Revisiting "Avoiding Shareholder Gain When Reduced-Basis Loan Is Repaid." (response to The Tax Advisor, p. 322, May 1992)

• Author: Kessler, Bertram E.

This Studies in Taxation is written by Bertram E. Kessler, Esq., in response to the May 1992 Studies in Taxation, "Avoiding Shareholder Gain When Reduced-Basis Loan Is Repaid," at 322. Mr. Kessler is counsel to Hahn & Hessen, New York, N.Y., and is an Associate Professor of Taxation, Lubin Graduate School of Business, Pace University, New York. N.Y.

Facts

Paul, sole shareholder of S corporation New Leaf, loaned $60,000 to the corporation and received a $60,000 note bearing fair market interest. Thereafter, the basis of the note was reduced to $45,000 by a passthrough loss. Under the facts in the May Study, the reduction in debt basis occurred prior to 1983 and therefore debt basis would not be restored by subsequent corporate income inasmuch as Sec. 1367(b)(2))(B)permits increases in debt basis only for reductions occurring in tax years beginning after 1982.

Full repayment will result in income to the shareholder to the extent it exceeds his basis According to the IRS, even a partial repayment will result in income to the shareholder because each dollar of repayment must be allocated pro rata to income and basis. Under the facts as presented, a $45,000 repayment would be deemed to be made up of a $33,750 nontaxable return of basis and $11,250 of gain. 554

Various strategies for offsetting the assumed income were discussed in the May Study. One approach not discussed is a method for completely avoiding income or gain to the shareholder for a distribution of an amount equal to the face value of the note, even though such face value exceeds the basis to the shareholder.

Analysis

If Paul contributes the note to New Leaf as a contribution to capital, the basis of his stock will be increased by his basis for the note. In all likelihood (since the corporation is able to repay the debt), it will have an accumulated adjustment account in such amount. Also, New Leaf may have no earnings and profits inasmuch as it is an S corporation. In either event, a distribution not in excess of the stock basis will be nontaxable to the shareholder and merely...