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By Gerald S. Deutsch, Esq.
Glen Head, NY
Sam learned from his accountant that he would be taxed on the amount of the open account that had been due to him from his S Corp that had been repaid to him during the year, because the basis of that account had been reduced by losses. So Sam decided to advance money to the corporation before the year end to restore the reduction before the end of the year, and thus he would not be taxed on the repayments to him during that year. Then, early the next year Sam had the corporation repay that advance to him. This was repeated for several years. Open account advances, unlike term loans, were for many years treated as one single indebtedness and so advances and repayments went to the same account.
The IRS did not like this plan but the Tax Court held for the taxpayer in similar circumstances.1 This caused the IRS to change its regulation and those changes were finalized in October, 2008 by T.D. 9428 amending Regs. §1.1367-2.
The new regulation provides that if a threshold of $25,000 or more (determined at the end of the year) is reached in an open account, then " for any subsequent taxable year the aggregate principal amount of that indebtedness" won't be treated as open account indebtedness but like a term loan – a separate loan.2 So Sam's plan will be greatly limited going forward.
In the examples given in the new regulations, the IRS states that they "do not result in foregone interest, original issue discount, or total unstated interest."3 While these provisions, if applicable, might not cause additional tax problems (because interest income imputed to the stockholder could provide an interest deduction to the pass- through corporation and then there may be the benefit of the "self charged" interest rules), those imputed interest rules could raise many complications.
S corporations may need funds from shareholders for operations, or, as in the Brooks case, to provide basis to allow operating losses to be deducted by shareholders. But why not, instead of lending money, have the stockholders contribute the funds to the capital of the corporation? It would seem that those funds could later be withdrawn with far better tax consequences. First, if the corporation has an Accumulated Adjustment Account (AAA), funds withdrawn are deemed to first come tax free from that account. Second, withdrawn funds are deemed to come from "earnings and profits" from a C corporation year, if any (if the corporation was ever a C corporation and had earnings and profits) but this would be taxed as dividends – and, as qualified dividends the rate would be at capital gain rates. Third, withdrawal are tax free to the extent of any basis that the shareholder has in the stock until that balance is zero. Finally, withdrawals in excess of basis will be taxed as capital gains.
In the case of repayments of loans (term or open account) where there has been a reduction of basis, part of any payment will be taxable.
While term loans would be taxed as capital gains, repayments of open account indebtedness will be taxed as ordinary income,4and it's not clear that the new regulations will change that. The regulation reads, "If … shareholder advances not evidenced by a separate written instrument … exceeds … $25,000 … that indebtedness … is treated … as indebtedness evidenced by a separate written instrument for purposes of this section" - and the section is called "Adjustments to Basis" so for other purposes – capital gain or ordinary income – the debt may well still be considered open account debt.5
So if funds are needed by an S Corp and the funds are to be from shareholders it may well be better to have those funds credited to a "paid in capital" account rather than a loan account.
Of course if the corporation has more than one stockholder, and not all will be contributing, then perhaps some arrangement would have to be made to compensate that stockholder (or those stockholders) by, say, (i) paying interest if the contribution is to be in the form of a note or loan, or (ii) issuing more stock if the advance is to go to capital. Not only would this be equitable, but it may avoid the IRS claiming that there is a second class of stock, and thus jeopardizing the S election.
For more information, in the Tax Management Portfolios, see Starr and Sobol, 731 T.M., S Corporations: Operations, and in Tax Practice Series, see ¶4280 , Basis of Stock and Debt, and ¶4290, Distributions and Repayment of Shareholder Debt.
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