Cash Basis: Interest on SCorp owner loan

[TaxBird]

I have a cash basis S-Corp owner who has loaned significant amounts to his cash poor S-Corp since inception (3 years now). Every year, he properly accrues interest to the outstanding amount but he doesn't 'pay' the interest (no cash out). Every year, since he is cash basis, I exclude the interest expense on the note from the tax reporting.

For background, the model he developed calls for cash infusions until the business itself gets underway. So far he is on projection to realize positive cash flows by year 5. In the meantime, he isn't paying himself anything (he has other sources of income outside this S-Corp to support himself so this isn't some bogus claim).

This year, he asked me whether or not he could have the S-Corp 'pay' the interest every year so he could take the deduction.

To me, the intuitive answer is no. 'No' because the S-Corp still doesn't generate enough cash to cover itself (hence the annual increase to the loan balance) so you can't go in and create a phantom by 'paying' the interest only to turn around the next year and loan it back.

Also, it seems to me that he would first have to pay himself a salary before he could justify paying himself interest. (My current working theory for why he gets no salary from the SCorp is that it's been running at a consistent loss and is cash poor).

However, I have no better answer for him than than this.

Can anyone help me craft a more 'intelligent' response, maybe tied to a precedent or cite or something? Or if I am wrong, point me in the right direction?

Thank you in advance.

[BHoffman]

Try this one

Treasury Regulations, Subchapter A, Sec. 1.267(a)-1

Here's a link:

http://www.taxalmanac.org/index.php/Treasury_Regulations%2C_Subchapter_A%2C_Sec._1.267%28a%29-1

[TaxBird]

Thank you

Thank you for the link, BHoffman!

Slowly but surely I'm coming to it.

[Roland Slugg]

Pay interest each year

I would recommend that the corporation pay the accrued interest each year by December 31st. The corporation will get the interest deduction, and the tax affect on the shareholder will be zero (as long as he has sufficient basis). It will also keep everything current.

If the corporation doesn't have enough cash to pay the interest, the shareholder should loan enough so it does. I would advise any client doing this to make the loan a different amount from the interest itself. For example if the interest is, say, $3,248, I'd recommend the shareholder loan the corporation an even $3,200 or $3,300. This isn't absolutely necessary, of course; I just happen to prefer loans in "even" amounts.

[BHoffman]

That looks like a wash to me, so why bother? Looks like he has only debt basis anyway.

The real trick with clients who show consistent losses is to help them figure out what's not working and how to make some profit.

[TaxBird]

If the corporation doesn't have enough cash to pay the interest, the shareholder should loan enough so it does. I would advise any client doing this to make the loan a different amount from the interest itself. For example if the interest is, say, $3,248, I'd recommend the shareholder loan the corporation an even $3,200 or $3,300. This isn't absolutely necessary, of course; I just happen to prefer loans in "even" amounts.

Wouldn't that make him vulnerable upon audit if asked how he could pay the interest and yet not pay a wage? Or doesn't that even matter? I guess I'm thinking that the salary has to come first in order to fly my theory that he doesn't get wages because the company is cash poor. But maybe not necessarily so.

Still, to what end? How does this convey an advantage over my current method?

[TaxBird]

True

The real trick with clients who show consistent losses is to help them figure out what's not working and how to make some profit.

This guy's good, though. We worked out a model early on, planned for these losses, and darn if it isn't tracking. Two more years and he'll be out of the hole.

[JON]

Deemed

paid-otherwise a bigger chance that it will not be considered debt, but equity-and a second class of stock it cash did go out subsquently. Installment notes or open working capital loans do work- but are treated differently if basis used and repayment received.

[TaxBird]

Holy Smokes!

paid-otherwise a bigger chance that it will not be considered debt, but equity-and a second class of stock it cash did go out subsquently. Installment notes or open working capital loans do work- but are treated differently if basis used and repayment received.

You're right! That hadn't even occured to me! Thank you very much for pointing this out.

I now have a new question, I'm thinking I should recommend that all interest accrued to date be paid and then going forward, have the annual interest paid annually. This should correct the matter in short order, yes?

Thanks again!