Using capital contributions and debt to increase the loss basis of S shareholders.

• Author: Streer, Paul J.

In these troubled economic times, many S corporations are faced with the unfortunate prospect of generating operating losses. Shareholders who are material participants in an S corporation can use their proportionate share of these losses to reduce taxable income from other sources to the extent that they have a positive year-end basis in their S stock.(1) Any remaining losses in excess of stock basis can be deducted by a shareholder currently only to the extent that the shareholder has remaining basis, at the close of the S corporation's tax year, in loans made directly by him to the S corporation.(2)

This article will discuss the requirements that must be met for shareholder capital contributions and loans to create tax basis; cover the proposed regulations as they pertain to adjustments to the basis of S corporation indebtedness to its shareholder; and delve into the very important and all too often neglected interaction between the Sec. 465 "at risk" rules and shareholder's basis in capital contributions and loans.

The Impact of Loans on Shareholder Basis

When a shareholder makes a direct loan to his S corporation, the shareholder acquires additional basis in his investment in the corporation that can be used to offset losses that flow through to the shareholder's return. The initial basis of each loan is the face amount of the loan (subsequently decreased by principal payments). Basis in the loan is reduced by any net losses allocated to a shareholder in excess of his basis in the corporation's stock. If a shareholder has made more than one loan to a small business corporation, the basis reduction is applied to each loan in the same proportion that the basis of each loan bears to the aggregate bases of the total indebtedness owed to the shareholder by the corporation.(3) To the extent that such losses exceed both the shareholder's stock and debt basis, they can be carried forward indefinitely and used in a later tax year when stock or debt basis is increased.(4)

If an S shareholder has insufficient stock basis to absorb his share of anticipated corporate losses and cannot (or will not) make additional capital contributions, serious consideration should be given to making a loan to the corporation before the close of its tax year. The failure to consummate such a loan will reduce the present value of the tax benefit stemming from the loss and, in the worst case scenario, the loss would never be used by the shareholder.

Treatment of Loss Carryforwards

Loss carryforwards are available for use only by the shareholder who owned the stock during the time period the losses were actually incurred.(5) They are not transferable when ownership of the S stock changes. Thus, unused loss carryforwards will be lost when stock is sold, given away or transferred by reason of death.

If an S corporation revokes its s election, loss carry forwards that have not been used by shareholders because of basis limitations can be taken during a one-year post-termination period. Shareholders have an opportunity during this time to restore basis through capital contributions (but not through additional loans to the corporation).(6) Any loss carryover that remains at the end of a one-year post-termination period is permanently lost. This final opportunity to make use of unused loss carryforwards can be used only in a revocation of S status; it is not available in a transfer of stock ownership. Since a shareholder's ability to quickly increase basis may be far from assured, an affected shareholder may want to increase his debt basis instead, to the extent necessary, before an S election is revoked, so that all current and carryforward losses can be fully used.

Increasing Stock Basis

Shareholders can increase their basis in S stock by making additional cash transfers to the corporation. In addition, shareholders can transfer other property to an S corporation in exchange for stock, tax free under Sec. 351(a), provided that an 80% post-transfer control requirement is met.(7) In this case, basis increases only to the extent of the basis of the property transferred.

This control requirement will often present income recognition problems for minority shareholders who transfer appreciated property to a corporation. If the control requirement cannot be met, gain is recognized to the extent that the fair market value (FMV) of the stock received is greater than the basis of the property transferred to the corporation.

In addition, if a shareholder contributes property in a Sec. 351 transaction that is encumbered by a liability the corporation...