Final Treasury Regulations Limit Shareholders’ Use of Open Account Debts to Absorb S Corporation Losses

December 8, 2008

On October 20, 2008, the IRS issued final regulations that would limit the use of “open account debt” to pass through S corporation losses to shareholders. The final regulations, which include pro-taxpayer changes from the earlier proposed regulations, address an IRS concern that S corporation shareholders are manipulating their tax bases in so-called “open account debts” (loans by shareholders to the S corporation that are not evidenced by separate written instruments) to defer taxable income.

A tax benefit of using a partnership over an S corporation is that partners can increase their bases in their partnership interests by their allocable share of partnership debts. (The same is true for a limited liability company with more than one member, unless it elects to be treated as a corporation, because it would be treated as a partnership for tax purposes.) The amount of partnership losses that can pass through to a partner to be used to reduce his or her income is limited to the partner’s basis in his or her partnership interest (as increased for the partner’s share of partnership debt). Thus, a partner’s increased basis from his or her share of partnership debt allows more partnership losses to pass through to the partner.

In contrast to partners, S corporation shareholders cannot increase their stock bases by their proportionate share of the S corporation’s debts. Under Section 1367 of the Internal Revenue Code, S corporation losses that pass through to a shareholder are first applied against the shareholder’s stock basis, and, once the stock basis has been reduced to zero, the losses are applied against the shareholder’s basis in any loans he or she has made to the S corporation.

When a shareholder loans money to an S corporation, the shareholder takes a basis in the corporation’s debt equal to the amount of the loan, called “debt basis.” With open account debt, the shareholder calculates debt basis at the end of each year by netting advances and repayments into one debt basis. If debt is not open account debt (i.e., “single indebtedness”), the shareholder takes a separate basis in each advance, and the basis in each such advance is not increased by future advances. If the S corporation’s losses exceed the shareholder’s stock basis, the losses pass through to the shareholder up to the amount of the debt basis (the losses in excess of stock basis reduce the debt basis). Future income of the S corporation restores the debt basis before it increases stock basis. Repayment of debt in excess of the holder’s basis in such debt results in taxable income.

Under these principles, as in Brooks v. Commissioner, T.C. Memo 2005-204, taxpayers have used an open account debt to defer taxable income by increasing open account debt basis at successive year ends to permit losses to pass through to them without having to recognize income from repayments of the advances. In that case, an S corporation shareholder borrowed money from a bank and advanced it to the corporation as open account debt at the end of year #1. The shareholder’s debt basis allowed him to recognize S corporation losses for year #1 in excess of his stock basis. The losses reduced his debt basis. In early year #2, the corporation repaid the shareholder. To prevent taxable income from such year #2 repayment, and to allow him to recognize year #2 losses, the shareholder made a second advance at the end of year #2 with more money he borrowed from a bank. The second advance increased his debt basis sufficiently to cover both the beginning year #2 repayment of the year #1 advance and the year #2 losses. The shareholder repeated this pattern in the following year.

The IRS argued that the shareholder must determine his debt basis at the time of the repayment in early year #2 without regard to the advance at the end of year #2. Under the IRS’s argument, the shareholder would have had a debt basis smaller than the repayment because the year #1 losses had reduced his debt basis. The shareholder would have had taxable income equal to the excess of the repayment over his debt basis. The shareholder successfully argued that he properly calculated his debt basis at year end, allowing him to net the repayment against the combined year #1 and year #2 advances. Consequently, the shareholder had sufficient debt basis to avoid taxable income from the year #2 repayment. If the debt had not been open account debt, the advances made later in the year would not have increased the debt basis, and the repayment of the debt would have triggered gain.

The final regulations under Section 1367, in less onerous fashion than the proposed regulations, curtail this type of activity, in part, by imposing a $25,000 limit, per shareholder, on open account debt (the IRS agreed with commentators that the aggregate principal limit of $10,000 in the proposed regulations was too low for most businesses). Moreover, while the proposed regulations would have required taxpayers to maintain day-to-day monitoring of open account debt (i.e., if at any day during the taxable year, the net of advances and repayments would exceed $10,000, the debt would cease to be open account debt on that day), the final regulations more sensibly provide that the determination of whether the advances and repayments exceed the $25,000 limit for open account debt will be made at the end of the S corporation’s taxable year and, if such limit is exceeded, such debt would cease to be open account debt for any subsequent taxable year. These changes from the proposed regulations substantially lessen the burden on shareholders while at the same time furthering the IRS’s objective of limiting taxpayers’ ability to manipulate their tax bases in open account debt to defer taxable income.

Accordingly, if at the end of an S corporation’s taxable year, the net of advances and repayments on open account debt for any particular shareholder exceed $25,000, such shareholder debt would cease to be open account debt for any subsequent taxable year. The aggregate principal amount of the advances on the close of such taxable year would be treated as single indebtedness. Future advances would not increase the shareholder’s basis in the single indebtedness. Thus, a shareholder that exceeds the $25,000 limit would have taxable income when the S corporation repays the single indebtedness (that would no longer be treated as an open account debt) to the extent the repayment exceeds the shareholder’s debt basis, reduced by the S corporation’s losses, in the particular debt the corporation is repaying. Any future advances not evidenced by a written instrument would be treated as open account debt until such advances exceed the $25,000 limit.

The final regulations apply to any shareholder advances to an S corporation made on or after October 20, 2008 (the “effective date”) and repayments on those advances by the S corporation. If a shareholder has open account debt (net of prior repayments in the taxable year) outstanding prior to the effective date, however, the prior rules apply to any repayments on such pre-effective date open account debt. Accordingly, any pre-effective date open account debt will not be subject to the $25,000 limit and a shareholder, while unable to make additional advances with respect to pre-effective date open account debt (because all shareholder advances made on or after the effective date constitute new open account debt subject to the final regulations), will be able to receive repayments on that debt under the prior rules. Although not specifically addressed by the final regulations, it appears that it is the shareholder, rather than the S corporation, that decides whether a post-effective date repayment is to be applied to a pre-effective date advance or a post-effective day advance. The S corporation would have to treat the post-effective date repayment consistently with the shareholder’s decision.