S corporation shareholder loans: a cautionary tale.

• Author: Jacobs, Harriet

A practitioner should take special care in advising clients on shareholder loans to an S corporation. Repayment of the loans by the corporation has the potential to generate unexpected taxable income to the shareholder.

First, a quick review of the mechanics of S corporation loans. An S corporation shareholder in a closely held corporation might make loans to the company to improve liquidity and to provide working capital. The face amount of the loan becomes the shareholder's initial basis in the loan. The S corporation might also pass through losses to its owners, which can be deducted by the shareholders to the extent of their adjusted stock and loan basis (Sec. 1366(d)).

If a passthrough loss exceeds a shareholder's stock basis, the excess loss then reduces the shareholder's loan basis, but not below zero (Regs. Sec. 1.13672(b)(1)). When the corporation passes through net income in a subsequent year, the loan basis is increased first, but only to the extent of the indebtedness at the beginning of that tax year. Any excess net income is next used to increase the shareholder's stock basis (Regs. Sec. 1.1367-2(c)(1)).

Special rules apply in cases of multiple indebtedness--i.e., if a shareholder has multiple loans to the corporation that are each evidenced by separate notes. This item will deal only with single loans, with or without written notes. If there is no note, the loan is considered open account debt, which is defined in Regs. Sec. 1.1367-2(a) as "shareholder advances not evidenced by separate written instruments and repayments on the advances."

Full or partial cash repayment of the debt by the corporation reduces the shareholder's loan basis. (Repayment with property other than cash is beyond the scope of this item.) If the debt basis has previously been reduced to zero, all the subsequent repayment is treated as taxable income to the shareholder. In the case of a reduced loan basis, each repayment is allocated between return of basis and income (Rev. Rul. 68-537).

The character of the income is determined by whether or not the loan is evidenced by a written note. Generally, repayment of a loan is not considered to be the sale or exchange of a capital asset, and thus produces ordinary income. However, if the loan is evidenced by a written note, income from the repayment is capital gain, because the note itself is considered a capital asset in the shareholder's hands (Rev. Rul. 64-162). The usual rules apply in determining whether...