Taxing Definitions

Definitions — Based on debt

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In the world of karma, no debt goes unpaid. In the world of tax law, the question is whether the debt is bona fide. The answer makes a difference for S corporation shareholders when calculating basis.

As you know, shareholders can only claim S corporation losses and deductions up to their adjusted basis in stock and debt. Basis can’t be reduced below zero and any losses or deductions disallowed due to the limitation are carried forward indefinitely and used in years with sufficient basis.

In an earlier Taxing Lessons post, Puzzling out the basis, you got to test your skill in calculating a shareholder’s stock basis.

Now you get to take a turn at debt basis. The questions are based on a practice unit released in March 2018, that discusses what debts increase an S corporation shareholder’s debt basis.

 

Question 1

In general, a third-party loan to an S corporation does not increase the shareholder’s debt basis. Instead, in order for a loan to increase a shareholder’s debt basis, the shareholder must be the lender and the loan must be bona fide.

What constitutes a bona fide loan? A general rule of thumb is that at the time of the transaction, the lender had a real expectation of repayment and intent to enforce the collection of the debt.

 

Which image do you think represents a loan that would create valid debt basis?

Image 1

 

or

 

Image 2

 

Question 2

An S corporation’s name is on a $50,000 loan, with the shareholder signing as a guarantor in case the S corporation defaults.

Do you think the loan guarantee creates debt basis for the shareholder?

or

 

Question 3

Suppose the same facts as in Question 2: The corporation’s name is on a $50,000 loan, with the shareholder signing as a guarantor in case the S corporation defaults.

Now suppose that in a year when the corporation has not defaulted on the loan, the shareholder pays $30,000 of the loan.

Do you think the payment creates debt basis for the shareholder?

or

 

Question 4

A third-party lender requires both the S corporation and the shareholder to sign a loan as the borrowers so that both the S corporation and the shareholder are liable to the third-party lender.

Do you think the co-signed loan creates debt basis for the shareholder?

or

 

Question 5

The installment method is an accounting method for reporting gains (not losses) from the sale of property when at least one payment is received in a tax year after the year of sale. The gain is recognized over the years as payments are received.

Do you think a shareholder can increase debt basis when an S corporation buys an asset from the shareholder in an installment sale and issues a note to the shareholder for the balance due?

or

 

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
Sorry, wrong answer :(
Right answer!

The guarantee itself does not create debt basis for the shareholder because there is no loan between the shareholder and the corporation. The shareholder only has a contingent liability. A shareholder is not allowed debt basis for merely guaranteeing the corporation’s debt.

This is true even if the S corporation defaults as the primary obligor on its loan obligation and a judgment is imposed on the shareholder as a result of a guarantee. The judgment does not create a debt between the shareholder and the S corporation. Therefore, a judgment on default does not create debt basis.

Right answer!

Upon the shareholder’s payment, the corporate debt becomes an obligation to the shareholder under the Doctrine of Subrogation, and the shareholder can now include the payment of $30,000 as part of her debt basis in the year of payment. However, the shareholder is still not allowed to claim debt basis for the remaining $20,000 outstanding corporate loan until she pays the debt.

As in Question 2, remember that the guarantee itself does not create debt basis for the shareholder because there is no loan between the shareholder and the corporation. The shareholder only has a contingent liability. A shareholder is not allowed debt basis for merely guaranteeing the corporation’s debt.

Also remember this is true even if the S corporation defaults as the primary obligor on its loan obligation and a judgment is imposed on the shareholder as a result of a guarantee. The judgment does not create a debt between the shareholder and the S corporation. Therefore, a judgment on default does not create debt basis.

However, when a shareholder repays a debt of the S corporation for which the shareholder has acted as a guarantor or in a similar capacity, the shareholder may increase debt basis to the extent of that repayment.

Sorry, wrong answer :(
Sorry, wrong answer :(
Right answer!

A shareholder’s debt basis is not increased in a co-making or co-borrowing situation because the co-borrowed amount is not debt the S corporation owes to the shareholder. Instead, both the shareholder and the S corporation owe the third-party lender.

Since the S corporation and the shareholder have not entered into debtor-creditor relationship, the shareholder’s debt basis is not increased.

NOTE: This issue is not specifically addressed in the regulations.

Right answer!

When the S corporation issues a note to the shareholder to purchase the asset, the S corporation and the shareholder essentially enter into a debtor-creditor relationship, which may increase the shareholder’s debt basis in the S corporation.

Under internal revenue code section 453B(b), the basis of an installment obligation equals the excess of the face value of the obligation (the remaining principal amount) over an amount equal to the income which would be returnable were the obligation satisfied in full (the remaining unreported gain). This results in the shareholder’s basis in the note being equal to the shareholder’s remaining basis in the property sold.

As the installment note is repaid by the S corporation, the shareholder’s basis in the note will also decrease. Once the initial basis in the note has been established, the shareholder can use that debt basis to claim S corporation losses in excess of stock basis. Claiming the losses will reduce the shareholder’s basis in the note.

NOTE: The practice unit has an example with numbers to illustrate this concept.

Sorry, wrong answer :(
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