S shareholder's note payable and note receivable as two separate items.

• Author: Pease, Joseph V., Jr.

Can an S corporation have a note payable and a note receivable from the same shareholder?

The answer is an unequivocal maybe.

This situation is occasionally seen after a C corporation makes an S election. The scenario often develops as follows.

A C corporation shareholder withdraws funds from the corporation in the form of a loan. This is usually done to avoid or delay taxation of what would otherwise be wages or dividends. The C corporation then makes an S election. The S corporation suffers losses, and either requires capital or the shareholder needs additional basis to deduct losses on his Form 1040. The shareholder contributes funds to the corporation in the form of a loan.

The issue is whether to net the receivable against the payable or to leave them as two separate items on the balance sheet. If the amounts are netted against each other, the loan to the corporation is in effect treated as a repayment of the receivable from the shareholder. The shareholder's contribution of capital to the corporation will not result in additional basis against which the shareholder can deduct S losses on his Form 1040.

However, if the items remain segregated and are treated as two separate items on the balance sheet, the taxpayer may be able to claim the basis created by the shareholder loan to the corporation. This allows the shareholder to use flowthrough losses that would otherwise be in excess of basis.

There is very little guidance in this area, with the subject not addressed in the Code or the regulations. The answer must be found by looking at the law in other areas and then reasoning by analogy to arrive at the proper conclusion.

The IRS often takes the position that economic reality determines how an issue should be resolved. What "economic reality" is can be determined by looking at the treatment of debt with regard to a partner's basis in a partnership. In the partnership area, the regulations stipulate that regardless of what the books say, there is a valid debt if the partner faces a risk of loss, i.e., if the partner may be required to pay the liability.

When an S shareholder has both a receivable and a payable, the economic reality is that the shareholder can be forced to pay the debt owed to the S corporation while receiving nothing on the receivable. When there is both a payable and a receivable, the shareholder is put in the position of being both a debtor to and a creditor of the corporation.

If the S corporation was to go into...