[Federal Register Volume 79, Number 141 (Wednesday, July 23, 2014)]
[Rules and Regulations]
[Pages 42675-42678]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-17336]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9682]
RIN 1545-BG81
Basis of Indebtedness of S Corporations to Their Shareholders
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to basis of
indebtedness of S corporations to their shareholders. These final
regulations provide that S corporation shareholders increase their
basis of indebtedness of the S corporation to the shareholder only if
the indebtedness is bona fide, which is determined under general
Federal tax principles and depends upon all of the facts and
circumstances. These final regulations affect shareholders of S
corporations.
DATES: Effective Date: These final regulations are effective July 23,
2014.
Applicability Date: These final regulations apply to indebtedness
between an S corporation and its shareholder resulting from any
transaction occurring on or after July 23, 2014.
FOR FURTHER INFORMATION CONTACT: Caroline E. Hay, (202) 317-5279 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Background
The final regulations contain amendments to the Income Tax
Regulations (26 CFR part 1) under section 1366 of the Internal Revenue
Code (Code). On June 12, 2012, the Treasury Department and the IRS
published in the Federal Register (77 FR 34884) a notice of proposed
rulemaking (REG-134042-07) (the proposed regulations) relating to when
shareholders have basis in indebtedness that the S corporation owes to
the shareholder (basis of indebtedness). The proposed regulations
provide that basis of indebtedness of the S corporation to the
shareholder means the shareholder's adjusted basis in any bona fide
indebtedness of the S corporation that runs directly to the
shareholder. No requests to speak at the scheduled public hearing were
received and the hearing was canceled. Comments responding to the
notice of proposed rulemaking were received. After consideration of all
the comments, the proposed regulations are adopted
[[Page 42676]]
without substantive change by this Treasury decision, except for
changes to the effective/applicability date of the regulations and
minor clarifying revisions. The comments, which are available at
www.regulations.gov or upon request, are discussed in this preamble.
Summary of Comments
1. Actual Economic Outlay
Courts developed the actual economic outlay standard, which
requires that shareholders be made ``poorer in a material sense'' to
increase their bases of indebtedness. Some courts concluded that an S
corporation shareholder was not poorer in a material sense if the
shareholder borrowed funds from a related entity and then lent those
funds to his S corporation. See, for example, Oren v. Commissioner, 357
F.3d 854 (8th Cir. 2004), aff'g, T.C. Memo. 2002-172. Instead of
applying the actual economic outlay standard, the proposed regulations
provided that shareholders receive basis of indebtedness if it is bona
fide indebtedness of the S corporation to the shareholder.
One commentator suggested that language be added to the regulations
providing that actual economic outlay is no longer the standard used to
determine whether a shareholder obtains basis of indebtedness. After
considering this comment, the Treasury Department and the IRS believe
that the proposed regulations clearly articulate the standard for
determining basis of indebtedness of an S corporation to its
shareholder, and further discussion of the actual economic outlay test
in the regulations is unnecessary. Accordingly, the final regulations
adopt the rule in the proposed regulations without change.
With respect to guarantees, however, the final regulations retain
the economic outlay standard by adopting the rule in the proposed
regulations that S corporation shareholders may increase their basis of
indebtedness only to the extent they actually perform under a
guarantee. The final regulations make some minor changes to clarify the
treatment of guarantees, including changing the heading to reiterate
that the rule for guarantees is distinguished from the general rule
adopting a bona fide indebtedness standard and moving the guarantee
example after the examples illustrating the general rule consistent
with the order of the regulations.
2. Regulation Examples and ``Circular Flow of Funds''
One commentator requested a change to the fact pattern presented in
proposed regulations Sec. 1.1366-2(a)(2)(iii), Example 4. In Example
4, a loan that originally was made by S1 to S2, two related S
corporations wholly-owned by the same shareholder, is restructured to
be a loan from the shareholder. The restructuring involved S1
distributing the debt to the shareholder and S2 being relieved of its
liability to S1 so that S2 is only liable to the shareholder on the
debt. The commentator recommended that Example 4 not require that S2 be
relieved of its liability to S1. As stated in the proposed regulations
and finalized in these regulations, whether indebtedness is bona fide
indebtedness to a shareholder is determined under general Federal tax
principles and depends upon all of the facts and circumstances. Whether
S2 is relieved of the original liability is an appropriate fact to
consider in determining whether the transaction is a restructuring of a
debt that results in a bona fide debt that runs directly from S2 to the
shareholder. See, for example, Rev. Rul. 75-144 (1975-1 CB 277)
(holding that a shareholder increases the shareholder's basis of
indebtedness when the shareholder, who had guaranteed a liability of
his S corporation, executed his own promissory note in full
satisfaction of the S corporation's note to the bank, the bank relieved
the S corporation of its liability, and the S corporation became
obligated to the shareholder under the doctrine of subrogation). See
also Gilday v. Commissioner, T.C. Memo. 1982-242 (holding that
shareholders increased their bases of indebtedness when the
shareholders gave a bank their notes, the bank canceled the S
corporation's note to the bank, and the facts indicated that the S
corporation became indebted to the shareholders, regardless of whether
subrogation occurred under state law). Accordingly, this comment is not
adopted.
This commentator also requested that an example be added to the
regulations addressing a ``circular flow of funds.'' The commentator
described a circular flow of funds as including a restructuring of a
loan originally made by an S corporation owned by the shareholder to
another S corporation owned by that shareholder (for purposes of this
discussion, S1 and S2, respectively). This loan is restructured by one
of two alternative methods: (i) S1 lends money to the shareholder, the
shareholder lends that money to S2, and S2 uses that money to repay S1;
or (ii) S2 repays S1, S1 lends money to the shareholder, and the
shareholder lends that money back to S2.
The Treasury Department and the IRS recognize that there are
numerous ways, including certain circular cash flows, in which an S
corporation can become indebted to its shareholder. The proposed
regulations included Example 4 as an example of a loan originating
between two related entities that is restructured to be from the S
corporation to the shareholder to show that the debt need not originate
between the S corporation and its shareholder, provided that the
resulting debt running between the S corporation and the shareholder is
bona fide. The Treasury Department and the IRS are aware, however, of
cases involving circular flow of funds that do not result in bona fide
indebtedness. See, for example, Oren v. Commissioner, 357 F.3d at 859
(purported loans, although meeting all the proper formalities, lacked
substance); Kerzner v. Commissioner, T.C. Memo. 2009-76, at *5
(transaction lacked substance because money wound up right where it
started and shareholder was merely a conduit through which the money
flowed). Whether a restructuring results in bona fide indebtedness
depends on the facts and circumstances. Because the Treasury Department
and the IRS believe that the examples in the proposed regulations
adequately illustrate that a restructuring of a debt that did not
originate between the shareholder and the S corporation may result in
basis of indebtedness as long as the resulting debt is bona fide, these
final regulations do not contain additional examples.
Another commentator requested that an example be added to the
regulations concerning a fact pattern in which bona fide indebtedness
is present, but the shareholder has zero basis in that indebtedness.
The commentator concluded that the shareholder would have zero basis of
indebtedness in the shareholder's S corporation because the
shareholder's basis in the debt is zero. The Treasury Department and
the IRS believe that the regulations are clear that shareholders only
increase their basis of indebtedness to the extent of the shareholder's
adjusted basis (as defined in Sec. 1.1011-1 and as specifically
provided in section 1367(b)(2)) in that bona fide indebtedness of the S
corporation that runs directly to the shareholder. If the shareholder's
basis in the indebtedness is zero, then the shareholder's basis of
indebtedness is increased by zero. As such, an additional example
illustrating a zero
[[Page 42677]]
basis of indebtedness has not been added to the final regulations.
3. Section 1366(d)(1)(A) and Stock Basis
The preamble to the proposed regulations requested comments
regarding the basis treatment when an S corporation shareholder or a
partner contributes the shareholder's or partner's own note to an S
corporation or a partnership. An S corporation shareholder does not
increase his basis in the stock of his S corporation under section
1366(d)(1)(A) from a contribution of his own note. See Rev. Rul. 81-187
(1981-2 CB 167) (holding that a shareholder who (i) merely executed and
transferred the shareholder's demand note to the shareholder's wholly
owned S corporation, and (ii) made no payment on the note until the
following year had a zero basis in the note until the following year
when the shareholder made a payment on the note). The preamble to the
proposed regulations described as one potential model Sec. 1.704-
1(b)(2)(iv)(d)(2), which provides that a partner's capital account is
increased with respect to non-readily tradable partner notes only (i)
when there is a taxable disposition of such note by the partnership, or
(ii) when the partner makes principal payments on such note. One
commentator recommended consideration of, and consistency with, Sec.
1.166-9(c) (regarding contributions of debt to capital). Another
commentator noted that courts have applied the ``actual economic
outlay'' standard to determine when shareholders increase their bases
in their S corporation stock. See, for example, Maguire v.
Commissioner, T.C. Memo. 2012-160. This commentator requested that the
final regulations provide that actual economic outlay does not apply to
determinations of a shareholder's stock basis under section
1366(d)(1)(A). To expedite finalization of the proposed regulations,
the scope of these final regulations is limited to basis of
indebtedness. The Treasury Department and the IRS continue to study
issues relating to stock basis and may address these issues in future
guidance.
4. Potential Abuses From Shareholders Claiming Indebtedness Basis
One commentator stressed that, because S corporations are
passthrough entities, allowing shareholders to claim S corporation
losses if they have basis of indebtedness could allow shareholders to
claim losses that are not bona fide. This commentator recommended that
the IRS require that shareholders provide information to the IRS that
all claimed S corporation losses are bona fide. The proposed
regulations, however, do not affect the normal substantiation rules for
the validity of claimed losses. See sections 6001 and 6037. See also
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992) (providing that
``an income tax deduction is a matter of legislative grace and that the
burden of clearly showing the right to the claimed deduction is on the
taxpayer'' (quoting Interstate Transit Lines v. Commissioner, 319 U.S.
590, 593 (1943))). Accordingly, this comment is beyond the scope of
these final regulations.
5. Effective and Applicability Date
Commentators also suggested that the Treasury Department and the
IRS should permit retroactive application of the regulations. These
commentators suggest that, pursuant to section 7805(b)(7), final
regulations should allow taxpayers to elect to apply the rules in the
regulations retroactively.
The proposed regulations provided that these regulations apply to
transactions entered into on or after the regulations are published as
final in the Federal Register. Upon further consideration of the
applicability date, the Treasury Department and the IRS believe that
allowing taxpayers to rely on these regulations will provide greater
certainty for determining when shareholders have basis of indebtedness.
As such, taxpayers may rely on these regulations with respect to
indebtedness between an S corporation and its shareholder that resulted
from any transaction that occurred in a year for which the period of
limitations on the assessment of tax has not expired before July 23,
2014.
Special Analyses
It has been determined that these final regulations are not a
significant regulatory action as defined in Executive Order 12866, as
supplemented by Executive Order 13563. Therefore, a regulatory
assessment is not required. It also has been determined that section
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does
not apply to these regulations. Because these regulations do not impose
a collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to
section 7805(f) of the Code, the notice of proposed rulemaking that
preceded these final regulations was submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact
on small business, and no comments were received.
Availability of IRS Documents
The IRS revenue rulings cited in this preamble are published in the
Internal Revenue Cumulative Bulletin and are available from the
Superintendent of Documents, United States Government Printing Office,
Washington, DC 20402.
Drafting Information
The principal author of these regulations is Caroline E. Hay,
Office of the Associate Chief Counsel (Passthroughs and Special
Industries). However, other personnel from the Treasury Department and
the IRS participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.108-7 is amended by:
0
1. Removing the language ``Sec. 1.1366-2(a)(5)'' in paragraph
(d)(2)(iii) and adding ``Sec. 1.1366-2(a)(6)'' in its place.
0
2. Adding two sentences to the end of paragraph (f)(2).
The addition reads as follows:
Sec. 1.108-7 Reduction of attributes.
* * * * *
(f) * * *
(2) * * * Paragraph (d)(2)(iii) of this section applies on and
after July 23, 2014. For rules that apply before that date, see 26 CFR
part 1 (revised as of April 1, 2014).
0
Par. 3. Section 1.1366-0 is amended:
0
1. By redesignating the entries in the table of contents for Sec.
1.1366-2(a)(2), (a)(3), (a)(4), (a)(5), and (a)(6) as Sec. 1.1366-2
(a)(3), (a)(4), (a)(5), (a)(6), and (a)(7), respectively, and adding
new entries for Sec. 1.1366-2 (a)(2) and (a)(2)(i) through (iii).
0
2. By revising the heading in the table of contents for Sec. 1.1366-5.
The additions and revisions read as follows:
Sec. 1.1366-0 Table of contents.
* * * * *
[[Page 42678]]
Sec. 1.1366-2 Limitations on deduction of passthrough items of an S
corporation to its shareholders.
(a) * * *
(2) Basis of indebtedness.
(i) In general.
(ii) Special rule for guarantees.
(iii) Examples.
* * * * *
Sec. 1.1366-5 Effective/applicability date.
0
Par. 4. Section 1.1366-2 is amended by:
0
1. Removing the language ``(a)(3)(i)'' in paragraph (a)(1)(i), and
adding the language ``(a)(4)(i)'' in its place.
0
2. Removing the language ``paragraph (a)(3)(ii)'' in paragraph
(a)(1)(ii), and adding the language ``paragraphs (a)(2) and
(a)(4)(ii)'' in its place.
0
3. Redesignating paragraphs (a)(2), (a)(3), (a)(4), (a)(5), and (a)(6)
as paragraphs (a)(3), (a)(4), (a)(5), (a)(6), and (a)(7) respectively,
and adding a new paragraph (a)(2).
0
4. Removing the language ``(a)(3)(i) and (ii)'' in newly designated
paragraph (a)(3), and adding the language ``(a)(4)(i) and (ii)'' in its
place.
0
5. Removing the language ``paragraphs (a)(1)(i) and (2)'' in newly
designated paragraph (a)(4)(i), and adding the language ``paragraphs
(a)(1)(i) and (3)'' in its place.
0
6. Removing the language ``paragraphs (a)(1)(ii) and (2)'' in newly
designated paragraph (a)(4)(ii), and adding the language ``paragraphs
(a)(1)(ii) and (3)'' in its place.
0
7. Removing the language ``(a)(3)(i)'' and ``(a)(3)(ii)'' in newly
designated paragraph (a)(5), and adding the language ``(a)(4)(i)'' and
``(a)(4)(ii)'', respectively, in their place.
0
8. Removing the language ``(a)(5)(ii)'' in newly designated paragraphs
(a)(6)(i) and (a)(6)(iii), and adding the language ``(a)(6)(ii)'' in
its place.
0
9. Removing the language ``(a)(4)'' in newly designated paragraph
(a)(6)(ii), and adding the language ``(a)(5)'' in its place.
0
10. Removing the language ``paragraphs (a)(1)(i) and (2)'' in newly
designated paragraph (a)(7), and adding the language ``paragraphs
(a)(1)(i) and (3)'' in its place.
The additions read as follows:
Sec. 1.1366-2 Limitations on deduction of passthrough items of an S
corporation to its shareholders.
(a) * * *
(2) Basis of indebtedness--(i) In general. The term basis of any
indebtedness of the S corporation to the shareholder means the
shareholder's adjusted basis (as defined in Sec. 1.1011-1 and as
specifically provided in section 1367(b)(2)) in any bona fide
indebtedness of the S corporation that runs directly to the
shareholder. Whether indebtedness is bona fide indebtedness to a
shareholder is determined under general Federal tax principles and
depends upon all of the facts and circumstances.
(ii) Special rule for guarantees. A shareholder does not obtain
basis of indebtedness in the S corporation merely by guaranteeing a
loan or acting as a surety, accommodation party, or in any similar
capacity relating to a loan. When a shareholder makes a payment on bona
fide indebtedness of the S corporation for which the shareholder has
acted as guarantor or in a similar capacity, then the shareholder may
increase the shareholder's basis of indebtedness to the extent of that
payment.
(iii) Examples. The following examples illustrate the provisions of
paragraph (a)(2)(i) and (ii) of this section:
Example 1. Shareholder loan transaction. A is the sole
shareholder of S, an S corporation. S received a loan from A.
Whether the loan from A to S constitutes bona fide indebtedness from
S to A is determined under general Federal tax principles and
depends upon all of the facts and circumstances. See paragraph
(a)(2)(i) of this section. If the loan constitutes bona fide
indebtedness from S to A, A's loan to S increases A's basis of
indebtedness under paragraph (a)(2)(i) of this section. The result
is the same if A made the loan to S through an entity that is
disregarded as an entity separate from A under Sec. 301.7701-3 of
this chapter.
Example 2. Back-to-back loan transaction. A is the sole
shareholder of two S corporations, S1 and S2. S1 loaned $200,000 to
A. A then loaned $200,000 to S2. Whether the loan from A to S2
constitutes bona fide indebtedness from S2 to A is determined under
general Federal tax principles and depends upon all of the facts and
circumstances. See paragraph (a)(2)(i) of this section. If A's loan
to S2 constitutes bona fide indebtedness from S2 to A, A's back-to-
back loan increases A's basis of indebtedness in S2 under paragraph
(a)(2)(i) of this section.
Example 3. Loan restructuring through distributions. A is the
sole shareholder of two S corporations, S1 and S2. In May 2014, S1
made a loan to S2. In December 2014, S1 assigned its creditor
position in the note to A by making a distribution to A of the note.
Under local law, after S1 distributed the note to A, S2 was relieved
of its liability to S1 and was directly liable to A. Whether S2 is
indebted to A rather than S1 is determined under general Federal tax
principles and depends upon all of the facts and circumstances. See
paragraph (a)(2)(i) of this section. If the note constitutes bona
fide indebtedness from S2 to A, the note increases A's basis of
indebtedness in S2 under paragraph (a)(2)(i) of this section.
Example 4. Guarantee. A is a shareholder of S, an S corporation.
In 2014, S received a loan from Bank. Bank required A's guarantee as
a condition of making the loan to S. Beginning in 2015, S could no
longer make payments on the loan and A made payments directly to
Bank from A's personal funds until the loan obligation was
satisfied. For each payment A made on the note, A obtains basis of
indebtedness under paragraph (a)(2)(ii) of this section. Thus, A's
basis of indebtedness is increased during 2015 under paragraph
(a)(2)(ii) of this section to the extent of A's payments to Bank
pursuant to the guarantee agreement.
* * * * *
0
Par. 5. Section 1.1366-5 is revised to read as follows:
Sec. 1.1366-5 Effective/applicability date.
(a) Sections 1.1366-1, 1.1366-2(a)(1), and 1.1366-2(b) through
1.1366-4 apply to taxable years of an S corporation beginning on or
after August 18, 1998.
(b) Section 1.1366-2(a)(2) applies to indebtedness between an S
corporation and its shareholder resulting from any transaction
occurring on or after July 23, 2014. In addition, S corporations and
their shareholders may rely on Sec. 1.1366-2(a)(2) with respect to
indebtedness between an S corporation and its shareholder that resulted
from any transaction that occurred in a year for which the period of
limitations on the assessment of tax has not expired before July 23,
2014.
(c) Sections 1.1366-2(a)(3) through (7), and this section apply on
and after July 23, 2014. For rules that apply before that date, see 26
CFR part 1 (revised as of April 1, 2014).
Sec. 1.1367-1 [Amended]
0
Par. 6. Section 1.1367-1(h) Example 5(iii) is amended by removing the
language ``Sec. 1.1366-2(a)(2)'' in the third and fourth sentences and
adding the language ``Sec. 1.1366-2(a)(3)'' in its place.
0
Par. 7. Section 1.1367-3 is amended by adding two sentences to the end
of the paragraph to read as follows:
Sec. 1.1367-3 Effective/applicability date.
* * * Section 1.1367-1(h), Example 5(iii) applies on and after July
23, 2014. The rules that apply before July 23, 2014 are contained in
Sec. 1.1367-3 in effect prior to July 23, 2014 (see 26 CFR part 1
revised as of April 1, 2014).
John Dalrymple,
Deputy Commissioner for Services and Enforcement.
Approved: May 27, 2014.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2014-17336 Filed 7-22-14; 8:45 am]
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