S shareholder loans: potential tax trap.

• Author: Goldberg, Michael J.

Shareholders with passthrough losses who have exhausted their common stock basis have readily turned to shareholder loans as a method of increasing basis. The basis increase allows shareholders to recognize flowthrough losses immediately. Given the time value of money, conventional thinking has it that it is better to use losses as soon as possible, rather than to wait for S gains to offset such losses.

Many S shareholders, however, do not have the financial ability to make shareholder loans from personal savings. A typical strategy for an S shareholder is to arrange for a personal loan from a bank and then reloan the funds to the S corporation. This strategy requires preparation of two loan documents: one for the loan from the bank to the individual shareholder and the other for the loan from the shareholder to the S corporation. Terms of shareholder loans are usually the same as the bank loan terms to an individual shareholder, resulting in back-to-back loans.

A problem with this strategy occurs on loan repayment. On repayment of a debt owed to a shareholder after a reduction in the shareholder's basis and a deduction passed through to him, the shareholder realizes income to the extent of the amount repaid over the reduced basis of the debt. This can be ordinary income or capital gain, depending on the type of loan. In Rev. Rul. 64-162, repayment of a loan evidenced by an instrument was considered capital gain. In contrast, Rev. Rul. 68-537 stated that repayment of a shareholder loan not evidenced by an instrument (known as an "open account" loan) resulted in ordinary income treatment.

However, using shareholder loans generated from individual bank loans to increase S basis can be a potential tax trap for an uninformed S shareholder.

Example 1: R is an S corporation wholly owned by X. R incurs tax losses during its startup phase. It has a $150,000 loss in year one, a $100,000 loss in year two, and a $50,000 loss in year three. Finally, in year four, R breaks even. In years five through 10, it has an annual $50,000 profit. X has previously used R's common-stock basis against prior losses. X is single with no dependents. R pays X a salary of $50,000 per year, which is considered reasonable compensation.

X injects a $500,000 shareholder loan, originally obtained from a bank, into R to recognize early-year losses. The loan is evidenced by a note. In year one, the total shareholder tax loss for the year is $82,787, consisting of R's loss of...