S-Corp loans from shareholder

[equinecpa]

I have a similar situation...

I have a client who formed an S corporation about 2 years ago. It has incurred large losses and the sole shareholder's capital or loan is now up to approx $800,000.

I've just completed the first year return and am not sure if the money that has been injected should be classified as loan or capital. I have already filed the return but then was wondering about the treatment.

Treatment as a loan will reduce capital for franchise tax purposes and is the primary reason I classified this as a loan. I didn't calculate any imputed interest - should this be done for the first year? The corporation is a cash basis taxpayer so how is imputed interest handled?

In 2006 the corp has sold some fixed assets (no big gains but corp now has cash). The shareholder may want to take some of this cash out.

Considering this what would be the best treatment for the money going in? I fear that if the shareholder treats the funds going in as as a loan that it will be partially taxed on withdrawl due to past loan basis reduction. Is is possible to separate these notes out on annual basis and therefore reduce her basis on her 2005 loans but then have full basis on any 2006/07 loans?

Can capital be withdrawn at any time?

Thanks for any input, this has me stumped. I've read a lot of discussion about this issue but am still not sure what scenario is best.

Carolyn

[sea-tax]

Carolyn I would first find out what the intentions of the sh are. Do they intend to have the corporation ever pay this money back. If not then I would call it contributed capital.

[equinecpa]

If the money is ever there yes they would like them repaid. Does this mean we should record it as capital so that a distribution would not be taxable?

Carolyn

[sea-tax]

If the money is ever there yes they would like them repaid. Does this mean we should record it as capital so that a distribution would not be taxable?

Carolyn

you have a very long question ? ???

I would if I understand you correctly.

Have the client draw promisary notes up between him/her and s-corp. have the client personally record any interest and claim it on personal return for any payments recieved.

The notes would be added to basis which would accumulate year to year with each additional loan being added to the basis of the last years end. When the clients takes more out than basis then a taxable event would occur. I do not think you can seperate each years note against that years distribution for basis purposes. You must have one calculation of basis that is a reoccuring calculation.

I hope that helps some, maybe someone else can chime in.

[equinecpa]

As an S Corporation if we called this ladies contributions Capital, could she not draw some of the funds out as distributions even if there were no earnings? IAnd incur no tax liability?

[Bees Knees]

If the shareholder intends to be paid back once there is cash, it should be set up as a loan. This is common for a corporation to have huge amounts contributed in the beginning as debt with repayment much later.

The problem with trying to pull capital out is that in an S corp, you have ordering rules to follow. That means distributions first come from other stuff before you can call it a return of capital. If these are loans, you don't have to worry about those things.

As to imputed interest, there is none unless you try to take out principal. A loan can be structured so that a repayment waits until there is cash. Once you do start to repay the loan, you have to count some of it as interest and some as principal. So have the shareholder sign a promissory note with a stated interest amount. Then every time a repayment is made, you can calculate the proper amount that represents interest.

[Bees Knees]

The other nice thing about calling it a loan is that the interest income to the shareholder avoids FICA taxes. In other words, you are pulling profits out as interest income rather than W-2 wages. If you pull the money out as a return of capital, it is not a deduction for the corporation against profits.

[equinecpa]

What I am worried about is in the first year the corporation has incurred losses to the tune of $350,000.

This year I am aware they sold some assets and perhaps will have some cash to distribute to the 100% shareholder. I still don't see a profit, and the shareholder I am sure has advanced further funds for the year.

If I call the $800,000 a loan, her basis will be reduced. So if she takes say a payment of $100,000 in cash this year she will be taxed on 355/800x100,000 of the withdrawl.

If I call it capital, I don't see that she will have to pay any tax on the distribution. I've run through the ordering rules but since there is no AAA, E&P etc. I don't see why this wouldn't be a straight return of capital.

Am I missing something or on the right track?

[OldJack]

If I call the $800,000 a loan, her basis will be reduced. So if she takes say a payment of $100,000 in cash this year she will be taxed on 355/800x100,000 of the withdrawl.

You say the S-corp sold some assets so that would be income but it sounds like there would still be a loss to deduct on the 1040 if the taxpayer has basis. A shareholder loan is considered as basis for purposes of deducting $355,000 losses [Bees cite: TTT page 19-8 and IRC§1366(d)(1)(A)] the same effect as if it was capital. The withdrawal of the $100,000 could easily be considered as non-taxable payment of principal on the $800,000 loan. I don't see where you have a problem.

[dsi]

could someone explain what "debt basis" is?

[OldJack]

could someone explain what "debt basis" is?

Well.. in simply terms, if say capital was $10,000 and a shareholder loan of say $800,000 with a operating loss of $355,000 available for current year deduction. When the taxpayer deducts the $355,000 loss $345,000 of the loss is deducted because of the shareholder loan considered as basis even though it is not. This then reduces the "debt basis" of the loan even though the shareholder is still owed the $355,000. This is important in cases such as if the corporation fails and has to be liquidated with losses to be established for the same.

[dsi]

Thank you Old Jack. Now, when the corp repays the loan, the S/H then reports CG on his/her tax return, right?

[OldJack]

Thank you Old Jack. Now, when the corp repays the loan, the S/H then reports CG on his/her tax return, right?

No.. the corporation still owes the loan and the loan principal payments are still tax-free unless the debt basis has not been replaced with profit earnings. Attached is a worksheet that shows how this whole thing works reducing loan basis and replacing loan basis. Its a worksheet that has been floating around the internet and TheTaxBook has a worksheet in the deluxe edition on page 24-5..

[equinecpa]

Wouldn't the loan payment of $100,00 have to be prorated (taxable/nontaxable) since the Loan Basis is less than the Loan Face Amount? (see page 2 of worksheet posted earlier).

To clarify above:

Year one was losses of $350,000. Shareholder injected approx $800,000. Loan basis reduced to $450,000 (1120s losses passed through)

Year two sold some fixed assets for approx $200,000
Bottom line still a loss, say $100,000

Shareholder would like to take out $100,000 of the proceeds from the sale of the assets. If I call the original $800,000 a loan, I believe I have to prorate the repayment. If I call it capital can she not withdraw the $100,000 without incurring tax currently? I am aware it will reduce her basis further.

Thanks for sticking with me...

Carolyn

[Taxman]

Line of Credit

If a 100% shareholder of an S-Corp is always lending money to the S-Corp and the S-Corp pays the money back through out the year can the shareholder just set up a line of credit between him and the S-Corp and charge an interest rate of prime instead of making a new loan document each time the shareholder lends money to the S-Corp?