Avoiding gain at the S shareholder level when a loan is repaid.

• Author: Hunley, Shaun M.

Corporate repayment of loans owed to an S corporation shareholder reduces the shareholder's basis in such loans. However, when basis in a shareholder's loan has been reduced by passthrough losses, repayment of the loan is a taxable event to the extent full repayment exceeds the shareholder's basis in the debt, or to the extent partial repayments exceed a pro rata portion of the basis in the debt (Rev. Ruls. 64-162 and 68-537).

This gain on the repayment of reduced-basis debt does not increase debt basis for purposes of using S corporation losses in the hands of that shareholder.

Recognition and character of gain on repayment of reduced-basis loan

Reductions in debt basis result in gain when the loan is partially or fully repaid. This is inevitable because corporate income increases debt basis to the extent debt basis was reduced by losses or deductions (Sec. 1367(b)(2)(B)).

The character of the gain depends on whether the debt is evidenced by a written note. If there is no note, as with an open account receivable, the gain is ordinary income (Rev. Rul. 68-537). If the indebtedness is evidenced by a written instrument, the repayment is treated as a sale or exchange of a capital asset (Rev. Rul. 64-162). Thus, the gain is long-term capital gain if the debt instrument has been held for more than 12 months, and it is short-term capital gain otherwise.

Example 1. Recognizing gain on repayment of reduced-basis note: P is the sole shareholder of Nine, a calendar-year S corporation that has had a valid S corporation election in effect for all years it has existed. Five years ago, P loaned N $60,000. The loan was documented properly and pays interest at a fair market rate. A passthrough loss in the following year reduced the basis of the loan by $15,000, bringing P's debt basis to $45,000. At the beginning of the current year, P has stock basis of $29,000 and debt basis of $45,000.

N's only passthrough item for the year is nonseparately stated trade or business income of $12,500. The corporation made distributions of $14,000 during the year. (Therefore, there is no "net increase" in basis for the year, and debt basis is not increased by the current year's income items.)

The corporation has paid the interest annually. This year, P decides he would like to have N pa[gamma] him the face amount of the note, $60,000, and tells his tax planner that he wants N to make a principal payment of at least $45,000. (The payments can be made from funds the...