On July, 22, 2014, the IRS issued final regulations clarifying the requirements for creating basis with debt by transitioning from the economic outlay test to a requirement that the debt of the S corporation be bonafide indebtedness to the shareholder. The final regulations may provide flexibility to S corporation shareholders experiencing basis limiations. This is because the clarification creates a more favorable outcome from the previous standard that required the loan to have caused a significant change to the shareholder’s economic wealth, with the shareholder being made poorer in a material sense.
Shareholder Loan Example
An example in the regulations helps illustrate the difference between these tests. In the example, an individual is the sole shareholder of multiple S corporations. The shareholder borrows $200,000 from the first S corporation and loans that money to a second S corporation. Under the final regulations, this transaction creates $200,000 of additional basis for the shareholder in the second S corporation because there is a bona fide debt between the parties. Under the old rule the shareholder would probably not experience a debt basis increase which required an actual economic outlay. However, the change from the “actual economic outlay” rule to the “bona fide debt” rule would allow the shareholder to obtain debt basis for properly structured circular or back-toback intercompany loans, which have been a constant source of litigation for many years.
Taxpayers also need to pay particular attention to the proper documentation of the transfer of funds to the S corporation. When a shareholder loans funds to an S corporation, the corporation should execute a note bearing a rate of interest that is at least equal to the applicable federal rate (AFR). This step may avoid an IRS position that shareholder loans are a second class of stock or otherwise not bonafide debt.