The S corporation is a pass through entity. The corporate income and/or losses are "passed" through to shareholders for reporting in their own personal tax returns. In general, shareholders can deduct losses only to the extent of their adjusted tax basis in the S corporation stock plus their adjusted tax basis in loans made directly to the S corporation. To the extent that a taxable loss exceeds shareholder basis and is not currently deductible, the loss is eligible to be carried forward indefinitely into future tax years where it can be deducted if sufficient tax basis in the corporation is restored by the shareholder.
The computation and determination of S corporation debt for basis purposes must meet two requirements:
- The debt must be "directly" from the shareholder to the S corporation.
- The shareholder must have an actual "economic outlay."
A shareholder has basis in a loan if he or she makes a direct loan to the S corporation. If the shareholder merely guarantees the debt of the S corporation, the shareholder does not have basis in debt to the S corporation. For a guarantee, the shareholder must have actually paid the guaranteed debt in order to obtain tax basis in the debt. Prior to the actual payment, ‘liability’ may exist, but not debt to the shareholder. The denial of tax basis is due to the simple fact that there is no direct indebtedness between the shareholder and the S corporation.
To satisfy the economic outlay requirement, a shareholder must be "poorer in a material sense" after the transaction. In making this evaluation, the courts and the IRS have placed great emphasis on
(1) the funding source of the debt to the S corporation, and
(2) the flow of funds.
Source of Funds
The source of funds plays a major role in determining whether a shareholder satisfies the economic outlay requirement. If a shareholder borrows from an independent third party and then lends the money to an S corporation, the courts and the IRS are much more willing to find sufficient economic outlay for loan basis. If the source of the funds is from a related party, however, the shareholder has very limited success in meeting the economic outlay requirement. When funds come from an unrelated third party, the arm’s-length transaction tends to ensure that repayment will be enforced and the so called "economic outlay" concept is generally satisfied because the taxpayer is or will be poorer in a "cash" sense.
Flow of Funds
The courts and the IRS also have disallowed basis increase on loans that involve circular flow of funds that are designed solely to generate basis in an S corporation. If a shareholder borrows from an S corporation and lends the money to another S corporation of which he or she controls and the second S corporation in turn lends the money back to the first S corporation, there is no increase in tax basis in the shareholder’s debt to the second S Corporation. Tax Courts have held that these circular cash movements were equivalent to mere offsetting bookkeeping entries, since the loan proceeds originated and ended with the first S corporation. In addition, the economic positions of each party did not change and, therefore, there was no economic outlay from the shareholder.
Taxpayers should avoid related party loans and loan transactions involving circular cash flow of funds. If a related party loan structure is desirable or necessary, each of the loans must be
- a bona fide obligation with adequate interest and set payment terms,
- properly documented in written form,
- paid according to the loan terms, and
- consistently recorded and shown in the books and financial statements of each S corporation and related party.
The shareholder must be ready to establish and demonstrate that he or she has a definite enforceable obligation to repay the loan obtained from the related party.
The above analysis includes a summary of items which contribute to debt basis. Should you have any questions related to shareholder basis and debt, contact your Marcum tax professional.