Final Regulations Address Debt Basis for S-Corporation Shareholders
July 31, 2014
On July 23, the IRS issued final regulations clarifying when a shareholder loan to an S corporation increases basis. The regulations finalize with little change proposed regulations issued in June 2012. The final regulations apply to transactions on or after July 23, 2014, but taxpayers can rely on the regulations for any loan between an S-corp and its shareholders resulting from a transaction occurring in a year for which the period of limitations has not expired by July 23, 2014.
The final regulations permit S-corp shareholders to increase their basis for “bona fide” loans from a shareholder to the S-corp. The regulations establish a facts-and-circumstances test that uses general federal tax principles to determine if a loan is bona fide. Taxpayers seeking to meet this test should take steps to formally document and support any loans, such as documenting the loan in writing and making interest and principal payments as required.
The regulations also address whether back-to-back loans qualify as bona fide loans. In one example from the regulations, A is the sole shareholder of two S-corps, S1 and S2. S1 loaned $200,000 to A, who in turn loaned $200,000 to S2. The regulations would allow this transaction to result in shareholder basis in S2 if the loan to S2 constitutes bona fide indebtedness. However, A would not receive debt basis in S2 if S2 subsequently loaned the $200,000 back to S1. A is prevented from creating debt basis in this situation because the funds end up back in the hands of the original lender.
A shareholder who owns an interest in two S-corps (again, S1 and S2) would increase his or her basis in S2 if S2 owed money to S1, the obligation constitutes bona fide debt, and S1 distributes the obligation to the shareholder. The regulations also clarify that a guarantee of S-corp debt by a shareholder does not create debt basis until the shareholder performs on that guarantee. Once the shareholder does make payment under the terms of the guarantee, debt basis is created but only to the extent of the amount paid to satisfy the guarantee.
The regulations are not a surprise as they follow established case law. However, they do offer confirmation that the IRS will allow the creation of shareholder basis by properly structured back-to-back loans.
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