Calculating basis in debt.

• Author: Ellentuck, Albert B.

Direct shareholder loans to an S corporation can be very important tools for tax planning. Unlike a partner, an S corporation shareholder does not increase basis by a ratable share of corporate indebtedness to third parties. This is because a shareholder generally is not liable for the corporation's obligations.

To obtain basis, the debt must be owed by the corporation directly to the shareholder (Sec. 1366(d)(1)(B); Regs. Sec. 1.1366-2(a)(2)(i)). The shareholder's personal guarantee of the corporation's obligations to third parties does not create basis (Regs. Sec. 1.1366-2(a) (2)(ii); Rev. Ruls. 70-50 and 71-288).

Passthrough Losses Can Reduce Debt Basis

Once a shareholder's basis in S corporation stock has been reduced to zero, passthrough losses and deductions still can be deducted to the extent the shareholder has debt basis (i.e., basis in direct loans from the shareholder to the S corporation) (Sec. 1367(b)(2)(A); Regs. Sec. 1.1367-2).

Basis Reduction Applies to Each Debt Outstanding at Year End

If the shareholder holds more than one debt at the end of the corporation's year, the basis reduction applies to each debt in the same proportion that the basis of each debt bears to the aggregate bases of all debt (Regs. Sec. 1.1367-2(b)(3)).

No Basis Reduction If Debt Is Not Outstanding at Year End

Debt basis is not reduced by passthrough losses or deductions if the debt has been satisfied, disposed of, or forgiven during the corporation's tax year (Regs. Sec. 1.1367-2(b)). (Even though debt basis cannot be decreased if the loan was fully repaid during the year, it can be increased by the corporation's income under certain conditions.)

Increasing Previously Reduced Debt Basis by Corporate Income

When debt basis has been reduced by passthrough losses in a year after 1982, passthrough items of income or gain generally increase debt basis. However, the items of income, gain, loss, and deduction must first be netted, along with the nondividend distributions. (Nondividend distributions are distributions other than those made from accumulated earnings and profits.) If the result is a positive amount (income and gain amounts exceed losses, deductions, and nondividend distributions), there is a net increase, and debt basis is increased by the net increase to the extent debt basis has been reduced by post-1982 losses (Sec. 1367(b)(2)(B)). Debt basis is increased only up to the outstanding balance on the note at the beginning of the year (Regs. Sec...