Acquiring Basis in S Corp Shareholder Loans

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.

KEY ISSUES

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 taxsection@aicpa.org for a subscription to the magazine or to become a member of the Tax Section.