On July 23, 2014, the Department of the Treasury issued Final Regulations on basis increases for back-to-back loans involving S corporations. The Final Regulations adopt the proposed regulations without substantive change, except for changes allowing a retroactive effective date (which is a positive change to the Proposed Regulations) and minor clarifying revisions. The Proposed Regulations (and now the Final Regulations) constitute a vast improvement over the current state of the law which has applied the “actual economic outlay” test and the “poorer in a material sense” concept to determine whether a shareholder is entitled to a basis increase under section 1366(d)(1)(B). Rather, the Final Regulations allow for a basis increase under section 1366(d)(1)(B) if the debt running from the S corporation to the shareholder is a “bona fide” debt under general Federal tax principles. In view of the uncertainty and inconsistent judicial decisions regarding basis increases with respect to back-to-back loans, the guidance is welcome and the IRS should be applauded for its response to the request for regulations made by the ABA Tax Section, the AICPA and many tax practitioners, and for its abandonment of the “actual economic outlay” test with respect to back-to-back loans.
A back-to-back loan in the S corporation context refers to an arrangement in which an S corporation shareholder borrows funds from an unrelated or related third party, and then lends such funds to the S corporation. A loan can be structured as a back-to-back loan at the outset to enable the shareholder to obtain a basis increase immediately upon the infusion of funds into the corporation, or a back-to-back loan may arise later when a loan that originally was structured as a direct loan from the third party to the S corporation is restructured as a back-to-back loan in order to provide a basis increase for the shareholder.
The Final Regulations may be relied on by taxpayers 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.
Unfortunately, the Final Regulations did not incorporate the comments made by the ABA Tax Section on the Proposed Regulations. One of the comments that was not adopted was that although the Proposed Regulations expressly reject the application of the “actual economic outlay” test and the “poorer in a material sense” concept in the preamble, the Final Regulations should directly address these concepts in the body of the Regulations. The preamble to the Final Regulations states that the Treasury Department and the IRS believe that the regulations clearly articulate the standard for determining basis of indebtedness of an S corporation to its shareholder, and that further discussion of the actual economic outlay test in the body of the regulations was unnecessary.
The Proposed Regulations also provided an example that where a related corporation assigns its creditor position in a note from another related S corporation to the common shareholder of the two corporations by making a distribution to the common shareholder of the note, the shareholder will be entitled to increase the shareholder‘s basis where local law provides that such distribution results in the related S corporation’s relief of liability to the other related corporation and the related S corporation becoming directly liable to the common shareholder. The ABA Tax Section commented that the Proposed Regulations should be clarified to reflect that even if local law does not operate to relieve the related S corporation of its liability to the related corporation, the common shareholder should still be entitled to increase the shareholder’s basis under section 1366(d)(1)(B). The Final Regulations refused to adopt this comment on the basis that relief of the original liability is an appropriate fact to consider in determining whether the transaction is a bona fide debt. While it may indeed be a factor to be considered, the courts (and IRS agents) may very well misconstrue this example to require that the original debtor be relieved of liability to be classified as a bona fide debt.
Additionally, although the Proposed Regulations provided several examples of back-to-back loans that result in a shareholder being able to increase his or her basis in the S corporation under section 1366(d)(1)(B), the Proposed Regulations contained no example of loan restructurings achieved through loan repayments involving a circular flow of funds, and the ABA Tax Section specifically suggested that two examples involving a circular flow of funds be included in the Final Regulations which would result in a basis increase under section 1366(d)(1)(B). Again, the IRS did not adopt this comment and add the two examples on the basis that there are circumstances in which a circular flow of funds would not result in bona fide indebtedness, and as such, the IRS believed the regulations were adequate as drafted. Again, because of all the confusion in this area demonstrated by the conflicting court decisions, examples of loan restructurings involving a circular flow of funds resulting in a basis increase for a shareholder provided the transaction resulted in bona fide debt running from the S corporation to the shareholder would have been very helpful to taxpayers and tax practitioners. I believe by not addressing this issue in the regulations, there may be a tendency by courts to simply treat transactions involving a circular flow of funds as not increasing basis, rather than focusing on whether the debt from the S corporation to the shareholder is bona fide debt, the standard enunciated in the Final Regulations.
Finally, and very importantly, the ABA Tax Section comments requested clarification that the actual economic outlay test should likewise not be applicable in the context of increases in stock basis under section 1366(d)(1)(A), in addition to increases in basis for debt under section 1366(d)(1)(B). The Final Regulations did not adopt this comment either in order to “expedite the finalization of the proposed regulations…” As previously pointed out in the ABA Tax Section comments, while it is agreed that a shareholder should not be allowed to increase the shareholder’s stock basis under section 1366(d)(1)(A) by contributing the shareholder’s own promissory note to the S corporation, the IRS and the courts should also not apply the actual economic outlay test in cases involving section 1366(d)(1)(A) relating to increases in stock basis. For many, if not most, of the reasons that the “actual economic outlay” test and the “poorer in a material sense” concept are inappropriate to determine a shareholder’s basis in indebtedness of the S corporation to such shareholder under section 1366(d)(1)(B), both of these concepts are probably even more inappropriate to determine an increase in stock basis under section 1366(d)(1)(A). Therefore, the Final Regulations should have provided that the “actual economic outlay” test also does not apply in determining basis increases under 1366(d)(1)(A). The preamble to the Final Regulations also state that the “Treasury Department and the IRS continue to study issues relating to stock basis and may address these issues in future guidance.” I believe that this was the appropriate time for the IRS to address this issue for both increases in the basis of debt under section 1366(d)(1)(B) and increases in the basis of stock under section 13366(d)(1)(A). By not addressing this issue in the Final Regulations, I believe that IRS agents and the courts may continue to wrongly apply the actual economic outlay test and the material in a poorer sense concept in cases involving increases to stock basis.