Sec. 465 traps for the unsuspecting S corporation shareholder.

• Author: Taub, Lewis

When an S corporation has losses, one concern is whether the shareholders have basis in the stock or debt in order to use this loss on their tax returns. The basis issue was discussed in depth last month. (1) However, an issue often overlooked by shareholders and tax practitioners is whether shareholders have a sufficient amount at risk with regard to the investment in the S corporation. The at-risk rules are set out in Sec. 465. This article will address those rules, which without proper planning can limit the amount of deductible losses.

Congress originally enacted the at-risk rules in the Tax Reform Act of 1976 (2) to curb tax shelters that gave taxpayers deductions for nonrecourse debt. However, the scope of the rules has been continually broadened.

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The most inclusive provision of Sec. 465 is found in Sec. 465(c)(3), which states that for tax years beginning after December 31, 1978, the section applies to each activity engaged in by a taxpayer in carrying on a trade or business. Therefore, in the context of S corporations, the rules apply to any S corporation shareholder engaged in a trade or business. Often practitioners do not give the application of the rules to S corporations sufficient consideration because they incorrectly presume the concept applies predominantly to partnerships.

Contribution of Cash or Other Property

Sec. 465 starts simply enough by stating that a taxpayer is at risk for an activity for the amount of money and the adjusted basis of other property contributed to the activity. What if a shareholder contributes property that is subject to a debt? The amount at risk depends upon whether the shareholder is personally liable for the debt. If so, the shareholder's amount at risk is increased by the full amount of the property's adjusted basis. If the shareholder is not personally liable for the repayment of the loan, the amount at risk is increased by the adjusted basis of the property contributed and decreased by the non-recourse debt. (3)

Is the Shareholder at Risk for Borrowed Amounts?

A very significant difference between a shareholder's basis and at-risk amount may arise with regard to loans made by a shareholder to an S corporation. Under Secs. 1366 and 1367(b) and the applicable regulations, a shareholder's basis is increased by loans made to the S corporation. However, under Sec. 465, such loans might not increase the shareholder's at-risk amount. Specifically, Sec. 465(b)(2) states that an S corporation shareholder is at risk only with respect to amounts borrowed for use in the corporation to the extent that the shareholder:

(A) is personally liable for the repayment of such amounts; or (B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the fair market value of the taxpayer's interest in such property). Therefore, under (A) above, if a shareholder borrows funds from a bank and subsequently lends those funds to the S corporation, the terms of the note between the bank and the shareholder will determine the shareholder's liability. However, in the case of money borrowed from a related party as opposed to from a bank, the substance of the transaction, and not the form, will govern whether the S corporation shareholder is at risk. (4)

Another frequently overlooked at-risk issue occurs under (B) above when a shareholder borrows money from an unrelated party, pledges the property of an S corporation as security, and lends the funds to the S corporation. This loan from the shareholder to the S corporation gives the shareholder basis in debt but does not increase his or her at-risk amount. The effect is seen in Example 1.

Example 1: E is a 100% shareholder of an S corporation. The corporation is in need of cash. E borrows $50,000 from a bank on a nonrecourse basis and pledges the S corporation's assets to secure the loan. E subsequently loans these funds to the S corporation. Prior to making the loans to the S corporation, E's basis and at-risk amount had been brought down to zero from losses of the entity. In the current year, the S corporation has an ordinary loss of $20,000. The impact on E is as follows: Impact on basis: Basis from loan to S corp. $50,000 Ordinary loss (20,000) Stock basis $30,000 Impact on at-risk amount: Amount at risk 0 Ordinary loss allowed 0 E must meet both tests in order to take the S corporation's loss. Therefore, although E obtains basis in the debt, he cannot take the loss because he is not at risk for the loan obtained from the bank, which is secured by the company's assets. This is not an uncommon situation; company assets are often security for a loan the shareholder takes out in order to loan funds to the S corporation. A guarantee by the shareholder of a loan made directly from the bank to the S corporation would not create basis. (5) Therefore, the shareholders often use the back-to-back loan described above to create basis but neglect to consider the at-risk issue. Clearly, in order to avoid the trap of Sec. 465(b)(2)(B), collateral other than assets...