S Corporations - Sharedholder Basis in Debt

 

Problem:  Taxpayer owns an S Corp which owns an aircraft and the S Corp owes a third party debt against the aircraft yet the shareholder has no basis in this debt therefore limiting loss deductions which flow from the S Corp generated by depreciation.

 

Tax Law:  S Corporation Shareholder Basis in Debt,  CCH Federal Tax Service @ I;18.142.

 

The amount of losses and deductions a shareholder can claim or recognize is limited to the adjusted basis of the shareholder’s stock plus the adjusted basis of any indebtedness of the S corporation to the shareholder.  Code Sec. 1366(d)(1). 

 

Before any deduction is permitted with respect to debt, the shareholder must be able to demonstrate the status of the debt holder.  Thus, if there is no promissory note, book entries or any other evidence that a decision by the shareholder to lend money to the s corporation, basis will not be created.  A corporation’s financial statements indicating the existence of loans from shareholder is not enough to conclude that a debt in fact exists.

 

The debt must be a direct indebtedness of the shareholder, rather than a guarantee or other accommodation by the shareholder on behalf of the corporation.  Similarly, a loan is not included in basis if it is made through an intermediate entity such as a partnership.  Even if the loan is cast as a direct loan from the shareholder, there must be some economic outlay by the shareholder.  CCH Federal Tax Service @ I;18.142[a]

 

 For purposes of supporting a deduction, a shareholder’s basis in indebtedness is limited to basis in debt owed by the corporation directly to the shareholder.  No form of indirect borrowing be it a guaranty, surety, accommodation, co-making or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation.  Prior to that act, liability may exist, but it does not constitute debt to the shareholders.  Thus, a shareholder’s basis does not include corporate debt owed to a third party that has been guaranteed by the shareholder.  This is so regardless of whether the shareholder-guarantor has given the third party a security interest in his property to secure payment.

 

Tax Court has held (D.S. Gilday v Commr, 43 TCM 1295) that if a third party lender accepts a note issued by the shareholder in substitution for, and cancellation of, a note previously issued by the corporation and guaranteed by the shareholder, AND the corporation thereafter conducts itself as directly indebted to the shareholder for the amount of the loan, the transaction suffices to create shareholder basis even though the purpose of the transaction was to create basis to obtain a deduction.  Similarly, the IRS has ruled (IRS Letter Rulings 8747013, August 20, 1987 and 8443002, July 6, 1984) that a loan from a bank to a shareholder of an s corporation, secured by a lien on assets of the corporation but on which the corporation would not be a guarantor or co-maker, the proceeds of which the shareholders would then lend to the corporation to be used by it to repay its own loan to the bank secured by a lien on the same assets, would result in shareholder basis in the corporation’s indebtedness to them.

 

A failure to respect the form of the transaction can result in disallowances of the loss. (B. L. Spencer v Commr, 110 TC 62).

 

When both the corporation and the shareholder sign a note, the question of which party so the principal debtor and which the accommodation party is one of fact.  Key factor include whether the lender looks to the corporation, not the shareholder, for payment ad whether the initiative to add the shareholder as co-maker comes from the lender.  (R.J. Salem v Commr, 75 TCM1798)

 

When the status of the parties is unclear from the instrument, courts generally hold that the party who received the benefit from the proceeds of the note is the principal debtor.  (L.B. Harrington v US, DC Del)   

 

 

  

In order for the taxpayer to get basis in debt, the debt must be direct between the shareholder and the S corporation.  In order for the aircraft to be depreciated, it must be owned by and used in the ordinary course of business, in this case, the S corporation.  Therefore the solution is to have the aircraft refinanced such that the structural requirements are met.

 

Here’s how it would work:

 

            Step 1:  The shareholder loans the S corporation $5 and the S corporation uses the funds to retire the existing mortgage.

 

            Step2:  The shareholder borrows $5 from a third party lender and uses the asset owned free and clear by the S corporation as collateral for the loan.

 

            Result:  Shareholder’s net cash position is unchanged and yet the shareholder now has $5 basis in the debt.

 

In concept this structure will accomplish the objective of creating basis and therefore allow losses to flow; however, there are some obvious consequences which must be analyzed, understood and accepted:

 

1.      The shareholder’s basis will be rapidly depleted due to depreciation deductions related to aircraft.  As a result, loan payments made by the S corporation to the shareholder once the basis has expired will be taxable income to the shareholder, i.e.”the worm turns”. 

2.      Accordingly, to match a seven year MACRS schedule with a twelve or fifteen year loan amortization schedule will create obvious problems in later years. 

3.      The interest income paid by the S corporation to the shareholder will be deductible by the S corporation and therefore flow through to the shareholder.  This deduction will offset the related interest income recognized by the shareholder coming from the S corporation. 

4.      However, the nature of the interest paid by the shareholder to the third party lender may be subject to limitations. 

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