On July 23, 2014, the IRS issued final regulations (T.D. 9682) addressing the basis of indebtedness of S corporations to their shareholders. These final regulations provide that S corporation shareholders may increase their S corporation debt basis only if the indebtedness is bona fide, which is determined under general federal tax principles and depends on all of the facts and circumstances.
Actual Economic Outlay
Sec. 1366(d)(1) provides that the “aggregate amount of losses taken into account by a shareholder . . . for any taxable year shall not exceed the sum of (A) the adjusted basis of the shareholder’s stock in the S corporation . . . and (B) the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.”
Taxpayers and the IRS have long battled in the courts over what is indebtedness for purposes of Sec. 1366(d)(1)(B). This led the courts to develop the actual-economic-outlay standard, which requires that shareholders be made “poorer in a material sense” to increase their basis of indebtedness. However, this standard has in many ways proved inadequate. For example, it does not address issues dealing with borrowed funds from a related entity or back-to-back loans, in which the S corporation shareholder borrows from another person, often a related entity, and loans the proceeds to the S corporation.
Instead of applying the actual-economic-outlay standard, the final regulations provide that a shareholder receives basis of indebtedness if it is a bona fide indebtedness of the S corporation to the shareholder. Under the regulations, whether indebtedness is bona fide indebtedness to a shareholder is determined under general federal tax principles and depends on all of the facts and circumstances. A commenter suggested that the regulations specifically state that the actual-economic-outlay test does not apply in determining whether a shareholder obtains basis of indebtedness, but the IRS did not do so because it felt the language from the proposed regulations clearly articulated the correct standard and that further discussion of the actual-economic-outlay standard was unnecessary.
The final regulations, however, do not totally abandon the actual-economic-outlay standard, retaining it for loan guarantees. In the past, taxpayers have frequently attempted to create basis in indebtedness by merely guaranteeing a new or preexisting loan to an S corporation. The final regulations provide that S corporation shareholders may increase their basis of indebtedness only to the extent of loan payments the shareholders make on the S corporation’s behalf.
Circular Flow of Funds
The proposed regulations included an example of a loan originating between two related entities that is restructured to be from the S corporation to the shareholder to show that the debt need not originate between the S corporation and its shareholders, provided that the resulting debt running between the S corporation and the shareholders is bona fide, i.e., there is a circular flow of funds. In contrast, where a shareholder acts merely as a conduit through which the money flowed, there is no economic outlay for the shareholder and, thus, no increase in indebtedness of the S corporation to the shareholder.
The example reflected a loan that originally was made by S1 to S2, two related S corporations wholly owned by the same shareholder. This loan is restructured as a loan from the shareholder by distributing the S1 debt to the shareholder, which by law relieved S2 of its liability to S1 so that S2 is only liable to the shareholder on the debt. Based on the facts and circumstances, the debt would be considered additional basis to the shareholder. A commenter suggested that the IRS change the facts so that S2 not be relieved of its liability. The IRS did not adopt this suggestion because it concluded that relief of indebtedness was an appropriate factor to consider in determining whether the restructuring resulted in bona fide indebtedness. The commenter also requested that additional examples be included that illustrated other examples of a circular flow of funds, but the IRS rejected this request because it felt the examples in the proposed regulations adequately illustrated that restructured debt that was not originally between an S corporation and a shareholder could be bona fide indebtedness.
Other Items of Significance
The preamble to the final regulations also discusses a commenter’s suggestion that an example be included in the final regulations addressing a situation in which bona fide indebtedness is present but the shareholder has zero basis in the indebtedness. The IRS again declined to follow this suggestion, explaining that it believed that the regulations are clear that a shareholder may increase his or her basis of indebtedness only to the extent of the shareholder’s adjusted basis, and, if the shareholder’s basis in the indebtedness is zero, the shareholder’s basis of indebtedness is increased by zero.
Finally, the preamble to the final regulations notes that the preamble to the proposed regulations asked for comments on 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. After briefly describing two recommendations made in response to this request, the preamble states that to expedite the issuance of the final regulations, their scope was limited to basis of indebtedness and that the IRS continues to study issues relating to stock basis and may address them in future guidance.
In a favorable response to suggestions from commenters, the IRS modified the applicability date in the final regulations. The proposed regulations provided that they would apply to transactions entered into on or after the final regulations were published in the Federal Register. However, after considering suggestions that the regulations apply retroactively, the IRS changed the regulations to provide that taxpayers may rely on these regulations with respect to indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a year for which the tax assessment limitation period has not expired before July 23, 2014 (the date the final regulations were published in the Federal Register).