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June 2007 Loans to S corporations and pass-through losses An IRS proposal would limit the use of new open account debt to an aggregate $10,000 In 2005 the IRS lost an important Tax Court case surrounding how S corporation shareholders can use loans to support the deductibility of their S corporation losses. In response, the IRS has issued proposed regulations that may restrict the ability of shareholders to claim, on their Form 1040, any pass-through losses from their S corporation. When these regulations become final, they will represent an important change, and affected taxpayers will need to operate differently in order to continue claiming their shares of the S corporation losses. The Brooks case. In a 2005 Tax Court case, Fleming G. Brooks v. Commissioner, the shareholder had made a series of open account advances to his S corporation. The shareholder maintained a running loan account of advances to and from the S corporation. These were not evidenced by separate written notes but, rather, were simply tracked as a single ongoing open account debt. An S shareholder is allowed to deduct his or her share of the S corporation losses only to the extent of the shareholder’s cumulative investment in the corporation, whether in the form of stock purchases or loans to the corporation. For that reason, a loan to an S corporation can be very important if the corporation is running in the red. In the Brooks case, the shareholder used this open account debt in order to have sufficient investment in the S corporation to claim all of the pass-through losses. The tax law in this area focuses on the shareholder’s investment as of the last day of the S corporation year, usually December 31. In the facts of the Brooks case, the taxpayer personally borrowed money from a bank and advanced it as open account debt to his S corporation shortly before year-end. This provided sufficient investment in the corporation to allow the annual use of the losses. However, the corporation repaid the shareholder advance early in the next year. Normally, this would result in the recognition of gain from repayment of the debt. To avoid this, the shareholder again advanced money to the corporation shortly before the end of the subsequent tax year, on the premise that the loan was the same loan as in the previous year to the debt’s open account status. As a result of this in-and-out series of transactions in an ever-increasing amount, the shareholder was effectively able to use losses based on nothing more than very temporary year-end advances to the S corporation. New IRS rules. To prevent open account debt from being used to create a nearly perpetual tax deferral, the IRS has issued proposed regulations that will limit the use of new open account debt to an aggregate $10,000 limit. If an S shareholder’s open account advances exceed $10,000 at any point in time, the open account debt is treated for tax purposes as a separate debt instrument. As a separate debt used to support tax losses at year-end, any subsequent repayment of that loan would trigger gain to the shareholder. It could not be “covered up” at the end of the subsequent year with a fresh advance to the S corporation. While these new IRS rules will impact only S corporation shareholders who use revolving open account debt to support the tax deductibility of losses, the rules will have serious tax implications to those affected. The good news is that the proposed regulations are not yet final, so there is some time for tax planning. If you or your business associates may be in this position, please contact your Schmidt Westergard & Company tax professional so that we can address an appropriate structure that acknowledges the impact of these pending new rules. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |