Lending to Your S-Corp: Changes in the Treatment of Open Account Debt

November 18, 2008

As the end of a tough year approaches, many small business corporation owners may be looking to their own bank accounts for a way to pay those all-important year-end business expenses. However, in light of recent changes to IRS regulations concerning open account debt, S-Corporation shareholders should be cautious about the form in which they make advances to their business.

Open account debt has historically been defined as advances made by a shareholder to an S-Corporation when those advances are not evidenced by a formal written note. Effective October 20, 2008, IRS has introduced a new regulation that sets a $25,000 limit on the amount of open account debt that an S-Corporation can owe to each shareholder. This, combined with ambiguity about how income from the repayment of open account debt is to be treated, could mean some adverse tax consequences for S-Corporation shareholders who are trying to help their business meet year-end expenses.

Before the new regulations, S-Corporation shareholders could continually defer recognition of taxable gain from repayment of loans by incrementally adding new basis every year in the form of new loans. Thanks to the new regulations, this is no longer possible for open account debts that exceed $25,000. Open account debts that exceed $25,000 at the end of a taxable year now will be treated for adjustment of basis purposes just like loans that are evidenced by a formal note. This means that the basis in these loans can be decreased by losses passed through to the shareholders and cannot be restored by additional open account loans.

IRS has explicitly declined to provide guidance on whether income from these converted loans is to be treated as ordinary income or capital gains. Income from open account debt is treated as ordinary gain, while income from loans evidenced by a formal written note is treated as capital gain because the note itself is viewed by the IRS as a capital asset. Unfortunately, open account loans over $25,000 that are converted under the new regulations still do not have a formal written note behind them. Thus, these loans might receive the less-favorable basis treatment of loans evidenced by a formal note while also receiving the less-favorable income treatment of open account loans. This is obviously not a desirable result and could easily mean thousands of dollars in adverse tax consequences.

Fortunately, an S-Corporation’s legal counsel can provide cost-effective solutions to this problem. For instance, future advances to the corporation could be made in the form of capital, rather than debt, allowing the shareholder to use the basis of his or her stock in much the same rolling manner as open account debt was used in the past. This option makes sense especially when loans are made in proportion to stock ownership. Alternatively, legal practitioners can craft formal notes for past and future debts, allowing taxpayers to obtain the more favorable capital gains tax treatment.

For more information on open account debt and the ways that we can help you to avoid its adverse tax consequences, contact Frost Brown Todd’s Tax Law client services group.

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