S Corporation Loans Versus Capital Contributions: Tax Consequences May Differ Significantly

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By James M. Kehl, CPA
Weil, Akman, Baylin & Coleman, P.A., Timonium, MD

A tax advisor is sometimes asked if it is more advantageous from an income tax standpoint for an S corporation shareholder to make loans to the S corporation or to contribute capital. Let's discuss this issue by reviewing a typical example.

Assume that B formed a wholly owned S corporation (S) during 2008. The purpose of S is to develop a drug to cure diabetes.  S issued $1,000 of capital stock to B in a transaction that was governed by §351. During 2008, B lent S $20,000 on open account (i.e., the loan was not evidenced by a written debt instrument) in order to pay deductible research and development costs. S incurred a loss of $5,000 for 2008, which was passed through to B. In February 2009, S repaid $10,000 of B's advances. In June 2009, B lent S an additional $20,000 on open account. S generated a tax loss of $26,000 for 2009, which was passed through to B. In July 2010, S was able to borrow $35,000 from a third party lender and repaid B $15,000. In November 2010, B lent S an additional $40,000 in order to enable S to pay fully deductible expenses. S generated a loss of $30,000 for 2010. What are the tax aspects of these transactions? What would be the tax consequences if B had made capital contributions to S rather than loans?

Since S has been an S corporation during its entire existence, it has no Accumulated Earnings & Profits (AE & P). S does have an Accumulated Adjustments Account (AAA) at the end of each of its tax years with negative balances as a result of losses.1  For the years 2008 through 2010, S's AAA at the end of each year is as follows: 

 

 

2008

2009

2010

Balance at beginning of year

$-0-

($5,000)

($31,000)

Net Loss

(5,000)

(26,000)

(30,000)

Balance at end of year

($5,000)

($31,000)

($61,000)

At the end of 2008, B had a basis of $1,000 for his common stock and a basis of $20,000 for his indebtedness before reduction of those amounts for the 2008 loss of $5,000. B reduces his stock basis by the $1,000 loss, and then reduces his debt basis by the remaining $4,000 of loss. At December 31, 2009, the principal amount of S's debt to B is $20,000, but B's tax basis in the debt is $16,000. B's basis for B's stock in S is $-0-.

During 2009, the principal amount of B's open account debt is first reduced by the repayment to B of $10,000, and then increased by B's additional loans to S of $20,000, for net advances of $10,000. Before reduction for losses, the principal amount of B's loans was $30,000 (beginning amount of $20,000 plus net advances of $10,000) and the tax basis of those loans was $26,000 (tax basis at the beginning of the year of $16,000 plus net advances of $10,000).  B deducts the 2009 loss of $26,000 and thereby reduces the tax basis for the open account debt to $-0-. Since the advances, net of repayments, not evidenced by a separate written instrument from B to S exceed an aggregate outstanding principal amount of $25,000 at December 31, 2009, the $30,000 debt principal with a tax basis of $-0- is treated as debt that is evidenced by a separate written instrument for all subsequent taxable years.2

In 2010, there is no net increase in debt basis because S has no items of income. The loan repayment to B resulted in $15,000 of taxable income to B, because the amount of the repayment exceeded B's basis for the loan of zero by $15,000. The loan repayment in 2010 may not be netted with the subsequent advance of $40,000 in November 2010 because the former open account debt in the principal amount of $30,000 is considered to be a separate written debt instrument.  At December 31, 2010, the $40,000 of advances provided B with basis for deducting the 2010 loss of $30,000 that was passed through to B by S. For subsequent tax years, B has the following separate debt instruments: 1) a debt instrument in the principal amount of $15,000 that has a tax basis of $-0-; and 2) a debt instrument that has a principal balance of $40,000 and a tax basis of $10,000.

Let's summarize the tax results of B infusing the needed funds to S as loans. At December 31, 2010, B has invested $1,000 in the stock of S, made loans to S of $80,000, received loan repayments aggregating $25,000, recognized $15,000 of taxable income as a result of a loan repayment, and deducted tax losses of $61,000.

Instead of making loans to S, assume that B made capital contributions to S. A summary of B's basis in the stock of S for the years 2008 to 2010 is as follows: 

 

 

2008

2009

2010

Balance at beginning of year

$-0-

$16,000

$-0-

Initial stock investment

21,000

 

 

Additional capital contributions

-0-

20,000

40,000

Distributions

-0-

(10,000)

(15,000)

Deductible loss for year

(5,000)

(26,000)

(25,000)

Basis at end of year

$16,000

$-0-

$-0-

As confirmed in Nathel et al. v. Comr.3 and other cases, capital contributions by shareholders are not income to an S corporation and shareholder capital contributions increase the basis of the contributing shareholder's stock in the S corporation. Since S does not have a positive AAA or any AE &P, all distributions to B reduce the basis of B's stock.  B ends up with $5,000 of suspended losses at December 31, 2010, which are carried over to future years and will be deductible when B has sufficient basis.

The following observations can be made from these two examples:

  In the first example in which B elected to capitalize S with shareholder debt, B recognized $15,000 of taxable income; in the second example in which B made capital contributions, B recognized $-0- taxable income on the distributions and had $5,000 in suspended losses. The tax results in the first example where B lent funds to S were the result of the S corporation repaying shareholder debt before basis in that debt was fully restored.  Repayment of shareholder debt before its basis has been restored usually yields undesirable tax results. In this case, a shareholder recognized taxable income even though the S corporation had not made any money.

  If an S corporation has no AE & P, then capitalizing the S corporation with capital contributions rather than debt is probably advisable from an income tax standpoint, because any distributions will reduce the shareholder's stock basis and not result in taxable income to the shareholder.  On the other hand, if the S corporation has AE & P, it is probably more tax efficient to use debt rather than capital contributions to capitalize the S corporation because a shareholder will realize dividend income if the S corporation makes a distribution with respect to its stock at a time when the S corporation does not have AAA.

  Prior to October 20, 2008, the date when regulations concerning open account debt became final,4  a shareholder who made open account advances to an S corporation could net advances with repayments for the tax year to determine if open account shareholder debt increased or decreased for the year before applying the repayment rules. That is no longer the case. Regs. §1.1367-2(a)(2)(ii) now provides that if "shareholder advances not evidenced by a separate written instrument, net of repayments exceeds an aggregate outstanding principal amount of $25,000 at the close of the S corporation's taxable year, for any subsequent taxable year the aggregate principal amount of that indebtedness is treated in the same manner as indebtedness evidenced by a separate written instrument." As our first example illustrated, repayments that previously could be netted with advances are now considered repayments of a separate debt instrument and can result in taxable income.

  Shareholders who must continue to lend money to an S corporation may want to consider evidencing the debt with multiple written promissory notes. The shareholder can then choose the specific debt instruments that are repaid and may be have the flexibility to cause the S corporation to repay debt that will not result in taxable income.

It is quite common for small S corporations to have continuous advances from and repayments to their shareholders throughout a tax year. The Subchapter S regulations addressing open account debt may cause tax advisors to revise their planning strategies for accounting for these advances and repayments.

 For more information, in BNA's Tax Management Portfolios, see Starr and Sobol, 731 T.M., S Corporations: Operations,  and in Tax Practice Series, see ¶4290, Distributions and Repayment of Shareholder Debt.



1 See Regs. §1.1368-2(a)(3)(i)(A).  An AAA account of an S corporation is allowed to have a negative balance at the end of a tax year.

 

2 Regs. §1.1367-2(a)(2)(ii).

 

3 131 T.C. 262 (2008).

 

4 See Regs. §1.1367-3.