In the November issue of the Focus, Tom Tartaglia, CPA addressed some of the issues surrounding the question of whether a business should decide to be taxed as an S corporation. One of the advantages he discussed was the ability to pass through corporate losses to the shareholders of the S corporation. Those losses can then be deducted on the shareholders' personal tax return to the extent of the shareholders' basis in stock and debt of the S corporation.

Deducting S corporation Pass-through Losses to the Extent of Basis

The amount of pass-through losses and deductions that an S corporation shareholder may deduct in each tax year cannot be greater than the shareholder's basis. "Shareholder basis" is the shareholder's basis in the stock of the corporation along with the shareholder's debt basis. Debt basis is the basis in any loan owed to the shareholder by the S corporation, commonly referred to as a shareholder loan payable. The basis of a shareholder's stock in an S corporation is decreased by several items including the shareholder's individual share of the corporation's losses, deductions, and nondeductible expenses. The basis may not, however, be decreased below zero. If these items exceed the amount that would reduce the shareholder's stock basis to zero, the excess losses and deductions will then reduce the shareholder's debt basis.

Open Account Debt

An S corporation shareholder has basis in debt only if the loan is made by the shareholder directly to the S corporation. A shareholder may not have basis in debt that is made by a third party to the S corporation, regardless of the level of liability the shareholder holds in that debt. If the shareholder loan is not evidenced by written instruments, it may be considered open account debt. Recent IRS regulations have addressed the treatment of open account debt between S corporations and their shareholders.

On October 20, 2008, the IRS issued final regulations which updated the definition of open account debt. Open account debt is shareholder advances not evidenced by separate written instruments, the aggregate outstanding principal of which does not exceed $25,000. The $25,000 threshold amount applies to each shareholder separately. There is no requirement under these regulations to maintain a daily running balance of shareholder loan activity. In general, all advances and repayments on open account debt during the S corporation's taxable year are netted at the close of the S corporation's taxable year to determine the amount of any net advance or net repayment.

Once the balance of debt exceeds the $25,000 threshold it is no longer considered open account debt. At that point, it is treated as being evidenced by a written instrument, and therefore the netting of advances and repayments on that loan is no longer available. Repayments on the loan reduce the loan's face value and the shareholder's debt basis in the loan. Additional advances are considered to be new loans. If any new advances are not evidenced by written notes, they are considered to be additions to open account debt, and will be considered when determining whether the shareholder's $25,000 threshold has been reached.

If the S corporation pays back a loan from a shareholder in which the shareholder's debt basis has been reduced (i.e. used to deduct a loss), the shareholder will recognize a gain on that repayment.

Capital Gain vs. Ordinary Income on Repayment of Shareholder Loan

The character of the gain on repayment of reduced-basis debt depends on whether the debt is evidenced by a note. If there is no written note, the gain is treated as ordinary income (Rev Rul. 68-537). If the debt is evidenced by a written note, the repayment is treated as a sale or exchange of a capital asset (Rev. Rul. 64-162), and if held for over twelve months, it will be taxed at the long-term capital gains tax rate.

Under Regulation Section 1.1367-2, open account debt with a year-end balance of $25,000 or more is treated in the same manner as debt that is evidenced by a written note. Since the regulation specifies that treating the debt as evidenced by a written instrument is limited to the debt basis rules, capital gain treatment upon repayment of the debt will not be available. Therefore, if open account debt rises above $25,000 at the end of the tax year, it is important to execute written notes to make certain that the shareholders can report any gain on repayment of the debt as long-term capital gain (if the note is held for more than one year).

The difference between the ordinary income tax rate and the long term capital gain tax rate can be significant. The long term capital gain tax rate for 2009 and 2010 is 15%, while the ordinary income tax rates for those years can be as high as 35% of taxable income. As both rates are currently scheduled to increase beginning in 2011, tax planning is essential if a shareholder currently has reduced basis debt from an S corporation. We encourage you to contact a tax professional at Dermody, Burke & Brown to help guide you through this process.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.