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Eternal Question - Loan Basis

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    Eternal Question - Loan Basis

    I am calling this an "eternal question" because I keep finding two alternate teachings on the subject.

    For an S corporation, an owner is not allowed to increase loan basis by guaranteeing a loan. He may, however, increase loan basis by making a loan to the corporation himself[herself].

    The conflict is whether and when loan basis is added to stock basis. I was taught (and properly I think) years ago
    that a LOSS could not be deducted beyond stock basis. Period. However, if there was additional LOAN BASIS, the shareholder could avoid being taxed if a DISTRIBUTION was made, so long as loan basis was not exceeded. But now I read in an NATP article and also at a seminar that loan basis and stock basis can be added together for purposes of deducting a loss. These people are smarter than I but not sure smarter than those who taught me earlier.

    Desperate owns 100% of an S corp, that he started with $20,000 in capital stock. During the year he also loaned
    the corporation $10,000. During the first year, the corporation has a loss of $22,000, and Desperate has taken an
    additional distribution of $9000.

    Which of the following are true?
    a) [my belief] Desperate may deduct a loss of $20,000 but does not have to show gain on the $9000 distribution.
    He has a suspended loss of $2000 and only $1000 of loan basis left. Stock basis and loan basis are tracked
    b) Desperate may deduct a loss of $22,000 and does not have to show gain on the $9000 distribution.
    c) Desperate may deduct a loss of $22,000 but must show gain on the distribution to the extent of $1000. Stock
    basis and loan basis are added together interchangeably, and he has overdrawn the total by $1000.

    Any takers?

    Desperate does not have gain on the $9,000 distribution since he has $20,000 or stock basis.
    The distribution is subtracted from the stock basis leaving $11,000 or stock basis to apply
    against the loss. After applying the $11,000 against the loss of $22,000 he is left with
    $11,000 of loss. Applying his loan basis of $10,000 against the $11,000 remaining loss
    leaves him with $1,000 of suspended loss.


      The answer is C, based on assumptions.

      The stock basis is reduced to zero after applying $20,000 of the loss. The shareholder's debt basis is applied to the remaining $2,000 loss; see IRC 1367(b)(2)(A)

      "If for any taxable year the amounts specified in subparagraphs (B), (C), (D), and (E) of subsection (a)(2) exceed the amount which reduces the shareholder’s basis to zero, such excess shall be applied to reduce (but not below zero) the shareholder’s basis in any indebtedness of the S corporation to the shareholder. "

      Now, technically, you can't apply the loan basis to the distributions but I will assume the distributions will be treated as "loan repayments". In which case the original debt basis is $10,000 minus the $2,000 remaining loss (after stock basis was reduced to zero). Categorizing the $9,000 distribution as a repayment of the loan would reduce the shareholder's debt basis to $0, and in fact, he/she will have to recognize a $1,000 capital gain. The capital gain will probably be short term, as this is a first year corporation (don't quote me on that).

      I like Earl's response too because if these "distributions" are not loan repayments, then his answer is correct. I think the original question needs some revision, to clarify the meaning of distribution.
      Circular 230 Disclosure:

      Don't even think about using the information in this message!


        "Marshalling" of Transactions

        Wow! Quite a stretch from "marshalling of assets" but I had to come with something descriptive.

        I believe all the calculations occur at the end of the S corps fiscal year, and the various transactions described above are applied IN SEQUENCE. That prevents "netting" of basis elements, and the taxability is attached to what happens when the transactions happen in sequence.

        The transactions appear to be marshalled in at least three groups - Establishment of beginning basis, Basis Additions, then Basis Reductions. Loan basis is a separate calculation, but it looks like some of the loan basis can be used to rescue an otherwise nondeductible loss. So it would appear "C" is the correct answer to the above.

        This sequenced calculation is nicely presently on page 24-5 of the Small Business Edition in The Tax Book.