Basis of Indebtedness of S Corporations to Their Shareholders
A Rule by the
Entry Type: Rule
Action: Final regulations.
Document Citation: 79 FR 42675
Page: 42675 -42678 (4 pages)
CFR: 26 CFR 1
Agency/Docket Number: TD 9682
Document Number: 2014-17336
Shorter URL: https://federalregister.gov/a/2014-17336
This document contains final regulations relating to basis of indebtedness of S corporations to their shareholders. These final regulations provide that S corporation shareholders increase their basis of indebtedness of the S corporation to the shareholder only if the indebtedness is bona fide, which is determined under general Federal tax principles and depends upon all of the facts and circumstances. These final regulations affect shareholders of S corporations.
Effective Date: These final regulations are effective
Applicability Date: These final regulations apply to indebtedness between an S corporation and its shareholder resulting from any transaction occurring on or after
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The final regulations contain amendments to the Income Tax Regulations (26 CFR part 1) under section 1366 of the Internal Revenue Code (Code). On
Summary of Comments
1. Actual Economic Outlay
Courts developed the actual economic outlay standard, which requires that shareholders be made "poorer in a material sense" to increase their bases of indebtedness. Some courts concluded that an S corporation shareholder was not poorer in a material sense if the shareholder borrowed funds from a related entity and then lent those funds to his S corporation. See, for example, Oren v. Commissioner, 357 F.3d 854 (8th Cir. 2004), aff'g,
One commentator suggested that language be added to the regulations providing that actual economic outlay is no longer the standard used to determine whether a shareholder obtains basis of indebtedness. After considering this comment, the
With respect to guarantees, however, the final regulations retain the economic outlay standard by adopting the rule in the proposed regulations that S corporation shareholders may increase their basis of indebtedness only to the extent they actually perform under a guarantee. The final regulations make some minor changes to clarify the treatment of guarantees, including changing the heading to reiterate that the rule for guarantees is distinguished from the general rule adopting a bona fide indebtedness standard and moving the guarantee example after the examples illustrating the general rule consistent with the order of the regulations.
2. Regulation Examples and "Circular Flow of Funds"
One commentator requested a change to the fact pattern presented in proposed regulations section 1.1366-2(a)(2)(iii), Example 4. In Example 4, a loan that originally was made by S1 to S2, two related S corporations wholly-owned by the same shareholder, is restructured to be a loan from the shareholder. The restructuring involved S1 distributing the debt to the shareholder and S2 being relieved of its liability to S1 so that S2 is only liable to the shareholder on the debt. The commentator recommended that Example 4 not require that S2 be relieved of its liability to S1. As stated in the proposed regulations and finalized in these regulations, whether indebtedness is bona fide indebtedness to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances. Whether S2 is relieved of the original liability is an appropriate fact to consider in determining whether the transaction is a restructuring of a debt that results in a bona fide debt that runs directly from S2 to the shareholder. See, for example, Rev. Rul. 75-144 (1975-1 CB 277) (holding that a shareholder increases the shareholder's basis of indebtedness when the shareholder, who had guaranteed a liability of his S corporation, executed his own promissory note in full satisfaction of the S corporation's note to the bank, the bank relieved the S corporation of its liability, and the S corporation became obligated to the shareholder under the doctrine of subrogation). See also Gilday v. Commissioner,
This commentator also requested that an example be added to the regulations addressing a "circular flow of funds." The commentator described a circular flow of funds as including a restructuring of a loan originally made by an S corporation owned by the shareholder to another S corporation owned by that shareholder (for purposes of this discussion, S1 and S2, respectively). This loan is restructured by one of two alternative methods: (i) S1 lends money to the shareholder, the shareholder lends that money to S2, and S2 uses that money to repay S1; or (ii) S2 repays S1, S1 lends money to the shareholder, and the shareholder lends that money back to S2.
Another commentator requested that an example be added to the regulations concerning a fact pattern in which bona fide indebtedness is present, but the shareholder has zero basis in that indebtedness. The commentator concluded that the shareholder would have zero basis of indebtedness in the shareholder's S corporation because the shareholder's basis in the debt is zero.
3. Section 1366(d)(1)(A) and Stock Basis
The preamble to the proposed regulations requested comments regarding the basis treatment when an S corporation shareholder or a partner contributes the shareholder's or partner's own note to an S corporation or a partnership. An S corporation shareholder does not increase his basis in the stock of his S corporation under section 1366(d)(1)(A) from a contribution of his own note. See Rev. Rul. 81-187 (1981-2 CB 167) (holding that a shareholder who (i) merely executed and transferred the shareholder's demand note to the shareholder's wholly owned S corporation, and (ii) made no payment on the note until the following year had a zero basis in the note until the following year when the shareholder made a payment on the note). The preamble to the proposed regulations described as one potential model section 1.704-1(b)(2)(iv)(d)(2), which provides that a partner's capital account is increased with respect to non-readily tradable partner notes only (i) when there is a taxable disposition of such note by the partnership, or (ii) when the partner makes principal payments on such note. One commentator recommended consideration of, and consistency with, section 1.166-9(c) (regarding contributions of debt to capital). Another commentator noted that courts have applied the "actual economic outlay" standard to determine when shareholders increase their bases in their S corporation stock. See, for example,
4. Potential Abuses From Shareholders Claiming Indebtedness Basis
One commentator stressed that, because S corporations are passthrough entities, allowing shareholders to claim S corporation losses if they have basis of indebtedness could allow shareholders to claim losses that are not bona fide. This commentator recommended that the
5. Effective and Applicability Date
Commentators also suggested that the
The proposed regulations provided that these regulations apply to transactions entered into on or after the regulations are published as final in the
[*Federal RegisterVJ 2014-07-23]
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