Advances to S Corporations

Shareholders who lend money to an S corporation can deduct losses in excess of the stock basis. Recently the Tax Court considered how to compute the amount of deductible loss and the effect of a debt repayment.

Fleming S. Brooks owned 51% and Fleming G. Brooks owned 49% of the stock of Brooks AG Company Inc., an S corporation. After the shareholders deducted their losses, their stock basis was zero. Between 1997 and 2000 each of them advanced the corporation $500,000 (1997), $800,000 (December 31, 1999), and $1.1 million (December 29, 2000). On January 5, 1999, they each received $500,000 from the corporation; on January 3, 2000, each received $800,000. The corporation generated losses both years. The taxpayers argued that debt basis is determined at the end of each year; thus, they could deduct the losses and treat the repayments as nontaxable. The IRS disagreed.

Result. For the taxpayers. There are two tax rules that could apply. Under section 1367, S corporation shareholders can deduct losses up to the amount of their stock basis (with a corresponding reduction in basis). When the stock basis is reduced to zero, shareholders can deduct losses equaling their loans to the corporation with a corresponding basis reduction. Future profits fully restore the debt basis and then increase the stock basis.

Normally the repayment of a loan is tax-free. However, under section 1001, if the repayment exceeds the creditor’s basis in the loan, the taxpayer must report income. Thus, a shareholder has income if a loan to an S corporation is repaid before basis is restored. The court had to determine whether the basis determination occurred at repayment or at the end of the year. The IRS argued it was at repayment; the taxpayers argued it was at the end of the year.

The IRS relied on Cornelius v. Commissioner , which held that advances to an S corporation which were separate, closed transactions must be accounted for separately. The taxpayers argued that all the advances were a single, open account measured at yearend. Although relying on Cornelius, the IRS did not argue the advances were separate transactions. The Tax Court agreed with the taxpayers.

The case does not explain why the IRS did not argue separate advances or what is necessary to prove one open account. Taxpayers in similar circumstances will need to be prepared: It would be helpful if the accounting records and all documentation referred to such transactions as being part of a single, open account.

Even if a taxpayer succeeds in making an argument for a single, open account, he or she needs to pay attention to timing. If the advances occur at the end of the year and the repayment occurs shortly after the start of the next year, the IRS may argue the advance is a sham to generate a tax loss and disregard the entire transaction.

Fleming G. Brooks v. Commissioner , TC Memo 2005-204.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.