Tax aspects of contributions to capital of shareholder loans. (Federal Taxation)by O'Keefe, Thomas F.
The accounting entry to record the contribution to capital of a shareholder loan is straightforward. The loan payable account is reduced, and paid-in-capital is increased. The tax consequences are not as simple. Generally, when a loan is contributed to capital, the corporation is relieved of a liability and, pursuant to IRC Sec. 61(a)(12), the corporation realizes income in the amount of the discharged debt. Fortunately, this result is modified by IRC Sec. 108(e)(6). This section provides that when shareholder debt is contributed to capital, the amount of income is determined by treating the corporation as though it had satisfied the debt with an amount of money equal to the shareholder's adjusted basis in the indebtedness. This means that if the shareholder's basis in the indebtedness is the same as the amount of the corporation's liability, no income will be realized by the corporation when the debt is contributed to capital.
Example 1. A, the 100% shareholder of X Corp., advances $100,000 to X Corp. At year end, A decides to contribute his $100,000 receivable to X Corp.'s capital, rather than seeking repayment. Since in this case A's adjusted basis in the note is $100,000, X Corp. will realize no income because it is deemed to have paid the debt in full.
The full impact of IRC Sec. 108(e)(6) is more readily seen in the case of a contribution of shareholder debt to capital where the shareholder's adjusted basis in the debt has been reduced. A shareholder's adjusted basis could be less than the corporation's liability if, for example, he claimed a bad debt deduction under IRC Sec. 166 or, if the corporation accrued and deducted an expense to a cash basis shareholder who does not recognize the income until payment is made. Regardless of the cause of the shareholder's reduced adjusted basis, the effect on the corporation will be the same. The corporation will be treated as having satisfied its debt for less than the full amount, and will realize cancellation of indebtedness income on the difference between the amount of the debt and the adjusted basis.
Example 2. Y Corp. has accrued and deducted $50,000 of interest expense on a loan to B, a 15% shareholder of Y Corp. Since B is a cash-basis taxpayer, he has not recognized interest income and he has a zero basis in the $50,000 interest receivable. If B decides to contribute the interest receivable to capital rather than receive payment, Y Corp. will be treated as having satisfied the $50,000 liability for an amount of money equal to B's adjusted tax basis in the property. Since B's adjusted tax basis is zero, Y Corp. is treated as having satisfied a $50,000 liability for no money. This results in the realization of $50,000 of cancellation of indebtedness income by Y Corp.
Relief For Related Parties
The corporation in Example 2 was able to deduct the interest accrued to the shareholder because the related party rules of IRC Sec. 267 do not apply to a shareholder owning not more than 50% in value of the outstanding stock. If the interest expense was payable to a cash basis shareholder owning more than 50% of the stock, the corporation would be subject to the matching rules of IRC Sec. 267 and would not be allowed to deduct the interest until it was paid. If that were the case, a corporation could have cancellation of indebtedness income on an accrued expense that was never deducted by the corporation. Relief from this inequitable result is found in IRC Sec. 108(e)(2), which provides that no income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to deduction.
Cancellation of indebtedness income is excluded from taxable income to the extent the taxpayer is insolvent.
Pass Through Entities
An S corporation is unique in that its income and expenses are taxed directly to the shareholders, while the determination of insolvency is made at the corporate level. Thus, if an S corporation is insolvent and has cancellation of indebtedness income, that income is excluded and is not passed through to the shareholders. This is contrary to the rule applicable to partnerships. If a partnership has cancellation of indebtedness income, the test for insolvency is made at the partner level, not at the partnership level.
Shareholders in S corporations are required to reduce their basis in shareholder loans by losses passed through to them, after first reducing their basis in stock of the S corporation to zero. Therefore, it is possible that a shareholder will have a corporate loan with a reduced basis as a result of tax losses. If the shareholder were to contribute such debt to the capital of the S corporation, the S corporation would realize cancellation of indebtedness income. That income could then be excluded if the S corporation were insolvent.
If the S corporation is not insolvent the special rules of IRC Sec. 108(d)(7) apply. The section requires a shareholder's adjusted basis in indebtedness of the corporation to be determined without regard to the adjustments required by IRC Sec. 1367(b)(2). This refers to reductions in basis that include losses passed through to the shareholders. Thus, if an S corporation shareholder contributes debt with a basis that has been reduced by losses to the capital of the S corporations, those losses must be added back to the shareholders adjusted basis in the loans for purposes of determining the amount the corporation is deemed to have paid in satisfaction of the liability.
Example 3: C is a 100% shareholder of Z Corp., an S corporation. C has a $100,000 receivable from Z Corp. with a $25,000 adjusted tax basis because of $75,000 in losses passed through from Z Corp. Under the rule of IRC Sec. 108(e)(6), if C contributes the receivable to the capital of Z Corp., Z Corp. would be deemed to have satisfied the liability for $25,000 (C's adjusted tax basis), and would realize $75,000 of cancellation of indebtedness income. However, because of IRC Sec. 108(d)(7), C's adjusted tax basis has to be increased by the $75,000 in losses that were deducted. Therefore, his adjusted tax basis in the receivable is $100,000 for purposes of IRC Sec. 108(e)(6) and Z Corp. realizes no cancellation of indebtedness income.
It should be noted that C's basis in Z Corp. will only by increased by his $25,000 adjusted basis in the receivable. The special rule of IRC Sec. 108(d)(7) only modifies the shareholder's adjusted tax basis in the debt for purposes of determining the amount of corporation is treated as paying to satisfy the liability. It does not increase the shareholder's basis for purposes of IRC Sec. 351.
Document the Transaction
The tax consequences of a shareholder contributing debt to the capital of a debtor corporation can be very favorable. In considering what those consequences will be, the tax basis of the debt is critical. Accurate basis records are a must. However, the shareholder must be able to establish that he was acting as shareholder and not as an employee, or in some capacity other than as a shareholder.
Measures should be taken to ensure the transaction will stand as a contribution to capital. Corporate resolutions and any other relevant corporate measures should be prepared to document the transaction. The documentation should be in order before the transaction comes under the scrutiny of IRS examiners.
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