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Bona fide indebtedness determination lowers hurdle to obtain debt basis.
For S corporation shareholders, borrowing from one company they own to fund another is a common way to inject some cash into a growing business—especially in these days of conservative lending. But previously, if the funded company experienced losses and you wanted to take deductions for those losses on your personal tax returns, you had to meet a high bar to prove that loan increased your debt basis in the company.
As a result of the previous position of the IRS and tax courts, shareholders who borrowed from one related entity in order to loan to another had a particularly hard time defending their debt basis. But thanks to final rules from the IRS, that bar has been lowered and S corporation shareholders are now more likely to qualify for tax deductions for entity losses that have been passed through to them.
Bona Fide Indebtedness Determination
On July 23, the IRS issued final regulations on debt basis determinations for S corporation shareholders (T.D. 9682). These final rules implement a “bona fide” debt basis determination as opposed to the controversial “economic outlay” doctrine that has been developed by the courts over the last several years.
Under the economic outlay doctrine, in order to obtain debt basis an S corporation shareholder must incur a true economic outlay through a transaction, which when fully consummated, left the taxpayer poorer in a material sense.
On the other hand, bona fide indebtedness is determined under general Federal tax principles and depends on all the facts and circumstances. Basically, a bona fide debt is one that creates a true debtor-creditor relationship that is based on a valid and enforceable obligation to pay a fixed or determinable amount of money. This means that shareholders who structure and document their loans to an S Corporation in the correct way can now qualify for debt basis in that S corporation, and as a result, can claim current tax deductions for their share of any losses that S corporation experiences.
This is a win for both the shareholder and the company. The shareholder has potential for additional deductions and the company gets a cash infusion that has potential tax minimizing opportunities for the shareholder.
Previously, the IRS and tax court often used the economic outlay doctrine to deny debt basis to shareholders for funds borrowed from a related entity and then loaned to the S corporation by the shareholder. These transactions are often referred to as back-to-back loans. The reasoning was that, by borrowing from Peter to pay Paul, the shareholder was not considered to be making a true economic outlay.
But with the new debt basis rules, shareholders who structure and document their back-to-back loans to qualify as bona fide indebtedness (see below) are more likely to obtain debt basis—and claim tax deductions—as result of those loans.
The Look-Back Opportunity
While the final debt basis rules were issued with minimal changes to the proposed regulations, one significant highlight is that the final rules did expand their application to open tax years.
What does this mean for you? In addition to the potential tax benefits of restructuring related entity loans going forward, shareholders who have made back-to-back loans in any open tax year and didn’t increase their debt basis now have the opportunity to go back and claim deductions for any previously disallowed losses—if they can demonstrate there was bona fide indebtedness.
Determining Bona Fide Indebtedness
While there is no bright-line test to prove that a debt is bona fide, the key is to demonstrate that there is a true debtor-creditor relationship. Based on federal tax principles, the following steps can help support the determination of bona fide indebtedness:
- Make sure there is documentary evidence of the transaction (i.e. a written loan agreement).
- Both parties should reflect the transaction as a loan in their records.
- Setup a fixed repayment schedule and make efforts to follow the schedule in order to create a history of regular repayments.
- The loan should require interest and the rate should be at least as much as the Applicable Federal Rate (AFR).
- Consider collateral to secure the debt.
- A demand for repayment should be issued if necessary.
- There needs to be intent to create a valid debtor-creditor relationship and the lender must have an expectation of receiving repayment at the time of the loan.
Review S Corporation Financing Strategy
If you are a shareholder in one or more S corporations, work with your tax advisor to review any existing or prospective loans for the opportunity to demonstrate bona fide indebtedness—and therefore obtain debt basis to claim current tax deductions for any entity losses in the future and/or any suspended losses in open tax years.
Going forward, you and your CPA might find that funding S corporations with properly structured back-to-back loans provides a tax-advantaged way to finance a new venture with funds from a more established company.