Final Sec. 1367 Regs. address open account debt between S Corps. and their shareholders.

• Author: MacDonough, Laura

The Service has issued final regulations (T.D. 9428) amending the definition of open account debt, which may significantly affect when an S corporation shareholder recognizes gain on the repayment of such debt.

Background

Under Sec. 1366(d)(1), the aggregate amount of passthrough losses and deductions that an S corporation shareholder may take into account for any tax year cannot exceed the shareholder's adjusted basis in the corporation's stock and loans made by the shareholder to the corporation.

Under Sec. 1367(a)(2), the basis of each shareholder's stock in an S corporation is decreased (but not below zero) by, among other things, the shareholder's pro-rata share of the corporation's losses, deductions, and nondeductible, noncapital expenses. If these items reducing basis exceed the amount that reduces the shareholder's stock basis to zero, such excess losses and deductions are applied to reduce (but not below zero) the shareholder's basis in any indebtedness of the S corporation to the shareholder (Sec. 1367(b)(2)).

If an S corporation repays a loan from a shareholder in which the shareholder's basis has been reduced under Sec. 1367(a)(2), the shareholder recognizes gain on the repayment.

Final regulations issued in 1994 (T.D. 8508) provided that shareholder advances not evidenced by separate written instruments and repayments on the advances (open account debt) are treated as a single indebtedness. Under these rules, a shareholder would compare the amount of open account indebtedness outstanding at the beginning of the year with the amount of such indebtedness at the close of the year to determine if there was a net repayment for which gain might be recognized.

In Brooks, T.C. Memo. 2005-204, the taxpayer took advantage of these rules by making a large unwritten advance at the end of the tax year (year 1) against which he claimed passthrough losses; the S corporation repaid the loan shortly after the beginning of the following tax year (year 2). Shortly before the close of year 2, the taxpayer made another large unwritten advance. As a result of the advance made at the close of year 2, there was no net repayment of the open account debt for the year; accordingly, the taxpayer avoided recognizing gain on the repayment of the year 1 advance.

The taxpayer continued this pattern of making a loan at the close of one year, repaying the loan at the beginning of the following year, and making another loan just prior to the close of the...