Open account debt for S shareholders.

• Author: Sobochan, David

On April 12, 2007, the Service issued proposed amendments to Hess. Sec. 1.1367-2 and -3 (REG-144859-04), to address concerns about the treatment of S shareholders' open account debt.

Background

Regs. Sec. 1.1367-2(a) states that open account debt is a shareholder advance that is not evidenced by a note. Typically, open account debt refers to a situation in which multiple loans are historically made from a shareholder to a corporation throughout the year.

Repayments and advances are treated differently for open account debt than for a shareholder loan evidenced by a note. For debt evidenced by a note, additional advances made by shareholders constitute new loans. Advances for loam considered open account debt are treated as additions to the existing open account debt.

Similarly, loan repayments for debt evidenced by a note are applied to the specific loans for which the payments are made. Loan repayments on open account debt are applied to all such debt.

The debt basis calculation also differs. For shareholder loans evidenced by a note, additional advances do not restore or prevent income recapture to zero- or low-basis loans repaid during the year. Because additional advances are deemed new loam, they provide the shareholder with additional basis for deducting additional losses, but do not prevent income recapture for the zero- or low-basis loans repaid during the period.

However, for open account debt, additional advances restore zero-basis loans repaid during the year. Under Regs. Sec. 1.1367-2(b)(1), basis for open account debt is determined at the close of the year. Thus, advances and repayments are netted throughout the year; the final determination of debt basis for open account debt is determined at the dose of the year. This provision allows S shareholders time to make corrective loam before the end of the year to restore debt basis.

This is a very important distinction, because income recapture can occur when debt basis is used to deduct corporate losses. When debt basis is reduced to zero due to corporate losses, and payments are made against the zero-basis loam, income recapture may occur.

The proposed regulations were issued in response to the decision in Brooks, TC Memo 2005-204. There, S shareholders advanced money to their S corporation in one year and used the advances to deduct corporate losses. In the subsequent year, the corporation repaid the loans, then the shareholders made additional loam to restore debt basis. This...