On July 23, 2014, the Treasury Department and Internal Revenue Service (“IRS”) issued final regulations providing guidance on the circumstances under which an S corporation shareholder may increase their adjusted basis due to indebtedness of the S corporation. Internal Revenue Code (“Code”) Section 1366(d)(1) generally provides that the aggregate amount of losses and deductions taken by a shareholder in any tax year cannot exceed the sum of the shareholder’s adjusted basis in its stock and the adjusted basis of any indebtedness of the S corporation to the shareholder. To the extent a shareholder does not have sufficient basis in their stock to take losses in a particular year, they may use a loan to the S corporation to increase their basis and avoid having to carry forward losses to a subsequent year. The final regulations describe the circumstances under which such loans will be treated as “bona fide” indebtedness of the S corporation to the shareholder – allowing the shareholder to increase their basis by the amount of the indebtedness and recognize the losses currently.
The regulations amend Treasury Regulation Section 1.1366-2(a)(2) to define “basis of indebtedness” which is not otherwise defined in the Code. Finalized without substantive changes from the proposed regulations issued in 2012, the regulations provide that an increase in the shareholders basis is warranted only to the extent that indebtedness of the S corporation to the shareholder is “bona fide” – under general Federal tax principles. Further, shareholders may only increase their basis with respect to a guaranty of bona fide S corporation indebtedness to the extent they actually perform on that guaranty. The new regulations also provide several examples clarifying the interpretation of “bona fide” indebtedness in common situations.
While some courts have held that bona fide indebtedness exists only where a shareholder makes an actual economic outlay and is thus made “poorer in a material sense” as a result of the transaction, the regulations state that a basis increase will be permitted provided the indebtedness of the S corporation to the shareholder is bona fide, without regard to the economic outlay test. This standard would allow a basis increase in situations where a shareholder borrows funds from one wholly-owned S corporation and lends them to another wholly-owned S corporation and other transactions where there is no actual economic outlay by the shareholder, but, nonetheless, bona fide indebtedness exists.
With the implementation of these final regulations, shareholders of S corporation that desire to increase their adjusted basis in S corporation stock related to indebtedness of the S corporation should be mindful to structure debt arrangements as third-party or arm’s-length transactions, including execution of a note at third-party or market interest rates, adherence to repayment schedules and other formalities that would establish the indicia of bona fide indebtedness of the S corporation to the shareholder.
Should you have any questions or need guidance or assistance regarding the new regulations, please contact us at (210) 228-9500.