S-Corporation shareholder basis of indebtedness: new proposed regulation.

The IRS has today issued proposed regulations that clarify the requirements for a shareholder to obtain "basis indebtedness" for the purposes of increases losses, or deductions.

Background: Generally, deductions and losses of an S-Corporation are passed through to its shareholders to the extent of each shareholder's adjusted basis in his stock. § 1366(d)(1) provides that a shareholder can take losses and deductions to the extent of the adjusted basis of the shareholder's stock and adjusted basis of any indebtedness (basis of indebtedness) of the S-Corporation to the shareholder. Court cases have interpreted these provisions of § 1366 as requiring the investment be "an actual economic outlay" by the shareholder to the S-Corporation in order for the shareholder to qualify the loan for "basis of indebtedness." E.g. Maloof v. Comm'r, 456 F.3d 645, 649-650 (6th Cir. 2006); Spencer v. Comm'r, 110 T.C. 62, 78-79 (1998), aff'd without published opinion, 194 F.3d 1324 (11th Cir. 1999); Hitchins v. Comm'r, 103 T.C. 711, 715 (1994); Perry v. Comm'r, 54 T.C. 1293, 1296 (1970). Due to ongoing disputes on what qualifies for basis of indebtedness, the IRS is proposing this regulation that will provide greater certainty to taxpayers.

Proposed Reg: The proposed regulation requires that the loan transaction in question must represent "bona fide" indebtedness of the S-Corporation to the shareholder. This means, that the shareholder would not need to otherwise satisfy the "actual economic outlay" doctrine for purposes of § 1366(d)(1)(B). The IRS will look to general Federal tax principles (many of which were developed outside of § 1366) to determine whether or not the indebtedness is "bona fide." The proposed regulation also confirms that shareholder guarantees of S-Corporation debt do not result in basis of indebtedness.

Effective Date: The regulation (as proposed) will only apply to loan transactions made after final regulations are adopted.