Proposed regs. on basis for S corporation shareholders from bona fide indebtedness

On June 11, the IRS issued proposed regulations on when an S corporation shareholder can increase his or her basis in the S corporation’s stock based on loans to the corporation (REG-134042-07).

S corporation shareholders, unlike partners, generally are not permitted to increase their basis by guaranteeing a loan made by a third party to the corporation until they have to make payments on the guarantee. They are also not allocated basis from their allocable share of the entity’s debt, as a partner is for the partnership’s debt. The proposed regulations provide that, to increase a shareholder’s basis in indebtedness, a loan must represent the S corporation’s “bona fide indebtedness” that runs directly to the shareholder. “Bona fide indebtedness” is not defined in the regulations; rather, general federal tax principles determine whether a debt is bona fide. A shareholder does not obtain basis of indebtedness in the S corporation merely by guaranteeing a loan or acting as a surety, accommodation party, or in any similar capacity relating to a loan, except to the extent the shareholder actually performs under the arrangement (REG-134042-07 preamble; Prop. Regs. Sec. 1.1366-2(iii), Example 2).

As for loans running directly to the shareholder, the proposed regulations address loans made under what the IRS calls the “incorporated pocketbook” theory, in which a shareholder claims that a loan to an S corporation from an entity related to the S corporation shareholder is, in substance, a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corporation. Under the proposed regulations, these types of transactions would increase basis only when there is a bona fide creditor/debtor relationship between the shareholder and the S corporation (REG-134042-07 preamble).

The proposed regulations do not address whether a shareholder’s contribution of his or her unsecured promissory note increases the shareholder’s stock basis, leaving unchanged the conclusion in published guidance and case law that it will not increase basis (see, e.g., Rev. Rul. 81-187). According to the IRS, a similar rule applies to partners who give unsecured promissory notes to their partnerships. The IRS requested comments on its proposal to allow S corporation shareholders to increase the basis in their stock when the S corporation disposes of a note contributed by the shareholder or the shareholder makes principal payments on the note.
 
Taxpayers may submit written or electronic comments on the regulations, and/or request to speak at the public hearing scheduled for Oct. 9 in Washington. Comments and requests to speak must be received by Sept. 10. The regulations would apply to loan transactions entered into on or after the final regulations are published in the Federal Register.