Hopefully, it will be a long time before we go through another time period like our current one. Our current situation is leading small business owners to consider how to keep their doors open, and some may have to inject their own money into the company to maintain the business. While most are just trying to make payroll, some have proactively asked, “What is the best way to get money into my business? I have heard I can loan money to my business. Is this a good idea?” Like most tax and financial questions, the answer is usually, “It depends.” First, we will go through a quick background on basis rules including debt vs equity basis. Then, we will discuss three things S Corporation shareholders may want to consider when deciding to make a capital contribution or loan money to their S Corporation.
Why does basis even matter? Losses can only be taken if there is sufficient equity and/or debt basis. Also, the higher the basis, the less of a gain a seller would have when disposing of their S Corporation stock. Lastly, basis determines the taxability of non-dividend distributions.
There are two different kinds of basis: stock basis and debt basis. Many times, shareholders will loan money to their S Corporation so they can establish basis to use the loss in the current year. If there is no stock or debt basis, a loss will be suspended and carried forward to another year. Stock basis is established through the shareholder’s initial capital contribution, and it is increased/decreased annually depending on the pass-through items of the S Corporation. Income items increase stock basis, and losses, deductions, and distributions decrease stock basis.
Non dividend distributions are a nontaxable return of capital up to the amount of stock basis. Distributions in excess of stock basis are taxable to a shareholder. Sometimes, shareholders will loan money to their S Corporation so the S Corporation can make a taxable distribution to offset other losses and take money out of their corporation. Losses decrease debt basis, but distributions have no impact on debt basis.
Debt reclassified as a second class of stock
According to Treasury Regulation 1.1361-1(l)(4), debt is treated as a second class of stock unless an exception applies. In many cases, an exception will apply, but you should document these types of transactions to give yourself the best chance to stave off a challenge.
What is the big deal with having a second class of stock anyway? S Corporations are only allowed to have one class of stock. Having two classes of stock could lead to a termination of S Corp status. As you can see, you should seriously consider whether the benefits of loaning money to your company outweigh the risks.
Internal Revenue Code Section 1361(c)(5), however, provides for a “straight debt” safe harbor. The requirements stated must be met to qualify for the safe harbor. One of the requirements is the debt must be written.
Open debt ordinary income vs. written instrument capital gain
The devil is in the documentation. Unfortunately, many business owners are “too busy” to hold shareholder meetings, record corporate minutes, or document shareholder transactions. As fellow small business owners, we get it. There is always something trying to grab your attention. When it comes to shareholder loans, documentation can be extremely important. Repayment of reduced debt basis loans are taxable transactions.
According to Revenue Ruling 64-162, repayment of a shareholder loan evidenced by a written note is considered capital gain to the shareholder when the repayment has exceeded his/her reduced debt basis.
On the other hand, Revenue Ruling 68-537 indicates that “open account debt” repayments are considered ordinary income when the repayment exceeds the shareholder’s reduced debt basis. Open account debt is a shareholder loan less than $25,000 that is not evidenced by a written note (Treasury Regulation 1.1367-2(a)(2)(i)).
It also important to note that the Regulations also state that open account debt greater than $25,000 at year end would be treated in the same manner as indebtedness evidenced by a separate written instrument. This treatment applies to the debt basis rules. So, shareholders would be wise to document an open account debt greater than $25,000 with a written note to preserve capital gain treatment.
Debt or Equity
Is the money you put in debt or equity? This has been the age-old question. IRC 385(b) briefly discusses five characteristics taken into consideration when trying to make this determination, while some courts have considered up to 16 different items. Since you may be considering memorializing your shareholder loan to achieve “bona fide debt” status and possibly experience capital gain treatment, you may want to consider including some of the factors the courts weigh into your debt instrument.
This post will not discuss all of the different factors considering the high number of considerations, but we will discuss a couple. The main thing to take away is that a true shareholder loan should closely resemble a loan from an unrelated third party like a bank. The shareholder loan should be in writing with a fixed interest rate and repayment date, should not be subordinate to other debt, contain the ability to request advance payment, repayment should not be tied to earnings, and a high debt to equity ratio may more closely resemble equity as a bank may consider this a risky loan.
Courts have stated the classification of debt or equity is one of fact, but courts have considered different numbers of facts when deciding between debt or equity. While many of the factors are consistent between courts, capitalizing with shareholder loans vs a capital contribution can add a layer of complexity, and shareholders should consider the reasons why they would like to capitalize with debt.
While using bona fide shareholder loans can make sense in some cases, it can be very difficult for a busy shareholder to keep track of basis and have all the proper documentation in place. Shareholders should consider consulting their attorneys to draft written notes. One should consider all of their facts and circumstances to determine if they should inject capital through a capital contribution or shareholder loan.
James Enriquez is a partner of Adaptive Tax Planning, LLC (adaptivetaxplanning.com). He holds a Master of Science in Personal Financial Planning and a Master of Science in Taxation. He also holds the Enrolled Agent and CERTIFIED FINANCIAL PLANNERÔ designations. He can be reached at firstname.lastname@example.org