loan, and these payments exactly equal the shareholder's loan repayment schedule, the shareholder may still be at risk.(30) However, ultimately he must be liable for any borrowed amounts in the event of default by the corporation. In analyzing whether the shareholder is ultimately at risk, a worst case scenario rather than a realistic possibility test should be used.(31)
If a shareholder wishes to create additional basis by means of a direct loan, the shareholder can personally borrow the money for the loan using other assets as collateral. The transactions can be structured as back-to-back loans with similar payment schedules. Consequently, the shareholder will not have to personally repay his loan obligation, but instead can use the payments received from the corporation to meet his own loan obligation.
In providing collateral for a loan to an S corporation, shareholders must be careful not to use any corporate owned assets or the S corporation's stock. This may present them with a difficult problem to deal with, since frequently, entrepreneurs own few unencumbered assets other than their investment in a closely held business. To the extent stock in the S corporation or assets owned by the business are used as collateral, the shareholders' amount at risk is not increased.
Similarly, Rev. Rul. 85-113(32) illustrates that any loan for which a shareholder is personally liable will not increase his amount at risk if the loan can ultimately be satisfied by the S corporation's assets. In the ruling, investors had the option to assign to creditors a corporation's mineral rights in precious metals extracted from a mining operation in full payment of a note for which they were otherwise personally liable. The option to substitute property of the corporation in lieu of the shareholders' cash repayment caused the loans to be treated as not being at risk.
When property, other than stock in an S corporation and assets used in its business, is mortgaged as security for a loan, the shareholder will be at risk to the extent of the net FMV of his interest in the mortgaged property.(33) This would permit the use of a mortgage or second mortgage on property owned by the shareholder to obtain at-risk funds that could be loaned to an S corporation. However, care needs to be exercised when considering the option of obtaining a mortgage or second mortgage on a personal residence. The taxpayer's ability to service the mortgage in the face of adverse business conditions should be carefully weighed.
Substance Over Form
A substance over form test can also be applied by the Service to all financing arrangements to deny debt basis to S shareholders. Rev. Rul 80-236(34) illustrates a financing arrangement (in a pre-Sec. 465 setting) that did not provide basis in loans advanced by shareholders. Ten individuals formed a small business corporation, X, to carry on research and development (R&D). The individuals did not have sufficient capital to contribute or lend to the S corporation in order to provide sufficient basis to use losses generated by R&D costs. Each personally contributed $5,000 cash and arranged to borrow $25,000 from a financial institution in return for nonrecourse notes partially secured by the corporation's stock. As an inducement to make the loan, and as consideration for making it, Z, a corporation that was planning to purchase the R&D work, agreed to buy the nonrecourse notes from the financial institution for their face amount plus interest. The S corporation entered into a contract to provide R&D work to X for $300,000. The $300,000 was payable on execution of the contract. In reality, no one had use of the $300,000 because the funds were held by the financial institution as security for Z's promise to purchase the notes. These steps were all found to be part of a single transaction, the purpose of which was to create basis in order to use a net operating loss (NOL). The ruling illustrates that S shareholders who borrow funds and loan these funds to their corporation will not successfully increase their debt basis, even in the absence of Sec. 465 limitations, unless they actually put additional resources into the business.
In the current environment of economic uncertainty, shareholders of S corporations are increasingly faced with NOL passthroughs that they can use on their personal returns to the extent that they have sufficient basis. Careful planning is needed to assure that loans made by the shareholders to the corporation, for purposes of creating additional basis, meet not only the normal S corporation basis rules but the at-risk rules as well.
(1) Secs. 1366(d)(1)(A) and 469. The passive activity loss rules of Sec. 469, which can be an important consideration in determining whether losses can be used by shareholders, are beyond the scope of this article. (2) Sec. 1366(d)(1)(B) and Regs. Sec. 1.1367-2(b)(1). (3) Regs. Sec. 1.1367-2(b)(3). (4) Sec. 1366(d)(2). (5) Id. (6) Sec. 1366(d)(3)(B). (7) Sec.368(c). (8) Sec. 358(a) and (d). (9) Rev. Rul. 81-187, 1981-2 CB 167. (10) Rev. Rul. 80-236,1980-2 CB 240. (11) Homer z. Goatcher, 944 F2d 747 (10th Cir. 1991) (68 AFTR2d 91-5596, 91-2 USTC [paragraph] 50,450). (12) Arnold W. Shaver, Jr., TC Memo 1993-619. (13) See Est. of Daniel Leavitt, 90 TC 206 (1988), aff'd, 875 F2d 470 (4th Cir. 1989)(63AFTR2d 89-1437, 89-1 USTC [paragraph] 9332); and Lawrence R. Uri, 949 F2d 371 (10th Cir. 1991)(68 AFTR2d 91-5891, 91-2 USTC [paragraph] 50,556). But for a contrary view, see Edward M. Selfe, 778 F2d 769 (11th Cir. 1985)(57 AFTR2d 86-464, 86-1 USTC [paragraph] 9115) (case remanded to the district court to determine whether the substance of the transaction was a loan to a shareholder followed by a loan to the corporation). (14) Rev. Rul. 70-50, 1970-1 CB 178, as amplified by Rev. Rul.75-144, 1975-1 CB 277. (15) Id. (16) Donald S. Gilday, TC Memo1982-242. (17) William T. Ellis. TC memo 1988-280, aff'd, 937 F2d 602 (4th Cir. 1991), in an unpublished opinion. (18) Edward A. Wilson, TC Memo 1991-544. (19) Milton T. Raynor, 50 TC 762 (1968); and Michael A. Gurda, Jr., TC Memo 1987-394, in which in dicta the court indicated that the original back-to-back loans created basis. (20) Regs. Sec. 1.1367-2(c)(1). (21) Sec. 1367(b)(2)(B) and Prop. Regs. Sec. 1.1367-2(c)(1). (22) Regs. Sec. .1367-2(d)(1). (23) Regs. Sec. 1.1367-2(c)(2). (24) Joe M. Smith, 48 TC 872 (1967), aff'd in part and rev'd inpart, 424 F2d 219 (9th Cir. 1970)(25 AFTR2d 70-936, 70-1 USTC [paragraph]9327); and Rev. Rul. 64-162, 1964-1 (Part 1) CB 304. (25) Rev. Rul. 68-537, 1968-2 CB 372. (26) Bernard Barr, TC Memo 198-0-3; and Paul G. Cornelius, 494 F2d 465 (5th Cir. 1974)(33 AFTR 2d 74-1331, 74-USTC [paragraph]9446). (27) Irvin Goldfarb, TC Memo 1990-330. (28) Sec. 465(a)(1). (29) Sec. 465(b)(1). (30) George J. Emershaw, 949 F2d (6th Cir 1991) 68 AFTR2d 91-5849, 91-2 USTC [paragraph]50,551) aff'g TC Memo 1990-346. (31) Id. (32) Rev. Rul.85-113, 1985-2 CB 150, (33) Sec. 465(b)(2). (34) Rev. Rul. 80=236,1980 CB240.
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|Author:||Strobel, Caroline D.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1994|
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