IRS Final Regs Address Creation of S Corp Basis with Back-to-Back Loans; "Actual Economic Outlay" Standard Replaced. (Parker Tax Publishing August 6, 2014)

Under Code Sec. 1366, an S corporation 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 indebtedness" of the S corporation to the shareholder. The Code does not define "basis of indebtedness," but several court cases have interpreted Code Sec. 1366 to require an investment in the S corporation that constitutes "an actual economic outlay." Under the "actual economic outlay" standard, courts have held that S shareholders had to be made "poorer in a material sense" in order to increase their bases of indebtedness. Some courts concluded that an S corporation shareholder was not poorer in a material sense if the shareholder borrowed funds from a related entity and then lent those funds to his S corporation. See e.g. Oren v. Commissioner, 357 F.3d 854 (8th Cir. 2004) (discussed below). Disputes often arose over when a back-to-back loan gave rise to an actual economic outlay.

In order to reduce the uncertainty over whether certain loan transactions involving multiple parties, including back-to-back loan transactions, create shareholder basis in indebtedness, the IRS addressed the issue in proposed regulations in 2012 which it has now finalized in T.D. 9682 (7/23/14). The final regulations clarify the requirements for increasing basis of indebtedness and assisting S corporation shareholders in determining with greater certainty whether their particular arrangement creates debt basis. The final regulations provide that in order for an S shareholder to increase basis of indebtedness, the shareholder need only prove that the debt is a bona fide debt under federal tax principles. A shareholder need not otherwise satisfy the "actual economic outlay" doctrine. However, for purposes of determining whether a guarantee gives rise to debt basis, the "actual economic outlay" standard still applies.

Practice Tip: Originally, these regulations were only to apply to transactions entered into on or after the regulations were finalized. However, in a favorable development for taxpayers, the IRS reconsidered and the final regulations allow taxpayers to rely on the new rules for indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a year for which the statute of limitations on tax assessments has not expired before July 23, 2014.

Background

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

As previously noted, the Code does not define what constitutes debt basis for this purpose. However, several courts, including the Sixth Circuit in Maloof v. Comm'r, 456 F.3d 645 (2006), and the Tax Court in Hitchins v. Comm'r, 103 T.C. 711 (1994), interpreted the provision to require an investment in the S corporation constituting an actual economic outlay by the shareholder in order to create debt basis. Often, shareholders attempted to obtain debt basis by borrowing from another person typically, a related entity and then lending the proceeds to the S corporation (a back-to-back loan transaction). Alternatively, some S corporation shareholders sought 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.

Such transactions lead to disputes concerning when a back-to-back loan gave rise to an actual economic outlay, and in particular, whether a shareholder had been made "poorer in a material sense" as a result of the loan.

"Actual Economic Outlay" Standard No Longer Applies to Back-to-Back Loans

The final regulations provide that if a loan transaction represents bona fide indebtedness of the S corporation to the shareholder, the shareholder can increase debt basis. Therefore, an S corporation shareholder need not otherwise satisfy the "actual economic outlay" doctrine for purposes of increasing debt basis.

The key requirement of the regulations is that purported indebtedness of the S corporation to a shareholder must be bona fide indebtedness to the shareholder. In determining what constitutes bona fide indebtedness, general federal tax principles apply. Those principals generally depend on whether a valid debtor-creditor relationship exists and whether a transfer was made with a real expectation of repayment and an intention to enforce the debt. This determination in turn depends on all the facts and circumstances, including whether (1) there was a promissory note or other evidence of indebtedness; (2) interest was charged; (3) there was any security or collateral; (4) there was a fixed maturity date; (5) a demand for repayment was made; (6) any actual repayment was made; (7) the transferee had the ability to repay; (8) any records maintained by the transferor and/or the transferee reflected the transaction as a loan; and (9) the manner in which the transaction was reported for federal tax purposes is consistent with a loan.

Example: Al is the sole shareholder of two S corporations, ABC and DEF. In May 2014, ABC made a loan to DEF. In December 2014, ABC assigned its creditor position in the note to Al by making a distribution to Al of the note. Under local law, after ABC distributed the note to Al, DEF was relieved of its liability to ABC and was directly liable to Al. Whether DEF is indebted to Al rather than ABC is determined under general federal tax principles and depends upon all of the facts and circumstances. If the note constitutes bona fide indebtedness from DEF to Al, the note increases Al's basis of indebtedness in DEF.

In the preamble to the final regulations, the IRS recognized that there are numerous ways, including certain circular cash flows, in which an S corporation can become indebted to its shareholder. The above example illustrates a loan originating between two related entities restructured to be from the S corporation to the shareholder. This shows that the debt need not originate between the S corporation and its shareholder, provided that the resulting debt running between the S corporation and the shareholder is bona fide. The IRS is aware, however, of cases involving circular flow of funds that do not result in bona fide indebtedness. As an example, it cited the case of Oren v. Comm'r, 357 F.3d 854 (8th Cir. 2004).

In Oren, the taxpayer owned three S corporations. 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 lent over time 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 (i.e. he was not materially poorer afterwards). In the preamble to the final regulations, the IRS indicated that this was the appropriate result and noted that, under the final regulations, whether a restructuring will result in bona fide indebtedness depends on the facts and circumstances.

OBSERVATION: Some comments on the proposed regulations requested clarification regarding the basis treatment when an S corporation shareholder or a partner contributes the shareholder's or partner's own note to an S Corporation or a partnership, as an S corporation shareholder does not increase her basis in the stock of her S corporation under Code Sec. 1366(d)(1)(A). In order to expedite finalization of the proposed regulations, the IRS has limited the scope to the basis of indebtedness, and will continue to study issues relating to stock basis.

"Actual Economic Outlay" Standard Still Applies to Guarantees

The final regulations provide a special rule in Reg. Sec. 1.1366-2(a)(2)(ii) for guarantees. This rule provides that a shareholder does not obtain basis of indebtedness in the S corporation merely by guaranteeing a loan or acting as a surety, an accommodation party, or in any similar capacity relating to a loan. When a shareholder makes a payment on bona fide indebtedness of the S corporation for which the shareholder has acted as guarantor or in a similar capacity, the shareholder may increase the shareholder's basis of indebtedness to the extent of that payment.

Example: Al is a shareholder of ABC, an S corporation. In 2014, ABC received a loan from a bank. The bank required Al's guarantee as a condition of making the loan to ABC. Beginning in 2015, ABC could no longer make payments on the loan and Al made payments directly to the bank from his personal funds until the loan obligation was satisfied. For each payment Al made on the note, Al obtained basis in the debt. Thus, Al's debt basis in ABC increased in 2015 to the extent of Al's payments to the bank under the guarantee agreement. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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