Practitioners routinely face the challenge of helping S corporation shareholders increase their basis for purposes of deducting pass-through losses under IRC § 1366(d)(1). Often, planning to increase basis will result in shareholders making loans to the S corporation at year-end. In situations involving shareholder loans to S corporations facilitated by borrowings from a related entity, such as back-to-back and circular loans, the Tax Court continues to require that shareholders make an “economic outlay” to acquire basis.
Under the economic outlay doctrine, to obtain basis in a loan to an S corporation, a shareholder must make an actual economic outlay, the outlay must somehow leave the shareholder poorer in a material sense, and the debt created must run directly between the shareholder and the S corporation. Therefore, practitioners need to exercise care in the construction of shareholder loans to S corporations to provide the best opportunity for increasing basis for deduction of losses.
Practitioners advising on proper methods to use for shareholders to acquire basis in loans made to S corporations incurring losses should bear in mind several key issues:
- Identify S corporations with basis limitation issues as soon as possible to emphasize to shareholders the importance of structuring S corporation loans as coming directly from shareholders and to minimize last-minute recharacterization of advances from related entities as back-to-back loans from shareholders.
- Properly document, through interest-bearing promissory notes and contemporaneous corporate minutes, shareholder loans to S corporations. Have shareholders report interest income from these loans and interest expense on money borrowed to make loans to S corporations.
- If the source of shareholder funds for S corporation loans is a commonly controlled pass-through entity, consider taking the funds as a distribution from the entity rather than as a loan from the entity. While back-to-back loans have stood up in a few court decisions (such as in Ruckriegel, TC Memo 2006-78), they certainly draw greater attention from the IRS.
- For back-to-back loans, have all payments to make and repay loans go to and from the S corporation and shareholder, not directly to or from the S corporation and the related entity.
- Circular loans are risky. As Kerzner (TC Memo 2009-76) demonstrates, if funds for the shareholder loan to the S corporation begin and end with the same entity, the shareholder will not likely be considered to have made an economic outlay, which is essential for acquiring basis in a shareholder loan to the S corporation.
For a detailed discussion of the issues in this area, see “S Corp. Shareholder Basis for Circular or Certain Back-to-Back Loans,” by Carl Dolson, CPA, and James Sansone, CPA, in the April 2010 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also look for articles on the following subjects in the April 2010 issue of The Tax Adviser:
- What practitioners need to know about the accuracy-related penalty.
- Recent state and local corporate tax developments.
- A look at IRS strategies in R&D credit cases.
The Tax Adviser is the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year. Call 800-513-3037 or e-mail firstname.lastname@example.org for a subscription to the magazine or to become a member of the Tax Section.