Regulations issued July 23, 2014 finalize certain treatment of the basis of indebtedness of S corporations to their shareholders. The regulations adopt the June 2012 proposed regulations without substantive change, except for items related to the date of applicability.
Section 1366(d)(1) of the Internal Revenue Code generally provides that the amount of losses and deductions an S corporation shareholder may take for a taxable year may not exceed the sum of the shareholder’s adjusted basis in its stock and the adjusted basis of the indebtedness of the S corporation to the shareholder. The finalized regulations define indebtedness of the S corporation to the shareholder to include any bona fide indebtedness to the shareholder as determined under general federal tax principles. All facts and circumstances are to be considered in making this determination. The regulations generally do not adopt the "actual economic outlay" standard developed by the courts, which permits basis in S corporation shareholder debt only if the shareholder is made "poorer in a material sense" by the loan. The regulations retain the economic outlay concept in the guarantee context, however, providing that S corporation shareholders may increase their basis of indebtedness with respect to a guarantee only to the extent they perform thereunder.
Pursuant to the regulations, back-to-back and assigned related party loans may give rise to basis.
Back-to-Back Loans. In Example 2 of Treas. Reg. Sec. 1.1366-2(a)(2)(iii), the first of two S corporations makes a loan to the corporations’ sole shareholder. The shareholder then loans the same amount to the second S corporation. The example concludes that the loan to the second corporation may generate basis to the shareholder provided that it constitutes bona fide indebtedness under general federal tax principles given all the facts and circumstances. This is so even though the shareholder might not have received basis under the actual economic outlay test espoused by the courts because it was not made "poorer in a material sense."
Loan Restructuring Through Distributions. In Example 3 of the regulation, again, two S corporations are wholly owned by a single shareholder. The first corporation makes a loan to the second corporation. Thereafter, the first corporation distributes the note documenting the loan to the shareholder. The second corporation is now directly liable to the shareholder and relieved of its liability to the first corporation under local law. The example concludes that the shareholder receives basis in the note if the second corporation is indebted to the shareholder (and not the first corporation) under general federal tax principles given all the facts and circumstances.
The final regulations apply to indebtedness of an S corporation to its shareholder that results from a transaction occurring in a year for which the period of limitations on assessment has not expired before July 23, 2014.
The regulations provide basis with respect to bona fide indebtedness between an S corporation and its shareholder. As such, S corporation shareholders should take care to structure loans to their corporations following arm’s-length formalities. Notes with appropriate payment terms and interest rates should be executed and adherence to payment schedules should be followed.