SCorp distributions taken out of bus LOC

[BHoffman]

Two SCorp clients had losses. One took payroll, and the other did not. Both of them took distributions. They both had outstanding balances in their business lines of credit. Basically, they used their business LOCs to fund their distributions although there is no direct tracing available. They transferred money from the LOCs to their business checking at different dates, and took drawing checks at different dates.

I'd like to reverse the distributions against the business LOCs and disallow the applicable interest deduction. This would wipe out the distributions and lower the principal balance of the LOC. Not sure if this is OK.

Any advice?

[BOB W]

I'm not sure if any one wants to answer how they solve this problem. But this has been discussed before. See what you find by searching this board.

[BHoffman]

I've searched but evidently not using the right search terms. Any clues? I'll be researching this on my own to find whether this would be allowed. Hoping for some help.

[veritas]

Are you saying you want too

Two SCorp clients had losses. One took payroll, and the other did not. Both of them took distributions. They both had outstanding balances in their business lines of credit. Basically, they used their business LOCs to fund their distributions although there is no direct tracing available. They transferred money from the LOCs to their business checking at different dates, and took drawing checks at different dates.

I'd like to reverse the distributions against the business LOCs and disallow the applicable interest deduction. This would wipe out the distributions and lower the principal balance of the LOC. Not sure if this is OK.

Any advice?

apply the distributions against the lines of credit?

You said business lines of credit meaning lines of credit obtained by the corporations?

[BHoffman]

apply the distributions against the lines of credit?

You said business lines of credit meaning lines of credit obtained by the corporations?

Yes, the LOCs are in the business name and not the shareholder's. The shareholder has no qualified loan basis.

[ttbtaxes]

How can you reverse out anything on the LOC? For example, if the corporation borrowed $20,000 on a LOC, and used this to fund the distributions, what's to adjust? $20,000 is the correct liability for the corporation at year's end.

[BHoffman]

I'm concerned about deducting the interest if the tracing rules could be applied to show that the LOC proceeds were used for drawings.

Both of these clients have sufficient basis to take the drawings, so that is not an issue.

The companies had losses, and one took no payroll although did take drawings. The problem is: where did the money come from? It looks like it came from the LOC. So, should the LOC interest be deducted?

[ttbtaxes]

I can't see any issue with the corporation that paid wages. If the corporation had to borrow money to pay payroll, so be it. Valid corporate debt and deductible interest. Corporations borrow money all the time to subsidize payroll.

I can see the IRS arguing that the corporation that paid no wages should recharacterize the distributions as wages. I think that issue is a bigger one than is the interest deduction/tracing one.

The debate of whether the IRS can reclassify distributions in a loss year was waged recently on a Taxalmanac thread.

[BHoffman]

Thanks! That makes sense. I'll leave the LOC principal balance alone and deduct the interest, and address the payroll issue.

[veritas]

There are rules regarding

Thanks! That makes sense. I'll leave the LOC principal balance alone and deduct the interest, and address the payroll issue.

debt used to finance distributions from partnerships and S Corporations.

The interest may not be deductible or only partially deductible at the corporate level.

Temp. Regs. Sec. 1.163-8T and notice 89-35

[BHoffman]

Well, crap. It's the interest deduction that started me down this rabbit hole in the first place.

If the interest is not deductible because the loan proceeds funded the the distributions, then shouldn't the principal balance of the LOC be adjusted against the distributions?

Shouldn't that principal balance follow the treatment of the interest? Or doesn't that matter?

Thank you very much for giving the research reg and notice. I'll read them today.

[JON]

The S corp

either made a distribution to them or LOANED them the money. That is the stockholders choice that you explain to them.. Distributions have to be in the same % as stock ownership or your S corp election may be lost. I do not think this is a preparer's choice, you may want to explain it to them.??

[BHoffman]

either made a distribution to them or LOANED them the money. That is the stockholders choice that you explain to them.. Distributions have to be in the same % as stock ownership or your S corp election may be lost. I do not think this is a preparer's choice, you may want to explain it to them.??

Hi Jon - Single shareholder so no problem with the %. No distributions are in excess of basis. I don't like to see "Loan to Shareholder" on Sch L, and will be discussing a lot of things with new clients. Just looking at options and doing research right now

[BOB W]

Hi Jon - Single shareholder so no problem with the %. No distributions are in excess of basis. I don't like to see "Loan to Shareholder" on Sch L, and will be discussing a lot of things with new clients. Just looking at options and doing research right now

If you don't like "Loan To Officer" and the AAA has basis, then reduce shareholders basis for the distribution. The interest issue?, I'm not touching.

[geekgirldany]

I've been in the position where the shareholder took distributions and no payroll. I told them they had to make a reasonable salary. After questioning on how much he made at his previous job, research on salaries for his type of business, and how much he needs to actually live on a salary was established. Which was nearly all the distributions. I prepared a 4th qtr 941, 940, W-2s and state forms. He had to pay penalties because this was in March.

Set them straight to begin with and get them on a regular payroll schedule. Even if the LOC funded your client's distributions... I would either classify them as payroll or loan to shareholder. Its the client's pick.