Debt and proving basis in flowthrough entities.

• Author: Heroux, Mark S.

Taxpayers with ownership interests in flowthrough entities cannot deduct entity losses if they do not have basis in those entities. Consequently, a taxpayer's basis is often scrutinized by the IRS, particularly when basis is claimed based upon debts incurred by a flowthrough entity.

In mid-2012, the IRS issued Prop. Regs. Sec. 1.1366-2 (REG-134042-07) to establish a standard for when shareholders can increase basis in S corporations based upon loans to the S corporation. Under this standard, a shareholder may increase basis by "bona fide indebtedness" of the S corporation that runs directly to the shareholder. Partners, in contrast, are subject to the more complex partnership basis rules of Secs. 752 and 465. As basis laws change and develop over time, the IRS will continue to scrutinize reported losses.

Basis for Shareholders in S Corporations

The proposed regulations do not establish factors or criteria to determine when S corporation indebtedness is bona fide. Instead, whether indebtedness is bona fide is determined under general tax principles. The preamble to the proposed regulations cites four cases that establish whether a debt is bona fide: Knetsch, 364 U.S. 361 (1960); Geftman, 154 F.3d 61 (3d Cir. 1998); Estate of Mixon, 464 F.2d 394 (5th Cir. 1972); and Litton Business Systems, Inc., 61 T.C. 367 (1973). Geftrnan, for instance, established three factors to determine whether a loan is bona fide: (1) contemporaneous intent to repay; (2) objective indicia of indebtedness, e.g., the creation of a note, collateral, repayment schedule, etc.; and (3) economic reality.

The proposed regulations provide three examples of debt arrangements that may or may not be bona fide, depending on the facts and circumstances. The first example involves a "shareholder loan transaction," under which a sole shareholder makes a direct loan to the S corporation. The second example involves a "back-to-back loan transaction." In this example, A is the sole shareholder of two S corporations, S1 and S2. S1 first makes a loan to A, and then A makes a loan to 52. The third example involves a "loan restructuring through distributions." In this example, A is the sole shareholder of two S corporations, S1 and S2. S1 makes a loan to S2. S1 then distributes the note from this loan to A, placing A in a creditor position. In each scenario, the shareholder may obtain basis only "if the loan constitutes bona fide indebtedness."

To determine whether a shareholder loan...