News Column

IRS Issues Final Regulations on Indebtedness Basis of S Corporations to Shareholders

July 24, 2014



Targeted News Service

WASHINGTON, July 24 -- The U.S. Internal Revenue Service published the following rule in the Federal Register:

Basis of Indebtedness of S Corporations to Their Shareholders

A Rule by the Internal Revenue Service on 07/23/2014

Publication Date: Wednesday, July 23, 2014

Agencies: Department of the Treasury

Internal Revenue Service

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

RIN: 1545-BG81

Document Number: 2014-17336

Shorter URL: https://federalregister.gov/a/2014-17336

Action

Final Regulations.

Summary

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.

DATES:

Effective Date: These final regulations are effective July 23, 2014.

Applicability Date: These final regulations apply to indebtedness between an S corporation and its shareholder resulting from any transaction occurring on or after July 23, 2014.

FOR FURTHER INFORMATION CONTACT:

Caroline E. Hay, (202) 317-5279 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The final regulations contain amendments to the Income Tax Regulations (26 CFR part 1) under section 1366 of the Internal Revenue Code (Code). On June 12, 2012, the Treasury Department and the IRS published in the Federal Register (77 FR 34884) a notice of proposed rulemaking (REG-134042-07) (the proposed regulations) relating to when shareholders have basis in indebtedness that the S corporation owes to the shareholder (basis of indebtedness). The proposed regulations provide that basis of indebtedness of the S corporation to the shareholder means the shareholder's adjusted basis in any bona fide indebtedness of the S corporation that runs directly to the shareholder. No requests to speak at the scheduled public hearing were received and the hearing was canceled. Comments responding to the notice of proposed rulemaking were received. After consideration of all the comments, the proposed regulations are adopted without substantive change by this Treasury decision, except for changes to the effective/applicability date of the regulations and minor clarifying revisions. The comments, which are available at www.regulations.gov or upon request, are discussed in this preamble.

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, T.C. Memo. 2002-172. Instead of applying the actual economic outlay standard, the proposed regulations provided that shareholders receive basis of indebtedness if it is bona fide indebtedness of the S corporation to the shareholder.

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 Treasury Department and the IRS believe that the proposed regulations clearly articulate the standard for determining basis of indebtedness of an S corporation to its shareholder, and further discussion of the actual economic outlay test in the regulations is unnecessary. Accordingly, the final regulations adopt the rule in the proposed regulations without change.

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, T.C. Memo. 1982-242 (holding that shareholders increased their bases of indebtedness when the shareholders gave a bank their notes, the bank canceled the S corporation's note to the bank, and the facts indicated that the S corporation became indebted to the shareholders, regardless of whether subrogation occurred under state law). Accordingly, this comment is not adopted.

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.

The Treasury Department and the IRS recognize that there are numerous ways, including certain circular cash flows, in which an S corporation can become indebted to its shareholder. The proposed regulations included Example 4 as an example of a loan originating between two related entities that is restructured to be from the S corporation to the shareholder to show that the debt need not originate between the S corporation and its shareholder, provided that the resulting debt running between the S corporation and the shareholder is bona fide. The Treasury Department and the IRS are aware, however, of cases involving circular flow of funds that do not result in bona fide indebtedness. See, for example, Oren v. Commissioner, 357 F.3d at 859 (purported loans, although meeting all the proper formalities, lacked substance); Kerzner v. Commissioner, T.C. Memo. 2009-76, at *5 (transaction lacked substance because money wound up right where it started and shareholder was merely a conduit through which the money flowed). Whether a restructuring results in bona fide indebtedness depends on the facts and circumstances. Because the Treasury Department and the IRS believe that the examples in the proposed regulations adequately illustrate that a restructuring of a debt that did not originate between the shareholder and the S corporation may result in basis of indebtedness as long as the resulting debt is bona fide, these final regulations do not contain additional examples.

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. The Treasury Department and the IRS believe that the regulations are clear that shareholders only increase their basis of indebtedness to the extent of the shareholder's adjusted basis (as defined in section 1.1011-1 and as specifically provided in section 1367(b)(2)) in that bona fide indebtedness of the S corporation that runs directly to the shareholder. If the shareholder's basis in the indebtedness is zero, then the shareholder's basis of indebtedness is increased by zero. As such, an additional example illustrating a zero basis of indebtedness has not been added to the final regulations.

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, Maguire v. Commissioner, T.C. Memo. 2012-160. This commentator requested that the final regulations provide that actual economic outlay does not apply to determinations of a shareholder's stock basis under section 1366(d)(1)(A). To expedite finalization of the proposed regulations, the scope of these final regulations is limited to basis of indebtedness. The Treasury Department and the IRS continue to study issues relating to stock basis and may address these issues in future guidance.

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 IRS require that shareholders provide information to the IRS that all claimed S corporation losses are bona fide. The proposed regulations, however, do not affect the normal substantiation rules for the validity of claimed losses. See sections 6001 and 6037. See also INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992) (providing that "an income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer" (quoting Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943))). Accordingly, this comment is beyond the scope of these final regulations.

5. Effective and Applicability Date

Commentators also suggested that the Treasury Department and the IRS should permit retroactive application of the regulations. These commentators suggest that, pursuant to section 7805(b)(7), final regulations should allow taxpayers to elect to apply the rules in the regulations retroactively.

The proposed regulations provided that these regulations apply to transactions entered into on or after the regulations are published as final in the Federal Register. Upon further consideration of the applicability date, the Treasury Department and the IRS believe that allowing taxpayers to rely on these regulations will provide greater certainty for determining when shareholders have basis of indebtedness. As such, taxpayers may rely on these regulations with respect to indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a year for which the period of limitations on the assessment of tax has not expired before July 23, 2014.

[*Federal RegisterVJ 2014-07-23]

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