S corporation shareholder basis from bona fide indebtedness.

• Author: Nevius, Alistair M.

The IRS issued proposed regulations on the contentious subject of when an S corporation shareholder can increase his or her basis in the S corporation's stock, based on loans to the corporation, and thereby increase the amount of the corporation's losses and deductions the shareholder can recognize (REG-134042-07).

S corporation shareholders, unlike partners, generally are not permitted to increase their basis by guaranteeing a loan made by a third party to the corporation until they actually have to make payments on the guarantee. They are also not allocated basis from their allocable share of the entity's debt, as a partner is for the partnership's debt. As a result, S corporation shareholders spend a lot of time trying to avoid these rules and create basis that will allow them to deduct losses.

The proposed regulations provide that, to increase a shareholder's basis in indebtedness, a loan must represent the S corporation's "bona fide indebtedness" that runs directly to the shareholder. "Bona fide indebtedness" is not defined in the regulations; rather, general federal tax principles determine if a debt is bona fide. And the proposed regulations continue to deny basis from a shareholder's guarantee, or surety, or similar arrangement unless the shareholder actually performs under the arrangement (REG-134042-07 preamble; Prop. Regs. Sec. 1.1366-2(iii), Example (2)).

As for loans running directly to the shareholder, the proposed regulations address loans made under what the IRS calls the "incorporated pocketbook" theory, in which a shareholder claims that a loan to an S corporation from an entity related to the S corporation shareholder is in...