Winter Sunday tax tip: loans for S corporation basis.

December 22nd, 2013 by Joe Kristan

S-SidewalkYesterday we talked about making capital contributions to an S corporation before year-end to restore basis for deducting K-1 losses.  While that works well if you own all of the corporation stock, it gets difficult when there are other shareholders.  If they aren’t pro-rata, capital contributions will change the ownership percentages.  The other shareholders may not want to issue you more stock, and they may not want to make additional capital contributions themselves.

Fortunately, S corporation owners can also deduct losses based on loans they make to the corporation.  As the loans don’t need to be pro-rata, it’s easier to do.  But you need to do it right, as S corporation loans have some potential tax traps.

First, the shareholder has to make the loan directly.  A guarantee of a third-party loan to the S corporation doesn’t work.  Second, don’t borrow the money you wish to lend from another owner; we’ll explain why tomorrow.

Third, plan to leave the cash in the corporation until you have earned back any losses you take.  If you take losses against an S corporation loan, you reduce your basis in the loan itself, so a repayment can result in a taxable gain.  Subsequent K-1 income will first restore the basis of the loan before going against stock basis, but until that happens, a repayment of a loan used to deduct S corporation losses is a taxable event.

Finally, how you do the loan matters.  It is wise to document the loan with a note at the current Applicable Federal Rate with a definite repayment term.  Making the loan as just “open account debt” can be treacherous, as any time the balance exceeds $25,000, the tax law considers there to be a new separate loan.  An example shows how this works:

Joe owns all of Joe Inc., an S corporation. He is out of stock basis at the end of 2013 so he loans the company $30,000 at the end of 2013 to enable him to deduct $25,000 of corporate losses on his 1040. That leaves him a $5,000 basis is his open account loan.

In January 2014 a customer pays an overdue bill, enabling Joe to pay back his $30,000 advance. The company breaks even in 2014, and Joe loans the $30,000 back on open account in December 2014.

Unfortunately for Joe, he has $25,000 gain on the repayment in January 2014; because the corporation had no taxable income, Joe’s basis wasn’t restored before repayment. The 2014 year-end advance is considered a different loan.

Stop by tomorrow for a new tax tip – one daily through December 31!

 

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