S Corporation Shareholder Loans and Tax Basis

For income tax purposes, the definition of the word “basis” generally means the amount of after-tax investment in an asset.  Basis is a dollar amount that is used in various ways in the tax law, including the following examples:

1.     Basis is subtracted from the selling price of an asset to determine gain or loss.

2.     Basis is the amount that can be depreciated or amortized.

3.     Basis is the tax-free portion of retirement account or annuity distributions.

4.     Basis is the limitation on the amount of tax losses that can be deducted by a partner of a partnership, a member of a limited liability company, or a shareholder of a Subchapter S corporation.  These entities are called “pass-through” entities, meaning that the owner’s allocable share of the entity’s taxable income or loss (as shown on Schedule K-1) is reported on the owner’s income tax return.

Basis generally starts out as the after-tax cost of an asset or investment.  Then adjustments are made to basis depending upon the tax rules that apply.  For example, depreciation deductions reduce the original basis so that a double tax benefit isn’t received when the asset is sold:  once for the depreciation deduction and again in calculating gain or loss if basis isn’t reduced for the depreciation deduction.  When the asset is sold, “adjusted basis” is used in calculating the gain or loss.

For an S corporation shareholder, the original basis in the shares acquired is adjusted upward for allocated income and is adjusted downward for allocated losses and deductions and for distributions.  In addition, a special rule permits a shareholder to increase basis for the amount of loans made by the shareholder to the S corporation.  Unlike for a partnership or an LLC, third-party debt incurred by the S corporation does not increase basis for the shareholder.  Only bona fide shareholder loans to the S corporation create basis.  Loan basis permits the deduction of losses in excess of the shareholder’s basis in the S corporation’s stock.  Loan basis has been a source of controversy between the IRS and taxpayers over the years.  The IRS recently released final regulations governing shareholder loan basis.

The regulations permit loan basis only for bona fide, direct shareholder loans to the S corporation.  Personal guarantees of loans to the corporation made by third parties do not create basis, except when and only to the extent the shareholder actually makes payments under the guarantee.  Taxpayers run into trouble establishing basis when attempting to get around the third party debt limitation on basis if they engage in “circular loans” with a related party or if they do not properly structure “back-to-back” loans with an unrelated third party.  Generally a back-to-back loan will create basis if an independent third party loans money to the shareholder and the shareholder loans that amount to the S corporation in exchange for a promissory note secured with corporate assets.  This promissory note plus collateral of the shareholder is assigned to the third-party lender as security on the loan to the shareholder.  It is critical that the shareholder be directly liable on the third-party loan and not the corporation in order for the back-to-back loan structure to create basis.