t is not uncommon for S corporation shareholders to make cash advances to the corporation during years when the company’s operating results are unfavorable or cash is tight. In return shareholders get an increase in their basis that they can use to deduct additional flow-through losses. It’s also not unusual for the corporation to repay these advances when operating results are more favorable. Unfortunately, however, if the parties treat the advance as debt and the shareholder uses the debt basis to absorb flow-through losses, any loan repayment may subject the shareholder to capital gain, or worse, ordinary income. With careful planning, CPAs can help clients avoid an unnecessary tax when an S corporation repays shareholder loans.
The groundwork for adjustments to shareholder basis is found in IRC section 1367. The tax code uses shareholder basis in an S corporation to determine the deductibility of flow-through losses, the tax consequences of corporate distributions and gain on the sale of the stock. As in C corporations, initial stock basis is determined by looking at the amount of cash and the adjusted basis of the property the shareholder contributed in exchange for the stock, increased by any gain he or she recognized on the transfer and decreased (but not below zero) by any money or other property he or she received (boot). Unlike the rules for C corporations, though, the basis rules for S corporations provide that shareholders must adjust their basis each year for the flow-through items of income, losses and deductions.
When computing stock basis, CPAs first must increase it by separately stated income, nonseparately computed income and the excess of the deductions for depletion over the basis of the property subject to depletion. They need to consider taxable as well as tax-exempt items, such as tax-exempt interest and life insurance proceeds, which will increase basis. They then must reduce the basis for distributions by the corporation that are not includible in the shareholder’s income by reason of IRC section 1368 (distributions not taxable as dividends as a result of earnings and profits), for separately stated loss and deduction items, for nonseparately computed loss and for any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account (permanent differences).
Basis is further reduced by the amount of the shareholder’s deduction for depletion for any oil and gas property the S corporation holds, to the extent such deduction does not exceed the proportionate share of the adjusted basis of such property allocated to the shareholder under IRC section 613A(c)(11)(B). CPAs should apply the increases and decreases in basis in the order given above, as provided in Treasury regulations section 1.1367-1(f).
In addition to stock basis, taxpayers can use debt basis under IRC section 1367 to take flow-through loss deductions after their stock basis has been fully depleted. Like stock basis, debt basis cannot go below zero. CPAs can determine a shareholder’s debt basis by the face amount of the loan the shareholder makes to the corporation. Increases and decreases to debt basis are similar to adjustments to stock basis, except debt basis is not reduced for distributions not includible in income by reason of section 1368. However, since stock basis must be reduced to zero before debt basis is available, any distributions in excess of stock basis would be includible in the shareholder’s income as capital gains. As the corporation repays the debt, the debt basis decreases. If flow-through losses have depleted stock basis, subsequent basis increases first must restore debt basis.
Shareholders run into problems when they have reduced or depleted their debt basis and the corporation repays any part of a shareholder loan. When the company repays a loan where the shareholder’s debt basis is less than the face value of the loan, the shareholder must take a portion of the repayment into income. Revenue ruling 64-162 calculates the income by dividing the reduction in basis by the face value and multiplying the quotient by the repayment amount.
Example. In 2001 shareholder A, a 100% shareholder, made a loan of $100 to Widget Corp. During the year the corporation had net loss items of $60. Shareholder A had zero stock basis at the beginning of 2001. He was able to deduct the $60 loss by reducing his debt basis. Thus, at the beginning of 2002, shareholder A had a zero stock basis and a $40 debt basis. During 2002 Widget Corp. had $20 in income items and decided to repay shareholder A $10. The amount of income he recognized from the repayment was $4 (($40/$100)($10)). His debt basis was reduced by the $60 from 2001 and restored by the $20 from 2002, leaving a debt basis of $60 ($40 less than face value) at the time of repayment.
Whether shareholders recognize ordinary or capital gain income depends on the nature of the loans in their hands. IRC section 1271(a)(1) provides that retirement of debt instruments are exchanges. Thus, if a loan is evidenced by a note, the income portion of the repayment is considered capital because the note is considered capital in the shareholder’s hands. If the loan is an “open account,” or a loan not evidenced by a note, the income portion of the repayment is ordinary income.
In the above example the shareholder recognizes $20 ordinary income from operations and either $4 of capital gain or ordinary income, depending on the nature of the debt. However, with careful planning CPAs can help the shareholder avoid recognizing gain on repayment. Where the shareholder is a 100% owner, logically any advances should be capital contributions rather than debt. Substituting capital for debt completely eliminates any possibility of the distribution’s creating income, provided the distribution does not exceed stock basis. Distributions in excess of stock basis trigger capital gain recognition.
In the case of multiple shareholders, CPAs should recommend ratable capital contributions rather than debt. In the event a shareholder has a note outstanding in which the debt basis has been used to absorb losses, the S corporation may defer any repayments until the debt basis has been restored to face value through income items.
In addition, when restoring debt basis, Treasury regulations section 1.1367-2(c)(1) provides for a “net increase” of the adjustment items rather than following the ordering rules required when adjusting stock basis. This means that if the corporation has earnings and distributions up to the amount of earnings during the year there is no net increase in adjustment items. Thus, the earnings will increase stock basis rather than debt basis and the distribution will be tax-free.
Example. Shareholder B is the 100% shareholder of Zanziber Corp., an S corporation. Due to prior years’ losses, at the beginning of the tax year, she has a zero stock basis. In addition she had made a $20,000 loan to Zanziber Corp. in prior years that subsequently has been reduced to zero basis. During the current year, Zanziber incurs $10,000 in income items and distributes $6,000 to shareholder B. Under Treasury regulations section 1.1367-2(c)(1), the $10,000 income item is netted with the $6,000 distribution, resulting in a net increase of $4,000, which will increase debt basis.
CPAs should note the regulations allow a $6,000 increase in stock basis (the amount of the distribution) and an immediate decrease of $6,000 (due to the distribution), leaving $4,000 to increase debt basis under the basis restoration rules mentioned previously. Had the corporation repaid $6,000 and correspondingly reduced its note payable to the shareholder rather than distribute $6,000, shareholder B would have recognized a gain on the repayment due to the debt basis’ being less than face value.
In the above example the substance and economic reality of the matter, whether a distribution or a payment on a note, are identical. The result is the shareholder receives a portion of the money she put at risk. Whether the process creates a tax liability depends on the mechanics of transferring the money to the shareholder and how the transfer affects the accounts of the flow-through entity.
In many instances shareholder advances would be more wisely characterized as capital contributions than debt. The corporation can record the additional capital contribution on its books as additional paid-in capital. This does not necessarily mean the company needs to issue additional shares of stock. Where the use of a capital contribution is not practical, shareholders should closely track debt basis and avoid repayments until debt basis has been fully restored. Whether a capital injection is recognized as a capital contribution or debt, it usually is highly likely an unnecessary tax can be avoided.
BRIAN K. HOWELL, CPA, is a tax manager of KPMG in Kansas City, Missouri. His e-mail address is firstname.lastname@example.org .