Debt Basis in S Corp, do you have to use it?

[DaveinTexas]

Hello all, I hope you are all staying sane this year!

I have a client that owns part of an S Corp and has made loans to this S Corp in the amount of $100,000 over 2 years. The repayments do not begin for 5 years (giving the Corporation enough time to generate enough revenue to make payments).

The S Corp has suffered losses this year, roughly $180,000. My client's share is approx. half or $90,000. He is also filing Ch. 7 bankruptcy this year. His attorney has already told him that any tax refunds he has coming his way will be taken by the court to satisfy the debts he owes.

My client wants to know if he can suspend the losses to 2011 to capture a large refund generated by the losses on his personal return.

My client has no stock basis left, only debt basis. Is there any rule/law that states he must use apply his debt basis against the loss in the current year? My thought is, wait until next year's tax return (2011) because the S Corp is expected to generate further losses and apply his debt basis then to generate a large refund. This refund, by the way, he will be able to keep because the Bankruptcy will have been fully discharged.

I hope that makes sense. I just want to be ethical about this. I don't think the IRS would have a problem with this; I don't know about the BK courts. I told my client to also seek the advice of the bankruptcy attorney so the courts don't construe this procedure as fraud.

TIA.

[DaveinTexas]

Unabashed Bump

Hello all, I hope you are all staying sane this year!

I have a client that owns part of an S Corp and has made loans to this S Corp in the amount of $100,000 over 2 years. The repayments do not begin for 5 years (giving the Corporation enough time to generate enough revenue to make payments).

The S Corp has suffered losses this year, roughly $180,000. My client's share is approx. half or $90,000. He is also filing Ch. 7 bankruptcy this year. His attorney has already told him that any tax refunds he has coming his way will be taken by the court to satisfy the debts he owes.

My client wants to know if he can suspend the losses to 2011 to capture a large refund generated by the losses on his personal return.

My client has no stock basis left, only debt basis. Is there any rule/law that states he must use apply his debt basis against the loss in the current year? My thought is, wait until next year's tax return (2011) because the S Corp is expected to generate further losses and apply his debt basis then to generate a large refund. This refund, by the way, he will be able to keep because the Bankruptcy will have been fully discharged.

I hope that makes sense. I just want to be ethical about this. I don't think the IRS would have a problem with this; I don't know about the BK courts. I told my client to also seek the advice of the bankruptcy attorney so the courts don't construe this procedure as fraud.

TIA.

Anyone have any ideas regarding this question? Thanks to all!

[Corduroy Frog]

Here is Hope

maybe. Losses are limited by Stock Basis. Loan basis cannot be added to Stock Basis to permit a loss. So you don't even have the option to take the loss!

Loan basis is added to Stock Basis in situations where WITHDRAWALS (irrespective of losses) wish to avoid reporting of income.

I think I'm right about this. Would be nice to hear from others.

[Davc]

I think I'm right about this. Would be nice to hear from others.

Not per TTB 19-8:

"Deductibility of flow-through losses and deductions—stock and/or loan
basis. Loan basis is a second tier of basis that can be applied to deduct
flow-through losses and deductions if stock basis has been
reduced to zero.
Example: Bert is 100% shareholder of Writers, Inc., an S corporation.
Bert’s stock basis is $3,500. In addition, Bert has a loan basis of $5,000,
which occurred when he made a direct loan to the corporation.
In 2010, Writers Inc. made a cash distribution to Bert in the amount of
$4,000. Since distributions are taken into account before losses and
deductions, and loan basis may not be applied to distributions, Bert
must recognize a $500 capital gain on the distribution. The corporation
also passed through losses on Schedule K-1 in the amount of $3,000.
Bert can apply the losses against loan basis.
Stock Basis Loan Basis
$4,000 cash distribution (distributions
can go against stock basis only—
basis cannot go below zero)
$ 3,500
3,500
$ 0
$500 gain
$5,000
$3,000 flow-through loss $ 0 (3,000)
Ending basis $ 0 $2,000
On Bert’s return, he recognizes a $500 capital gain and deducts a $3,000
loss. His stock basis is $0, meaning any further distributions of cash or
property will result in a capital gain until stock basis is restored. He has
$2,000 in loan basis remaining, meaning he will be able to deduct up to
$2,000 of future flow-through losses against his loan basis."

And you can't elect to save the loss for next year, The IRS would have a problem with that. And I'm fairly certain the BK court would also have a problem. The loss is an asset of the BK estate.

[DaveinTexas]

That's what I figured

Not per TTB 19-8:

"Deductibility of flow-through losses and deductions—stock and/or loan
basis. Loan basis is a second tier of basis that can be applied to deduct
flow-through losses and deductions if stock basis has been
reduced to zero.
Example: Bert is 100% shareholder of Writers, Inc., an S corporation.
Bert’s stock basis is $3,500. In addition, Bert has a loan basis of $5,000,
which occurred when he made a direct loan to the corporation.
In 2010, Writers Inc. made a cash distribution to Bert in the amount of
$4,000. Since distributions are taken into account before losses and
deductions, and loan basis may not be applied to distributions, Bert
must recognize a $500 capital gain on the distribution. The corporation
also passed through losses on Schedule K-1 in the amount of $3,000.
Bert can apply the losses against loan basis.
Stock Basis Loan Basis
$4,000 cash distribution (distributions
can go against stock basis only—
basis cannot go below zero)
$ 3,500
3,500
$ 0
$500 gain
$5,000
$3,000 flow-through loss $ 0 (3,000)
Ending basis $ 0 $2,000
On Bert’s return, he recognizes a $500 capital gain and deducts a $3,000
loss. His stock basis is $0, meaning any further distributions of cash or
property will result in a capital gain until stock basis is restored. He has
$2,000 in loan basis remaining, meaning he will be able to deduct up to
$2,000 of future flow-through losses against his loan basis."

And you can't elect to save the loss for next year, The IRS would have a problem with that. And I'm fairly certain the BK court would also have a problem. The loss is an asset of the BK estate.

I figured so. I didn't want to be deceitful, and the arrangement to suspend the loss does look deceitful. When you put it in those terms (loss is an asset of the BK estate) it definitely puts everything in perspective.

Thank you for the wise words.

[Roland Slugg]

No option to delay. Shareholder loans to an S Corp do create basis, so if there are more losses ... as you say there are/were ... that basis will be reduced by said losses. If and when the loan is repaid, it is ordinary income, not capital gain.