Shareholder Loans to “S” Corporations

Shareholder Loans to “S” Corporations

On October 17, 2008 the IRS finalized regulations on the treatment of open account debt between S Corporations and their shareholders.  If a shareholder’s basis in S Corporation shareholder debt has been reduced by his or her share of the S Corporation losses and the S Corporation makes a distribution or pays off the debt with an amount in excess of the remaining basis, gain must be recognized.

A capital gain will result if the debt is evidenced by a written note.  If the S Corporation repays the debt and the shareholder lends more money later in the year for purposes of avoiding the gain, each payment is treated as an individual transaction, and the two payments are not netted for purposes of determining basis in debt at the end of the year.  When the debt of the S Corporation to the shareholder is paid off in installments, each installment is allocated between return of capital and gain based on the proportion of the shareholder’s basis in the debt to its face amount.  Under the final regulations, open account debt would be defined as shareholder advances not evidenced by separate written instruments for which the principal amount of the aggregate advances does not exceed $25,000 at the close of any day during the S Corporation’s tax year.  If the running balance exceeds $25,000, the entire principal amount of that debt would no longer be open account debt.  The principal amount would be treated as debt evidenced by a written instrument.

Regulation 1.1367-2(a) states that generally, if shareholder advances are not evidenced be separate written instruments for which the principal amount of the aggregate advances does not exceed $25,000 and repayments on the advances, the debt is called open account debt and treated as a single debt.  However, ordinary income results on the S Corporation’s repayment of the open account debt.

Although ordinary income is a disadvantage of not evidencing loans, an advantage is that multiple loans and repayments made throughout the year are considered open account debt and are netted at the end of the year rather than gain occurring on repayment of each individual debt.  The final regulations generally are proposed to apply to shareholder advances to S Corporations made on or after October 20, 2008.

If the indebtedness is evidenced by a note, the repayment is treated as a sale or exchange.  Accordingly, if the note is a capital asset in the shareholder’s hands the excess of the amount repaid over basis is taxed as capital gain. (Rev. Rul. 64-162, 1964-1 C.B. 304).

However, if the debt is not evidenced by a note, there is no sale or exchange when the debt is paid.  Thus, a payment by an S Corporation of a debt to a shareholder that is carried on an open account, will be ordinary income to the extent of the amount paid over the applied basis (Rev. Rul. 68-537, 1968-2 C.B. 372).

If a shareholder’s advances are not evidenced by a separate written instrument, net of repayments, exceed an aggregate outstanding principal amount of $25,000 at the close of the S Corporation’s tax year, for any later tax year, the aggregate principal amount is treated as indebtedness evidenced by a separate written instrument, with the result that the indebtedness is not open account debt and is subject to all basis adjustment rules applicable to basis of indebtedness of an S Corporation to a shareholder.  However, in this case the gain would be ordinary as there is no written note it is merely deemed a written note for purposes of the timing of taxability.  Should you find yourself in this situation, you should draw up actual notes so that the gain would be capital gain.

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