S Shareholder Loans: Potential Tax Trap

S shareholders with pass-through losses who have exhausted their common stock basis have readily turned to shareholder loans as a method of increasing basis. The basis increase allows shareholders to recognize flowthrough losses immediately. Given the time value of money, conventional thinking has it that it is better to use losses as soon as possible, rather than to wait for S gains to offset such losses.

Many S shareholders, however, do not have the financial ability to make shareholder loans from personal savings. A typical strategy for an S shareholder is to arrange for a personal loan from a bank and then reloan the funds to the S corporation. This strategy requires preparation of two loan documents: one for the loan from the bank to the individual shareholder and the other for the loan from the shareholder to the S corporation. Terms of shareholder loans are usually the same as the bank loan terms to an individual shareholder, resulting in back-to-back loans.

A problem with this strategy occurs on loan repayment. On repayment of a debt owed to a shareholder after a reduction in the shareholder's basis and a deduction passed through to him, the shareholder realizes income to the extent of the amount repaid over the reduced basis of the debt. This can be ordinary income or capital gain, depending on the type of loan. In Rev. Rul. 64-162, repayment of a loan evidenced by an instrument was considered capital gain. In contrast, Rev. Rul. 68-537 stated that repayment of a shareholder loan not evidenced by an instrument (known as an "open account" loan) resulted in ordinary income treatment.

However, using shareholder loans generated from individual bank loans to increase S basis can be a potential tax trap for an uninformed S shareholder.

Example 1: R is an S corporation wholly owned by X. R incurs tax losses during its startup phase. It has a $150,000 loss in year one, a $100,000 loss in year two, and a $50,000 loss in year three. Finally, in year four, R breaks even. In years five through 10, it has an annual $50,000 profit. X has previously used R's common-stock basis against prior losses. X is single with no dependents. R pays X a salary of $50,000 per year, which is considered reasonable compensation.

X injects a $500,000 shareholder loan, originally obtained from a bank, into R to recognize early-year losses. The loan is evidenced by a note. In year one, the total shareholder tax loss for the year is $82,787, consisting of R's loss of $150,000 plus his wages, plus X's loan recapture amount of $17,213 (as calculated in Exhibit 1).

Potential Federal tax savings for year one total $22,230 (ordinary income tax savings of $25,673, less capital-gain tax on X's loan recapture of $3,443). In year two, X's total loss is $17,844 (R's $100,000 loss, plus X's wages of $50,000, plus X's loan recapture of $32,356). Potential Federal tax savings for year two total $4,124 (ordinary income tax savings of $10,595, less capital gain tax on X's loan recapture of $6,471). Taxable income and total Federal income taxes for years three through 10 are: year three, $43,349 taxable income/$8,670 Federal income tax; year four, $96,483/$19,802; year five, $134,325/$32,538; year six, $112,679/$28,209, and years seven through 10, $100,000 each/$25,673 each.

Exhibit 1 shows the calculations for recapture income on the repayment of a shareholder loan, which has a reduced basis due to the recognition of flowthrough losses passed on to the shareholder.

Example 2: The facts are the same as in Example 1, except that X does not inject a shareholder loan into R and carries all losses forward for use against future income. As a result, X reports the same income for the entire 10-year period, which is $50,000 per year. He pays $10,595 each year in Federal income taxes.

Totals for the 10-year projection when X uses the shareholder loan to recognize early-year losses are as follows: total R income/(loss) over the 10-year period is zero; X's wages, $500,000; X's loan recapture, $186,405; X's basis at the end of the 10-year period, $186,405 (using the formula in Exhibit 1); tax on ordinary income, $128,275; capital-gain tax on loan recapture, $37,281 and total Federal taxes, $165,556.

Totals for the 10-year projection when the shareholder does not use a shareholder loan are as follow: total R income/(loss) over the 10-year period is zero; X's wages, $500,000; X's loan recapture, zero (because there was no shareholder loan); X's basis at the end of the 10-year period, zero; tax on ordinary income, $105,950; capital-gain tax on loan recapture, zero and total Federal taxes, $105,950.

Summary

In the examples, the gross Federal tax increased by $59,606 ($165,556 (shareholder loan method) – $105,950 (loss carry-forward method)) over the 10-year period if a shareholder uses a loan to recognize the losses in years one through three. Even considering the time value of money, there is $31,532 more in net present value Federal income taxes paid over the 10-year period if a shareholder uses a loan.

At the end of the 10-year period, the shareholder using a loan has $186,405 in shareholder basis (assuming no S distributions). Without a shareholder loan, there is no shareholder basis. It is possible that this buildup of shareholder basis may not be used until R is sold. Therefore, a tax has been incurred for potentially unusable shareholder basis during R's latter years.

Another aspect of this analysis is the state tax effect. Because R pays the X interest on the shareholder loan and X pays the same interest amount to the bank, the shareholder must report the amount as interest income on Form 1040, possibly also showing a matching amount as investment interest expense on Schedule A. In some states, Form 1040, Schedule A items are not deductible. Therefore, in Michigan, for example, state taxes would increase by $13,452 if a shareholder uses a loan.

Based on this analysis, a shareholder loan used for passthrough losses should be analyzed quite carefully. While the temptation is strong to use losses as soon as possible, this may not always be the best strategy.

From Frank A. Rosenbaum, Marcie Nelson and Phillip Smith, Frank A. Rosenbaum, P.C., Troy, Michigan (None affiliated with Grant Thornton LLP)