Proposed Regulations Address S Corporation Debt Basis Abuses

M&A Alert 2007-7

Key points and opportunities
On April 11, 2007 the Treasury issued proposed regulations(REG-144859-04), which propose rules intended to address abuses to theapplication of “open account debt” as defined within Treas. Reg. §1.1367-2. However, the proposed rulesare broad enough to capture valid financing transaction as well.

The abuse occurs through the shareholder’s short termadvance of funds to their S corporation (“S”) near year end to provide basisfor S losses followed by a repayment of the advance shortly after yearend. In abusive situations taxpayerscontinue this scheme of advance and repayment for several years to defer incomerecognition of the repayment of the debt. The new rules would eliminate the ability touse the short term advance and repayment scheme to avoid gain recognition onrepayment of reduced basis debt.

Background
A shareholder’s ability to utilize losses passing throughfrom S is limited to their basis in the S corporation. If reduced basis debt is repaid prior torestoration of basis, the shareholder recognizes gain to the extent the amountrepaid exceeds the shareholder’s basis in the debt. Under current rules, the testing of openaccount debt generally occurs at the close of S’s tax year. The Tax Court affirmed this treatment inBrooks v. Commissioner, T.C. Memo 2005-204, which is cited in the proposedregulations as a result that was outside the intent of the regulations.

Recent Guidance
If finalized in their current form the proposed regulationswill limit application of “open account debt” to advances with a total runningbalance of $10,000 or less. Prop. Reg. §1.1367-2(a)(2). As a result, repaymentof an advance with a reduced basis as a result of S losses will generallyresult in taxable income despite the fact that a new advance of an equal orgreater amount occurs.

Example under proposed regulations:
Shareholder has $0 basis in her stock of S. S expects to incur a $100K loss in 2007. On December 15, 2007 shareholder borrows $100from the bank and advances the $100K to S as an open account debt. Shareholder utilizes $100K loss on her incometax return. On January 15, 2008 S repaysthe advance and shareholder repays the bank. S expects to incur an additional $50K loss in 2008 and on December 15,2008 shareholder borrows $150K from the bank and advances the funds to S as anopen account debt. Under the proposedregulations the repayment of the $100K advance results in a repaymenttriggering gain in excess of the basis ($0) in the debt. As of December 31, 2008 the open account debtis equal to $150K, S has a $150K basis in the debt to offset the $50Kloss.

The same general result occurs if S generates income in2008. Using the same facts as theearlier example with the exception that in 2008 S earns $30, the Januaryrepayment would result in $70 of income, as the $30 of income earned wouldfirst restore basis in the $100K debt to $30.

Do the Regulations go too far? Unfortunately the proposed regulations willalso reach seemingly non-abusive situations as well. An S corporation that is incurring losses isoften in need of short term cash infusions that regularly exceed $10,000. These advances are often repaid to theshareholder when the S corporation has sufficient liquidity. In these cases the shareholder is acting as alender providing the S corporation with a line of credit, not necessarilyseparate borrowings.

Example of non-abusive financing:
Shareholder has $0 basis in her stock of S. S expects to incur a $100K loss in 2007. On December 15, 2007 the shareholder advancesthe $100K to S as an open account debt too fund continuing operations. Shareholder utilizes $100K loss on her incometax return. On June 15, 2008 S repaysthe advance out of operating cash flows. S expects to incur an additional $50K loss in 2008 and on December 15,advances $150K to S as an open account debt to fund continuing operations. Under the proposed regulations the repaymentof the $100K advance results in a repayment triggering gain of $100K. As of December 31, 2008 the open account debtis equal to $150K, S has a $150K basis in the debt to offset the $50Kloss. However, the shareholder advancesoperated as a line of credit and had real substance; they were required to fundoperations and were utilized by S rather than simply repaid shortly after yearend.

Summary
When applying the S corporation basis rules to shareholderdebt it is very important to consider the substance of shareholderadvances. While the regulations are notfinalized it gives a good indication of the concerns of the IRS and Treasury.

This bulletin discusses certain general principles of taxlaw. This bulletin does not address all the specific requirements orexceptions that may apply, and it does not apply these general tax principlesto any particular transaction or situation. Accordingly, you should notrely upon the information in this bulletin for the purpose of implementing orreporting any particular transaction, and this bulletin may not be relied uponto provide any relief from any penalties under the Internal Revenue Code or anystate, local, or foreign tax law. Consult your tax advisor regarding theapplication of these general tax principles to your specific situation.

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