Basis - Convertible Debt?

[Snaggletooth]

Sweet Sue begins an S corp with $100,000. She designates $20,000 as capital stock, and designates the remaining $80,000 as a loan from her to the corporation.

Her S corp basis begins with the $20,000 and then fluctuates upward and downward with profits and distributions. For the most part, the S corp is solidly profitable, but grows its property and receivables as fast as its profits.

The corporation never pays Sue back the $80,000. In fact, over the years, she manages to loan the corporation yet another $50,000. Her accountant (me) imputes interest on the debt because it never gets paid back.

After the $80,000 remains unpaid for years, and she complains about having to deal with the imputed interest, her accountant (me) tells her she should consider converting the debt to equity stock to stop the imputed interest. Keep in mind that had she been audited, the IRS would have insisted on this being done under these circumstances and would have taken the position that ALL of the original investment be considered equity instead of debt.

My question: Does the $80,000 converted to debt raise her BASIS by $80,000?

[abctax]

Loans to S Corp

Aren't they (loans) part of basis and considered in the computation done to determine if losses are deductible? Perhaps I'm missing the gist of your question.
(edit)
OK, I just looked at the basis schedule generated by my software. Technically, debt is figured in after all the additions/subtractions to determine stock basis. IMH (and completely unresearched) O, to actually be stock basis, you'd probably have to issue more stock for the debt.

[Snaggletooth]

ABC Tax

Good response, ABC, and healthy discussion.

Actually only the stock basis counts for purposes of deducting a loss.

To the stock basis, the "loan" basis is added for purposes of allowing
a distribution to exceed stock basis and remain tax free. (I think this is
the best way to say it). Losses and Distributions are two different things.

I believe the answer to the original post is that the recharacterization
from loan to stock does increase basis, but I don't think you would ever
see that on a basis worksheet calculation. Interested in what others think.

[BHoffman]

Snags - must beg to differ that loan basis cannot be used to determine the amount of allowed pass-through losses:

http://www.journalofaccountancy.com/Issues/2010/Apr/20102602.htm

[abctax]

Then...

Good response, ABC, and healthy discussion.

Actually only the stock basis counts for purposes of deducting a loss.

To the stock basis, the "loan" basis is added for purposes of allowing
a distribution to exceed stock basis and remain tax free. (I think this is
the best way to say it). Losses and Distributions are two different things.

I believe the answer to the original post is that the recharacterization
from loan to stock does increase basis, but I don't think you would ever
see that on a basis worksheet calculation. Interested in what others think.

I am in trouble....I've used loans from the shareholder to justify losses for years. I agree with BHoffman's post. (and by the way, how's the dog?)

[BHoffman]

Molly gets her 6 week checkup next Tues. She isn't worse, but still limps. We'll be keeping our fingers and paws crossed that the surgery is still intact and she is healing. It takes a long time for these injuries to heal.

You say you are in trouble. How? Shareholder loans increase basis and allow for pass-through losses. There are a lot of rules regarding these SH loans, and you have to be careful, but Debt Basis + Stock Basis = Total Basis used to compute the allowable loss.

http://www.irs.gov/businesses/small/article/0,,id=203101,00.html

Note especially: "If an S corporation repays reduced basis debt to the shareholder, part or all of the repayment is taxable to the shareholder."

[abctax]

I was (semi) joking. As I have used SH loans to deduct losses, I'd be in trouble if that was not allowed. I feel confident it is allowable, with all the various caveats associated with the basis (incl. loans) issue. I use Lacerte, and the worksheet provided as well as the diagnostics are excellent regarding basis issues.

(Glad Molly's improving; she's lucky to have such good 'parents')

[Snaggletooth]

Read the article

Snags - must beg to differ that loan basis cannot be used to determine the amount of allowed pass-through losses:

http://www.journalofaccountancy.com/...r/20102602.htm

Beth, your usual excellent background has betrayed you this time (I believe).

The article states that you cannot simple make loans to the corporation to accommodate the deductibility of losses.

You CAN use loan basis to stop distributions in excess of basis from being taxable. But this would not allow you to deduct a loss in excess of stock basis.

(Distributions and deducting losses are not the same)

[Davc]

Snag, I think you need to re-read the article, especially the first paragraph.

[Snaggletooth]

Messed up in the Head

Hoffman and Davc you are correct.

What upsets me big time is that I learned this years ago, and I must have
lost my mind. When distributions reduce stock basis to zero, loan basis
may be used to deduct additional losses.

Am I the only one getting old? Humble pie for me...

Thanks for correcting me and saving other readers from this overstated error.

Snag

[veritas]

Don't feel bad

Hoffman and Davc you are correct.

What upsets me big time is that I learned this years ago, and I must have
lost my mind. When distributions reduce stock basis to zero, loan basis
may be used to deduct additional losses.

Am I the only one getting old? Humble pie for me...

Thanks for correcting me and saving other readers from this overstated error.

Snag

It happens to us all. Except for the getting old part.

[abctax]

Found it..

Internal Revenue Code:Sec. 1366. Pass-thru of items to shareholders


(1) Cannot exceed shareholder's basis in stock and debt
The aggregate amount of losses and deductions taken into
account by a shareholder under subsection (a) for any taxable
year shall not exceed the sum of -
(A) the adjusted basis of the shareholder's stock in the S
corporation (determined with regard to paragraphs (1) and
(2)(A) of section 1367(a) for the taxable year), and
(B) the shareholder's adjusted basis of any indebtedness of
the S corporation to the shareholder (determined without regard
to any adjustment under paragraph (2) of section 1367(b) for
the taxable year).

(edit)

Oops - posted my research before I saw the last few posts.....