In July of 2014, the IRS announced final regulations regarding the basis on which S corporations are indebted to their shareholders. The final regulations specified that an S Corp shareholder may increase his or her S corporation debt basis only in cases in which the debt is bona fide, which is determined according to general federal tax principles and is dependent upon all facts and circumstances.
According to Sec. 1366(d)(1), “the aggregate amount of losses taken into account by a shareholder for any taxable year shall not exceed the sum of (a) the adjusted basis of the shareholder’s stock in the S corporation and (b) the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.
The final regulations take the place of the actual-economic-outlay standard, which required that the shareholder be made “poorer in a material sense” to increase their basis of indebtedness, but did not address situations in which the shareholder borrows and loans the proceeds to the S corporation. Nevertheless, the final regulations do not totally abandon the actual-economic-outlay standard as they provide that S corporation shareholders may increase their basis of indebtedness to the extent of loan payments they make on behalf of the S corporation.
The proposed regulations also explained that the debt need not originate between the shareholder and the S Corporation if the debt between the shareholder and the S corporation is bona fide, or if there is a circular flow of funds. However, if the shareholder acts solely as a conduit through which the money flowed, there is no increase in indebtedness of the S corporation to the shareholder.
Although the proposed regulations called for the final regulations to apply to transactions occurring after the regulations were published in the Federal Register, the IRS responded favorably to commenters who requested that the applicability date be modified. As a result, the final regulations will apply retroactively to indebtedness between S corporations and S Corp shareholders that resulted from transactions that took place any year for which the tax assessment limitation period has not expired prior to July 23, 2014, which is the date on which the final regulations were published.
