This is an extensive post - if you are short of time, think twice before continuing.
The topic is Loan basis in a S Corp, and a bizarre twist presented in a recent NATP seminar. Loan basis is often confusing to taxpayers, and is very well explained in plain English in The Tax Book on page 19-9 in the Small Business Edition. TTB does not mention this phenomenon, although there is mention of "Ordinary Income vs Capital Gain" in excess payments against a shareholder loan, which I don't believe is the same situation. On behalf of TTB, remember that they do not have space to describe every situation, or you would need a wheelbarrow to roll their book around. And I am suspicious that what I learned in the seminar is not true. The syllabus did not give cites.
Get Ready. Bail out if you wish.
1) Connie begins an S-corporation in 2015 with $5000 capital stock. Midway into 2015 she realizes there is not enough money to meet operations and loans the corporation another $10,000. At the end of 2015, there is an ordinary loss passed through on her K-1 of $8500. In order to deduct this loss on her personal return, she has to first wipe out her $5000 in stock basis, and then invade her loan basis with another $3500. At 12/31/15, her stock basis is zero, and loan basis is reduced to $6500. I don't think any of us have a problem with this, yet.
2) S Corp is marginally profitable in 2016 with some $1800 in ordinary income, $100 in interest income. During the year, Connie sees fit to distribute $500 to herself and pay herself $1000 to reduce the loan. Loan basis must be replenished to the extent of $10,000 first before any stock basis is replenished. What appeals to us at this point: Based on 2016 operations, there is a net increase of $1400 ($1900 minus $500) available to add back to loan basis. New loan basis is $7900 ($6500 plus $1400). Does this appeal to you? It appeals to me.
3) But NO! Here is the bizarre teaching from the seminar. A latent percentage must first be calculated entering 2016, consisting of the loan basis versus original loan. In the example above, this "latent percentage" is 65% ($6500 as of 12/31/15 divided by $10,000 original loan). Then we concentrate on the $1000 loan repayment. THE AMOUNT ADDED BACK TO THE LOAN BASIS MUST BE REDUCED BY $650. This is the "latent percentage" of 65% times the $1000 loan repayment. The new loan basis of $7900 discussed in 2) above is reduced by $650 to only $7250.
4) Incredibly it gets even worse. Out of the $1000 repayment, $650 is lost to basis and $350 becomes LT CAPITAL GAIN!!
What's worse, if the $350 is taxable to the shareholder, why is it not an addition to basis? I dunno, but it is not.
Conclusion: I would prefer to think the treatments in 3) and 4) are not true. The instructor appeared to be quite knowledgeable, and admitted that he only became recently aware of the treatment. The syllabus clearly showed the calculations, but for something this crazy, I felt like cites should have been provided.
I have provided the above for avid comrades and for the authors if they are interested in research. The most information in the code about basis is section 1367 and I have read regulation 1.1367-2 which specifically addresses loan basis. There is no mention of capital gains upon repayment of the loan.
Thank you for reading this far.
The topic is Loan basis in a S Corp, and a bizarre twist presented in a recent NATP seminar. Loan basis is often confusing to taxpayers, and is very well explained in plain English in The Tax Book on page 19-9 in the Small Business Edition. TTB does not mention this phenomenon, although there is mention of "Ordinary Income vs Capital Gain" in excess payments against a shareholder loan, which I don't believe is the same situation. On behalf of TTB, remember that they do not have space to describe every situation, or you would need a wheelbarrow to roll their book around. And I am suspicious that what I learned in the seminar is not true. The syllabus did not give cites.
Get Ready. Bail out if you wish.
1) Connie begins an S-corporation in 2015 with $5000 capital stock. Midway into 2015 she realizes there is not enough money to meet operations and loans the corporation another $10,000. At the end of 2015, there is an ordinary loss passed through on her K-1 of $8500. In order to deduct this loss on her personal return, she has to first wipe out her $5000 in stock basis, and then invade her loan basis with another $3500. At 12/31/15, her stock basis is zero, and loan basis is reduced to $6500. I don't think any of us have a problem with this, yet.
2) S Corp is marginally profitable in 2016 with some $1800 in ordinary income, $100 in interest income. During the year, Connie sees fit to distribute $500 to herself and pay herself $1000 to reduce the loan. Loan basis must be replenished to the extent of $10,000 first before any stock basis is replenished. What appeals to us at this point: Based on 2016 operations, there is a net increase of $1400 ($1900 minus $500) available to add back to loan basis. New loan basis is $7900 ($6500 plus $1400). Does this appeal to you? It appeals to me.
3) But NO! Here is the bizarre teaching from the seminar. A latent percentage must first be calculated entering 2016, consisting of the loan basis versus original loan. In the example above, this "latent percentage" is 65% ($6500 as of 12/31/15 divided by $10,000 original loan). Then we concentrate on the $1000 loan repayment. THE AMOUNT ADDED BACK TO THE LOAN BASIS MUST BE REDUCED BY $650. This is the "latent percentage" of 65% times the $1000 loan repayment. The new loan basis of $7900 discussed in 2) above is reduced by $650 to only $7250.
4) Incredibly it gets even worse. Out of the $1000 repayment, $650 is lost to basis and $350 becomes LT CAPITAL GAIN!!
What's worse, if the $350 is taxable to the shareholder, why is it not an addition to basis? I dunno, but it is not.
Conclusion: I would prefer to think the treatments in 3) and 4) are not true. The instructor appeared to be quite knowledgeable, and admitted that he only became recently aware of the treatment. The syllabus clearly showed the calculations, but for something this crazy, I felt like cites should have been provided.
I have provided the above for avid comrades and for the authors if they are interested in research. The most information in the code about basis is section 1367 and I have read regulation 1.1367-2 which specifically addresses loan basis. There is no mention of capital gains upon repayment of the loan.
Thank you for reading this far.
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