Many small and mid-size businesses operate as “S corporations” for income tax purposes. As an S corporation, the business does not compute a tax liability on its operations, but instead shareholders report their shares of the corporation’s income or loss on their individual income tax returns. In the current economic environment, many such businesses will be passing through losses to shareholders.
Under the Subchapter S rules, the shareholders can deduct losses only to the extent that they have basis in their S corporation stock or in loans that they have made directly to the corporation. The shareholders’ basis in loans is reduced by the amount of any losses supported by such loans after reducing stock basis to zero. Repayment by the corporation of such reduced basis loans would result in gain to the shareholder. Often, shareholders have arranged their loan repayments and subsequent advances so that they could (1) take losses supported by the loans at year end, (2) repay the loans early in the following tax year, and then (3) advance loans back to the corporation late in the following tax year in order to continue to support those prior losses.
This procedure of “netting” advances and repayments on “open account indebtedness” during the year was upheld several years ago by a Tax Court case. The Treasury Department and IRS concluded that this case provided for a result not intended by Congress or by the IRS Regulations in effect at the time, and they have now amended those regulations.
The new regulations adopt a $25,000 per shareholder limit on “open account indebtedness,” determined as of the close of the tax year. If the $25,000 limit is exceeded by aggregate indebtedness to a shareholder, the entire amount is considered a debt associated with a separate written instrument, the repayment of which will generate gain to the shareholder if the basis has been reduced by previous pass-through of losses. The determination of basis is made without regard to subsequent advances by the shareholder during the year because repayments and advances will not be netted.
These new regulations apply to any shareholder advances to the S corporation made on or after October 20, 2008, and to any repayments by the S corporation on those advances. Certain aspects of these regulations are too complex for this article. If you or your corporation has shareholder loans, please contact your HLB Gross Collins P.C. tax advisor for assistance in determining their impact on the tax liabilities of the shareholders.