Using S losses to generate future capital gains - planning opportunities available for shareholders with capital losses.

• Author: Lightfoot, Chip

It is not uncommon for an S shareholder with zero stock basis to loan money to the S corporation to use either current year or suspended losses. The debt basis is reduced by the used losses, resulting in "reduced-basis" debt. If the reduced-basis debt is repaid before its basis is restored by future S income, the shareholder recognizes income on otherwise tax-free principal repayments (usually an unfavorable result). But what may be surprising to some - and may present at least one planning opportunity - is that this income is considered capital in nature as long as the debt is evidenced by a note and is a capital asset in the shareholder's hands. (Note: The following discussion does not deal with any interest income paid on the note, which is always ordinary income.)

The use and benefit of current S losses at the cost of incurring a future year capital gain from the debt repayment may nevertheless result in a benefit to the shareholder, by allowing the use of capital losses he would not otherwise be using in the foreseeable future (besides the allowable $3,000 a year deduction). In effect, the shareholder can trade capital losses (i.e., by offsetting debt repayment capital gain) for the acceleration of S losses. And the shareholder can structure the loan to be made at or near year-end, with repayment early in the subsequent year, resulting in minimal economic loan costs to the shareholder (the shareholder can use his own cash or borrow the funds to loan to the S corporation for a short period of time). In any event, any loan costs may be partially or completely offset by interest income on the loan from the S corporation. Caution: It is necessary to "run the numbers" to determine the benefits and costs of using this strategy before entering into this type of transaction.

Capital gain treatment from

repayment of debt evidenced

by a note

Rev. Rul. 64-162 provided that if a shareholder-creditor has reduced-basis debt from the use of S losses and deductions, the retirement of the debt is considered to be an amount received in exchange for a capital asset when a note was issued to the shareholder-creditor and such note is a capital asset in the shareholder's hands. (See also Letter Ruling (TAM) 9304004, which follows Rev. Rul. 64-162 in its conclusion.) Installments received in retirement of the note must be allocated in part to a return of the shareholder's basis in the loan and in part to income capital gain income if a capital asset).

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