Avoiding shareholder gain when reduced-basis loan is repaid.

• Author: Ellentuck, Albert B.

Facts

Paul is the sole shareholder of New Leaf, Inc., a calendar-year S corporation. In 1982, Paul loaned the corporation $60,000. The loan was documented properly, and the note provided for payment of fair market interest. A passthrough loss in 1982 reduced the basis of the loan by $15,000, bringing Paul's debt basis to $45,000.

The corporation has paid the interest and renewed the note annually. This year, Paul decides that he would like to have the corporation pay him the face amount of the note, $60,000, and he asks his tax adviser for advice. He tells the adviser that he would like to have the corporation make a principal payment of at least $45,000.

Issue

How can the tax effects of the loan repayment be minimized?

Analysis

Paul must recognize gain if he receives payments on the note. Receipt of the face amount would result in gain of $15,000 ($60,000 payment - $45,000 basis).

The adviser then explains the effects of a partial repayment. Paul assumed that a repayment equal to his basis in the note, $45,000, would have no adverse tax effects. The IRS position, however, is that partial repayment of a shareholder loan that has been used as a basis for loss deductions represents income to the shareholder. Such income, computed on a pro rata basis, is $11,250: the note's face value ($60,000) less its basis ($45,000), divided by its face value ($60,000), multiplied by the repayment amount ($45,000).

It should be noted that pre-1983 reductions in debt basis ($15,000, in this case) will always result in gain when the loan is repaid. This is inevitable, corporate income increases debt basis only to the extent that debt basis was reduced by losses or deductions in tax years beginning after 1982. Even partial repayments cause gain to be recognized.

The character of the gain depends on whether the debt is evidenced by a note. If there is no note (e.g., an open account receivable). the gain is ordinary income. In contrast, gain generated by the retirement of a debt instrument is deemed to be sale or exchange of a capital asset. Paul's gain on the note is a long-term capital gain since he held the note for more than one year.

Thus, the repayment would be made up of a $33,750 nontaxable return of basis and an $11,250 capital gain. The note's face value at year-end would be $15,000 and Paul's basis in the note at year-end would be...