Prop. Regs Aim to Clarify Requirements for Increasing S Shareholder Basis in Debt. (Parker's Federal Tax Bulletin: June 25, 2012)

There has been an ongoing dispute between S shareholders and the IRS as to whether shareholders can increase their S corporation debt basis. Code Sec. 1366(d)(1) provides that a shareholder can take into account losses and deductions to the extent of the adjusted basis of the shareholder's stock and the adjusted basis of any debt of the S corporation to the shareholder. However, the Code does not define what constitutes debt basis.

As a result, the IRS has issued proposed regulations in REG-134042-07 (6/12/12) aimed at clarifying the requirements for increasing debt basis and assisting S corporation shareholders in determining with greater certainty whether their particular arrangement creates debt basis.

The proposed regulations would apply to loan transactions entered into on or after the date final regulations are issued.

Background

Under Code Sec.1366(d)(1), the aggregate amount of losses and deductions that an S shareholder takes into account for any tax year cannot exceed the sum of that shareholder's adjusted basis in S stock and adjusted basis of any debt of the S corporation to that shareholder. According to the IRS, the legislative history to that provision illustrates Congress's intent to limit the loss that a shareholder takes into account to that shareholder's investment in the corporationthat is, to the adjusted basis of the stock in the corporation owned by the shareholder and the adjusted basis of any indebtedness of the corporation to the shareholder.

Reg. Sec. 1.1366-2 provides rules relating to limitations on the deduction of passthrough items of an S corporation to its shareholder. Under Reg. Sec. 1.1366-2(a)(1), a shareholder's aggregate amount of losses and deductions taken into account under Reg. Sec. 1.1366-1(a)(2), (3), and (4) for any S corporation tax year cannot exceed that shareholder's adjusted basis in stock in the corporation and adjusted basis of any indebtedness of the corporation to that shareholder.

Several court cases have interpreted Code Sec. 1366 to require an investment in the S corporation that constitutes an actual economic outlay by the shareholder to create debt basis. Often, the cases involve attempts by an S corporation shareholder to obtain debt basis by borrowing from another persontypically, a related entityand then lending the proceeds to the S corporation (i.e., a back-to-back loan transaction). Alternatively, an S corporation shareholder might seek to restructure an existing loan of the S corporation into a back-to-back loan by assuming the S corporation's liability on the loan and creating a commensurate obligation from the S corporation to the shareholder. Disagreements continue to arise over whether a back-to-back loan gives rise to an actual economic outlay and, in particular, whether a shareholder has been made poorer in a material sense as a result of the loan.

In Maloof v. Comm'r, 456 F.3d 645 (6th Cir. 2006), the taxpayer owned several S corporations and claimed that a $4 million bank loan to the corporations, on which he was a co-obligor and guarantor, permissibly increased his basis in debt of the S corporation. The Sixth Circuit affirmed the Tax Court and held there was no increase in debt basis. According to the court, the relevant statutes and case law permit an increase S corporation debt basis (and stock basis) only when the taxpayer makes an economic outlay to the corporation, and the taxpayer's status as a co-obligor on the loan established just the possibility, not the reality, of an economic outlay for the corporation.

In Oren v. Comm'r, 357 F.3d 854 (8th Cir. 2004), the taxpayer owned three S corporations. He and the three S corporations entered into a series of loan transactions whereby one corporation loaned, over three years, approximately $15 million to the taxpayer, who, in turn, made loans totaling the same amount to the other two S corporations, both of which, over time, lent the same amount back to the first S corporation. Each loan transaction within a cycle occurred on the same day or within a few days of each other. The terms of the loans, including interest rate and repayment conditions, were the same in each transaction. The first S corporation's checks were drafted against its sweep account with its bank. That bank permitted the corporation to lend funds to the taxpayer so long as he contemporaneously lent the same amount to another related entity. All checks were drawn on the taxpayer or entity's bank account. The taxpayer signed all of the notes himself except the note from the first corporation to him, which was signed by that corporation's president. The taxpayer and the S corporations paid all interest due under the loan agreements by check. The Eighth Circuit affirmed the Tax Court and held that the taxpayer's loans were not actual economic outlays because he was in the same position after the transactions as before he was not materially poorer afterwards. According to the court, the transactions much more closely resembled offsetting book entries or loan guarantees than substantive investments in the S corporations. The court also concluded that the money the taxpayer lent to the corporations was not truly at risk because the possibility that he would suffer a direct loss was so remote. He was protected from personal loss by the circular nature of the loan transactions.

Proposed Regulations

The proposed regulations provide that, in order to increase a shareholder's debt basis, a loan must represent bona fide debt of the S corporation that runs directly to the shareholder. The proposed regulations provide that a shareholder acting as a guarantor of S corporation debt does not create or increase basis of indebtedness simply by becoming a guarantor.

The key requirement of the proposed regulations is that purported debt of the S corporation to a shareholder must be bona fide debt to the shareholder. The proposed regulations do not attempt to provide a different standard for purposes of Code Sec. 1366 as to what constitutes bona fide indebtedness. Rather, general federal tax principles determine whether indebtedness is bona fide.

Under the proposed regulations, shareholder guarantees of S corporation debt do not result in debt basis. As the IRS notes in the preamble to the proposed regulations, an overwhelming majority of courts considering whether shareholders may increase debt basis from their guarantees of S corporation debt have determined that the shareholders' guarantees did not create debt basis. Where an S corporation shareholder acts merely as a guarantor of a loan made by another party directly to the S corporation, or acts in a capacity similar to a guarantor (for example, as a surety or accommodation party), then the courts have held that the shareholder adjusts debt basis only to the extent the shareholder actually performs under the guarantee. One exception, the IRS notes, is the Eleventh Circuit's decision in Selfe v. U.S., 778 F.2d 769 (11th Cir. 1985), where the court held that under unique and limited circumstances, a shareholder who guarantees a loan to an S corporation may increase debt basis where, in substance, that shareholder has borrowed funds and subsequently advanced them to the S corporation.

The proposed regulations provide that an S corporation shareholder who merely acts as a guarantor or in a similar capacity has not created debt basis unless the shareholder actually makes a payment, and then only to the extent of the payment.

Additionally, the IRS notes, some taxpayers have relied on an incorporated pocketbook theory to claim an increase in debt basis in circumstances that involve a loan directly to the S corporation from an entity related to the S corporation shareholder. In these transactions, an S corporation shareholder claims that a transfer from the related entity directly to the shareholder's S corporation was made on the shareholder's behalf and is, in substance, a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corporation. A limited number of court decisions (e.g., Yates v. Comm'r, T.C. Memo. 2001-280 and Culnen v. Comm'r, T.C. Memo. 2000-139) have allowed shareholders to increase debt basis as a result of incorporated pocketbook transactions. Under the proposed regulations, an incorporated pocketbook transaction increases debt basis only where the transaction creates a bona fide creditor-debtor relationship between the shareholder and the borrowing S corporation.

The proposed regulations only address whether a shareholder has debt basis for purposes of Code Sec. 1366(d)(1)(B) and do not address how to determine the basis of the shareholder's stock in the S corporation. Therefore, the IRS notes, the proposed regulations leave unchanged the conclusion in Rev. Rul. 81-187 that a shareholder of an S corporation does not increase basis in stock upon the contribution of the shareholder's own unsecured demand promissory note to the corporation. According to the IRS, this conclusion is consistent with published guidance and case law in the partnership context that the contribution of the partner's own note will not increase such partner's basis in its partnership interest under Code Sec. 722.

The IRS is considering whether the principal holding of Rev. Rul. 81-187, and the holding of Rev. Rul. 80-235 as it relates to a partner's basis in its partnership interest upon the contribution of the partner's own note, should be issued as regulations. It has considered alternatives to the discussion of the applicable law in those revenue rulings. As one model, the IRS has, with respect to basis calculations in the S corporation and partnership context, considered adopting a rule similar to the one currently in Reg. Sec. 1.704-1(b)(2)(iv)(d)(2). That regulation provides that a partner's capital account is increased with respect to non-readily-tradable partner notes only (1) when there is a taxable disposition of the note by the partnership, or (2) when the partner makes principal payments on the note. The IRS is requesting comments concerning the propriety of this model in the S corporation and the partnership context.

Parker Tax Publishing Staff Writers

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