Amounts Borrowed from Fellow S Shareholder Not At-Risk for Basis Purposes

An S shareholder can deduct losses, but only to the extent of basis. Generally, stock basis includes amounts that a shareholder has loaned to an S corporation for which he is "at-risk." Thus, if a shareholder has loaned money to an S corporation and he is "at-risk," he can use the loan as basis for deducting losses passed through from the corporation.

In Van Wyk, 113 TC No. 29 (1999), the Tax Court ruled that a loan from a fellow shareholder, subsequently reloaned to the S corporation, did not create basis, because the shareholder was not at-risk.

The Van Wyks and the Roordas each owned 50% of the stock of an S corporation in the farming business. The Van Wyks borrowed money from the Roordas and were personally liable for repaying the loan. They then loaned the proceeds to the S corporation (some of the money paid off old debts and the balance was a new loan). The Van Wyks claimed they were at-risk on the loan and, thus, could use the loan's basis to allow them to deduct their share of the S corporation's loss for the year.

The IRS disallowed the loss on the Van Wyks' personal return, claiming that they were not at-risk; the Tax Court agreed with the Service. Sec. 465(b)(3)(A) states that amounts borrowed from a person who has an interest in the activity are not treated as at-risk, even if the borrower is personally liable for repayment. In addition, Sec. 465(b)(3)(B) states, "in the case of amounts borrowed by a corporation from a shareholder, subparagraph (A) shall not apply to an interest as a shareholder." Thus, for purposes of the at-risk rules and to claim losses, the party from whom the funds are borrowed is critical.

The Van Wyks argued that they met the Sec. 465(b)(3)(B)(i) interest-as-creditor test, because they were personally liable; thus, the fact that they were shareholders should be disregarded.

S stock basis is increased by loans that shareholders make to an S corporation. However, Prop. Regs. Sec. 1.465-9(f) considers whether the loans come from a shareholder's personal funds. The Van Wyks argued that the proposed regulations were over 19 years old and were still in proposed form. They also argued that neither the statute nor legislative history contains any mention of "personal funds." Thus, they argued the proposed regulations should carry little weight. The court stated that although the regulations are in proposed form, they are to be used as guidelines. The court also noted that the taxpayers "embraced proposed regulations as support for their argument, yet argue that they do not apply when the proposed regulations present contrary authority."

The Tax Court ruled that Sec. 465(b)(3)(B)(ii) allows at-risk treatment only for corporate borrowers, not for individual borrowers. The court also concluded the at-risk rules do not allow individual shareholders to claim "at-risk basis" simply because they loan money to their corporation. The court also cited the committee reports to the law that first introduced Sec. 465(b)(3)(B)(ii). In addition, the court noted that, before this provision, the at-risk rules had been revised to eliminate their application to S corporations.

In conclusion, monies borrowed from a person with an interest in an activity are not treated as "at-risk," even though the individual is personally liable for repayment.

From Jon E. Davis, Sioux Falls, SD

ESOPs, S Corporations and Sec. 267

Practitioners' understanding of how employee stock option plans (ESOPs) operate within S corporations continues to evolve. The identification of issues and opportunities has moved beyond the basic subchapters D and S matters to include the remainder of the Code. Sec. 267, however, is proving to be particularly troublesome.

The first wave of questions on this provision was easily handled. Because Sec. 267 limits the deduction by an accrual-basis corporation of payments to a cash-basis shareholder, would an ESOP's contribution have to be deposited by year-end to be deductible? Most Employee Retirement Income Security Act of 1974 (ERISA) plans report on an accrual or modified cash basis; specifically, they accrue the employer contribution. As such, there would not be any difference in the accounting period in which the deduction and income are recognized. Thus, the contribution can be deposited by the tax return's extended due date (as permitted by Sec. 404(a)(6)).

This simple question, however, led to a more thorough analysis of Sec. 267, specifically Sec. 267(e). Sec. 267(e)(1)(B)(ii) provides that any direct or indirect shareholder in an S corporation is considered to be a related party for this section's purposes. In a C corporation, only "more-than-50% owners" are subject to Sec. 267(e). To make this rule even more complicated, the Sec. 267(e)(1) rules for attributing ownership do not include the common exception found in most other attribution sections for shares held in a tax-qualified Sec. 401(a) retirement plan.

The result is that all ESOP participants who have shares allocated to their account are considered to be related parties under Sec. 267(c)(1). Because most individuals are cash-basis taxpayers, an employer may not accrue deductions at year-end for amounts payable to such participants. The normal year-end bonus accrual becomes subject to Sec. 267 and is deductible in the period paid to the participants. The option to allow a current deduction if paid within two-and-a-half months of year-end would not apply, except for the portion of the bonus paid to employees who are not participants in the ESOP or who have no shares allocated to their account as of the end of the tax year.

The determination of whether an employee has shares in his account as of year-end raises additional questions for new participants or those who first have the right to allocate shares. If a contribution is accrued as of year-end, but satisfied by a contribution of shares or a payment of debt and release of shares after year-end, is the participant deemed to have shares as of year-end? Sec. 404(a)(6) allows a contribution to be paid through the return's due date and attributed back to the tax year, if it is on account of such tax year. Rev. Rul. 76-28 interpreted this to mean that the contribution was to be treated the same as if it had been deposited before the last day of the tax year. This position could be interpreted to mean that the participant would be treated as if he owned shares on the last day of the tax year.

In contrast, Regs. Sec. 1.219-2(d) defines an "active participant" for individual retirement account eligibility purposes as, for the first year of participation in a plan, a person who participates as of the later of when a contribution is made or allocated. Under this rule, a participant would not be considered to hold shares until he is actually in the plan or shares are allocated to his account.

As a practical matter, attempting to distinguish between bonus awards that may or may not be accrued at year-end may be more of a problem than it is worth. It may be easier to change the whole bonus program to avoid any year-end accruals.

Caution: Many practitioners have expressed the opinion that this limit is an unexpected consequence of the 1996 and 1997 legislation and should be the subject of a technical correction. While that may be true, until such correction is made, practitioners must deal with the Code's literal language.

From Becky Miller, Rochester, MN