[Federal Register Volume 77, Number 113 (Tuesday, June 12, 2012)]
[Proposed Rules]
[Pages 34884-34887]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-14188]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-134042-07]
RIN 1545-BG81


Basis of Indebtedness of S Corporations to Their Shareholders

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations relating to basis 
of indebtedness of S corporations to their shareholders. These proposed 
regulations provide that S corporation shareholders increase their 
basis of indebtedness of the S corporation to the shareholder only if 
the indebtedness is bona fide. The proposed regulations affect 
shareholders of S corporations. This document also provides notice of a 
public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by September 10, 
2012. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for October 8, 2012, must be received by 
September 10, 2012.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-134042-07), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
134042-07), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at www.regulations.gov (IRS REG-134042-07). The 
public hearing will be held in the auditorium, Internal Revenue 
Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Caroline E. Hay at (202) 622-3070; concerning the submissions of 
comments, the hearing, and/or to be placed on the building access list 
to attend the hearing, Oluwafunmilayo (Funmi) P. Taylor at (202) 622-
7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document proposes amendments to Sec.  1.1366-2 of the Income 
Tax Regulations. In addition, this document proposes conforming changes 
to the effective date rules provided in Sec.  1.1366-5.
    Under section 1366(d)(1) of the Internal Revenue Code (Code), the 
aggregate amount of losses and deductions that a shareholder takes into 
account for any taxable year cannot exceed the sum of that 
shareholder's adjusted basis in stock and adjusted basis of any 
indebtedness of the S corporation to that shareholder. The Senate 
Report discussing section 1374 (the predecessor statute to section 
1366) illustrates Congress's intent to limit the loss that a 
shareholder takes into account to that shareholder's investment in the 
corporation; that is, to the adjusted basis of the stock in the 
corporation owned by the shareholder and the adjusted basis of any 
indebtedness of the corporation to the shareholder. S. Rept. 1983, 85th 
Cong., 2d Sess. 219-220 (1958) (1958-3 CB 922, 1141).
    Section 1.1366-2 provides rules relating to limitations on 
deduction of passthrough items of an S corporation to its shareholder. 
Under Sec.  1.1366-2(a)(1), a shareholder's aggregate amount of losses 
and deductions taken into account under Sec.  1.1366-1(a)(2), (3), and 
(4) for any taxable year of the S corporation cannot exceed that 
shareholder's adjusted basis in stock in the corporation and adjusted 
basis of any indebtedness of the corporation to that shareholder. These 
proposed amendments to the regulations provide that, in order to 
increase a shareholder's basis of indebtedness, a loan must represent 
bona fide indebtedness of the S corporation that runs directly to the 
shareholder. These proposed regulations also reaffirm that a 
shareholder acting as guarantor of S corporation indebtedness does not 
create or increase basis of indebtedness simply by becoming a 
guarantor.

Explanation of Provisions

    Section 1366(d)(1) provides that a shareholder can take into 
account losses and deductions to the extent of the adjusted basis of 
the shareholder's stock and the adjusted basis of any indebtedness of 
the S corporation to the shareholder (basis of indebtedness). The Code 
does not define basis of indebtedness, but several court cases 
involving passthrough losses from an S corporation interpret section 
1366 to require an investment in the S corporation that constitutes 
``an actual economic outlay'' by the shareholder to create basis of 
indebtedness. See, for example, Maloof v. Comm'r, 456 F.3d 645, 649-650 
(6th Cir. 2006); Spencer v. Comm'r, 110 T.C. 62, 78-79 (1998), aff'd 
without published opinion, 194 F.3d 1324 (11th Cir. 1999); Hitchins v. 
Comm'r, 103 T.C. 711, 715 (1994); Perry v. Comm'r, 54 T.C. 1293, 1296 
(1970). Often, the cases involve attempts by an S corporation 
shareholder to obtain basis of indebtedness by borrowing from another 
person--typically, a related entity--and then lending the proceeds to 
the S corporation (a back-to-back loan transaction). Alternatively, an 
S corporation shareholder might seek to restructure an existing loan of 
the S corporation into a back-to-back loan by assuming the S 
corporation's liability on the loan and creating a commensurate 
obligation from the S corporation to the shareholder. Disputes continue 
to arise concerning when a back-to-back loan gives rise to an actual 
economic outlay,

[[Page 34885]]

in particular whether a shareholder has been made ``poorer in a 
material sense'' as a result of the loan. See, for example, Oren v. 
Comm'r, 357 F.3d 854, 857-859 (8th Cir. 2004); Bergman v. U.S., 174 
F.3d 928, 932 (8th Cir. 1999).
    The frequency of disputes between S corporation shareholders and 
the government regarding whether certain loan transactions involving 
multiple parties, including back-to-back loan transactions, create 
shareholder basis of indebtedness demonstrates the complexity of and 
uncertainty about this issue for both shareholders and the government. 
The Treasury Department and the IRS propose these regulations to 
clarify the requirements for increasing basis of indebtedness and to 
assist S corporation shareholders in determining with greater certainty 
whether their particular arrangement creates basis of indebtedness. 
These proposed regulations require that loan transactions represent 
bona fide indebtedness of the S corporation to the shareholder in order 
to increase basis of indebtedness; therefore, an S corporation 
shareholder need not otherwise satisfy the ``actual economic outlay'' 
doctrine for purposes of section 1366(d)(1)(B).
    The key requirement of these proposed regulations is that purported 
indebtedness of the S corporation to a shareholder must be bona fide 
indebtedness to the shareholder. These proposed regulations do not 
attempt to provide a different standard for purposes of section 1366 as 
to what constitutes bona fide indebtedness. Rather, general Federal tax 
principles--many of which have developed outside of section 1366--
determine whether indebtedness is bona fide. See, for example, Knetsch 
v. U.S., 364 U.S. 361 (1960) (disallowing interest deductions for lack 
of actual indebtedness); Geftman v. Comm'r, 154 F.3d 61, 68-75 (3d Cir. 
1998) (based on the objective attributes and the economic realities of 
the transaction, holding that the transaction at issue was not a bona 
fide debt); Estate of Mixon v. U.S., 464 F.2d 394, 402 (5th Cir. 1972) 
(discussion of factors indicative that debt is bona fide); Litton 
Business Systems, Inc. v. Comm'r, 61 T.C. 367, 376-77 (1973).
    By contrast, shareholder guarantees of S corporation debt do not 
result in basis of indebtedness. An overwhelming majority of courts 
considering whether shareholders may increase basis of indebtedness 
from their guarantees of S corporation debt determined that the 
shareholders' guarantees did not create basis of indebtedness. Where an 
S corporation shareholder acts merely as a guarantor of a loan made by 
another party directly to the S corporation, or acts in a capacity 
similar to a guarantor (for example, as a surety or accommodation 
party), then the courts have held that the shareholder adjusts basis of 
indebtedness only to the extent the shareholder actually performs under 
the guarantee. See, for example, Estate of Leavitt v. Comm'r, 875 F.2d 
420 (4th Cir. 1989); Frankel v. Comm'r, 61 T.C. 343 (1973), aff'd 
without published opinion, 506 F.2d 1051 (3d Cir. 1974); Raynor v. 
Comm'r, 50 T.C. 762 (1968); Weisberg v. Comm'r, T.C. Memo. 2010-55; 
Maloof v. Comm'r, T.C. Memo. 2005-75, aff'd, 456 F.3d 645 (6th Cir. 
2006); Wise v. Comm'r, T.C. Memo. 1997-135. But see Selfe v. U.S., 778 
F.2d 769 (11th Cir. 1985) (holding that under unique and limited 
circumstances, a shareholder who guarantees a loan to an S corporation 
may increase basis of indebtedness where, in substance, that 
shareholder has borrowed funds and subsequently advanced them to the S 
corporation). These proposed regulations provide that an S corporation 
shareholder who merely acts as a guarantor or in a similar capacity has 
not created basis of indebtedness unless the shareholder actually makes 
a payment, and then only to the extent of such payment. See also Rev. 
Rul. 70-50 (1970-1 CB 178), (see Sec.  601.601(d)(2)).
    Additionally, some taxpayers have relied on an ``incorporated 
pocketbook'' theory to claim an increase in basis of indebtedness in 
circumstances that involve a loan directly to the S corporation from an 
entity related to the S corporation shareholder. In these transactions, 
an S corporation shareholder claims that a transfer from the related 
entity directly to the shareholder's S corporation was made on the 
shareholder's behalf and is, in substance, a loan from the related 
entity to the shareholder, followed by a loan from the shareholder to 
the S corporation. A limited number of court decisions have allowed 
shareholders to increase basis of indebtedness as a result of 
incorporated pocketbook transactions. See Yates v. Comm'r, T.C. Memo. 
2001-280; Culnen v. Comm'r, T.C. Memo. 2000-139. Under these proposed 
regulations, an incorporated pocketbook transaction increases basis of 
indebtedness only where the transaction creates a bona fide creditor-
debtor relationship between the shareholder and the borrowing S 
corporation.
    These proposed regulations only address whether a shareholder has 
basis of indebtedness for purposes of section 1366(d)(1)(B) and do not 
address how to determine the basis of the shareholder's stock in the S 
corporation for purposes of section 1366(d)(1)(A). Therefore, these 
proposed regulations leave unchanged the conclusion found in published 
guidance that a shareholder of an S corporation does not increase basis 
in stock for purposes of section 1366(d)(1)(A) upon the contribution of 
the shareholder's own unsecured demand promissory note to the 
corporation. Rev. Rul. 81-187 (1981-2 CB 167). This conclusion is 
consistent with published guidance and case law in the partnership 
context that the contribution of the partner's own note will not 
increase such partner's basis in its partnership interest under section 
722. Rev. Rul. 80-235 (1980-2 CB 229); Oden v. Comm'r, T.C. Memo. 1981-
184, aff'd without published opinion, 679 F.2d 885 (4th Cir. 1982) 
(because the partner incurred no cost in making the note, the partner's 
basis in the note to him was zero). In developing this project, the 
Treasury Department and the IRS have considered whether the principal 
holding of Rev. Rul. 81-187, and the holding of Rev. Rul. 80-235 as it 
relates to a partner's basis in its partnership interest upon the 
contribution of the partner's own note, should be promulgated as 
regulations. The Treasury Department and the IRS have considered 
alternatives to the discussion of the applicable law in those revenue 
rulings. As one model, the Treasury Department and the IRS have, with 
respect to basis calculations in the S corporation and partnership 
context, considered adopting a rule similar to the one currently in 
Sec.  1.704-1(b)(2)(iv)(d)(2), which provides that a partner's capital 
account is increased with respect to non-readily tradable partner notes 
only (i) when there is a taxable disposition of such note by the 
partnership, or (ii) when the partner makes principal payments on such 
note. The Treasury Department and the IRS request comments concerning 
the propriety of this model in the S corporation and the partnership 
context.

Proposed Effective Date

    The regulations, as proposed, apply to loan transactions entered 
into on or after the date of publication of a Treasury decision 
adopting these rules as final regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13563. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of

[[Page 34886]]

the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to 
these proposed regulations. Because these proposed regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The Treasury Department and the IRS request comments on all 
aspects of the proposed rules. All comments will be available for 
public inspection and copying.
    A public hearing has been scheduled for October 8, 2012, beginning 
at 10 a.m. in the auditorium of the Internal Revenue Building, 1111 
Constitution Avenue NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 15 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written 
comments and an outline of the topics to be discussed and the time to 
be devoted to each topic (signed original and eight (8) copies) by 
September 10, 2012. A period of 10 minutes is allotted to each person 
for making comments. An agenda showing the scheduling of the speakers 
will be prepared after the deadline for receiving outlines has passed. 
Copies of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these proposed regulations are Caroline E. 
Hay, Michael H. Beker, and Stacy L. Short, Office of the Associate 
Chief Counsel (Passthroughs and Special Industries). However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income Taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *


Sec.  1.108-7  [Amended]

    Par. 2. Section 1.108-7 is amended by:
    1. Removing the language ``Sec.  1.1366-2(a)(5)'' in paragraph 
(d)(2)(iii) and adding ``Sec.  1.1366-2(a)(6)'' in its place.
    2. Adding a sentence to the end of paragraph (f)(2).
    The addition reads as follows:


Sec.  1.108-7  Reduction of attributes.

* * * * *
    (f) Effective/applicability date.
    (2) * * * The revision to the citation to Sec.  1.1366-2(a) in 
paragraph (d)(2)(iii) of this section is applicable on and after the 
date these proposed regulations are published as final in the Federal 
Register.
* * * * *


Sec.  1.1366-0  [Amended]

    Par. 3. Section 1.1366-0 is amended by:
    1. Redesignating paragraphs (a)(2), (a)(3), (a)(4), (a)(5), and 
(a)(6) as paragraphs (a)(3), (a)(4), (a)(5), (a)(6), and (a)(7) in the 
table of contents for Sec.  1.1366-2, respectively, and adding a new 
paragraph (a)(2).
    2. Revising the title of Sec.  1.1366-5 in the table of contents.
    The additions read as follows:


Sec.  1.1366-0  Table of contents.

* * * * *


Sec.  1.1366-2  Limitations on deduction of passthrough items of an S 
corporation to its shareholders.

    (a) * * *
    (2) Basis of indebtedness.
    (i) In general.
    (ii) Guarantees.
    (iii) Examples.
* * * * *


Sec.  1.1366-5  Effective/Applicability date.


Sec.  1.1366-2  [Amended]

    Par. 4. Section 1.1366-2 is amended by:
    1. Redesignating paragraphs (a)(2), (a)(3), (a)(4), (a)(5), and 
(a)(6) as paragraphs (a)(3), (a)(4), (a)(5), (a)(6), and (a)(7) 
respectively, and adding a new paragraph (a)(2).
    2. Removing the language ``(a)(3)(i)'' in paragraph (a)(1)(i), and 
adding the language ``(a)(4)(i)'' in its place.
    3. Removing the language ``paragraph (a)(3)(ii)'' in paragraph 
(a)(1)(ii), and adding the language ``paragraphs (a)(2) and 
(a)(4)(ii)'' in its place.
    4. Removing the language ``(a)(3)(i) and (ii)'' in newly 
redesignated paragraph (a)(3), and adding the language ``(a)(4)(i) and 
(ii)'' in its place.
    5. Removing the language ``paragraphs (a)(1)(i) and (2)'' in newly 
redesignated paragraph (a)(4)(i), and adding the language ``paragraphs 
(a)(1)(i) and (3)'' in its place.
    6. Removing the language ``paragraphs (a)(1)(ii) and (2)'' in newly 
redesignated paragraph (a)(4)(ii), and adding ``paragraphs (a)(1)(ii) 
and (3)'' in its place.
    7. Removing the language ``(a)(3)(i)'' and ``(a)(3)(ii)'' in newly 
redesignated paragraph (a)(5), and adding the language ``(a)(4)(i)'' 
and ``(a)(4)(ii)'', respectively, in their place.
    8. Removing the language ``(a)(5)(ii)'' in newly redesignated 
paragraph (a)(6)(i) and (a)(6)(iii), and adding the language 
``(a)(6)(ii)'' in its place.
    9. Removing the language ``(a)(4)'' in newly redesignated paragraph 
(a)(6)(ii), and adding the language ``(a)(5)'' in its place.
    10. Removing the language ``paragraphs (a)(1)(i) and (2)'' in newly 
redesignated paragraph (a)(7), and adding the language ``paragraphs 
(a)(1)(i) and (3)'' in its place.
    The additions read as follows:


Sec.  1.1366-2  Limitations on deduction of passthrough items of an S 
corporation to its shareholders.

    (a) * * *
    (2) Basis of indebtedness--(i) In general. The term basis of any 
indebtedness of the S corporation to the shareholder means the 
shareholder's adjusted basis (as defined in Sec.  1.1011-1 and as 
specifically provided in section 1367(b)(2)) in any bona fide 
indebtedness of the S corporation that runs directly to the 
shareholder. Whether indebtedness is bona fide indebtedness to a 
shareholder is determined under general Federal tax principles and 
depends upon all of the facts and circumstances.
    (ii) Guarantees. A shareholder does not obtain basis of 
indebtedness in the S corporation merely by guaranteeing a loan or 
acting as a surety, accommodation party, or in any similar

[[Page 34887]]

capacity relating to a loan. When a shareholder makes a payment on bona 
fide indebtedness for which the shareholder has acted as guarantor or 
in a similar capacity, based on the facts and circumstances, the 
shareholder may increase its basis of indebtedness to the extent of 
that payment.
    (iii) Examples. The following examples illustrate the provisions of 
paragraph (a)(2)(i) and (ii) of this section:
    Example 1. Shareholder loan transaction. A is the sole 
shareholder of S, an S corporation. S received a loan from A. 
Whether the loan from A to S constitutes bona fide indebtedness from 
S to A is determined under general Federal tax principles and 
depends upon all of the facts and circumstances. See paragraph 
(a)(2)(i) of this section. If the loan constitutes bona fide 
indebtedness from S to A, A's loan to S increases A's basis of 
indebtedness under paragraph (a)(2)(i) of this section. The result 
is the same if A made the loan to S through an entity that is 
disregarded as an entity separate from A under Sec.  301.7701-3.
    Example 2. Guarantee. A is a shareholder of S, an S corporation. 
In 2013, S received a loan from Bank. Bank required A's guarantee as 
a condition of making the loan to S. Beginning in 2014, S could no 
longer make payments on the loan and A made payments directly to 
Bank from A's personal funds until the loan obligation was 
satisfied. For each payment A made on the note, A obtains basis of 
indebtedness under paragraph (a)(2)(ii) of this section. Thus, A's 
basis of indebtedness is increased during 2014 under paragraph 
(a)(2)(ii) of this section to the extent of A's payments to Bank 
pursuant to the guarantee agreement.
    Example 3. Back-to-back loan transaction. A is the sole 
shareholder of two S corporations, S1 and S2. S1 loaned $200,000 to 
A. A then loaned $200,000 to S2. Whether the loan from A to S2 
constitutes bona fide indebtedness from S2 to A is determined under 
general Federal tax principles and depends upon all of the facts and 
circumstances. See paragraph (a)(2)(i) of this section. If A's loan 
to S2 constitutes bona fide indebtedness from S2 to A, A's back-to-
back loan increases A's basis of indebtedness in S2 under paragraph 
(a)(2)(i) of this section.
    Example 4. Loan restructuring through distributions. A is the 
sole shareholder of two S corporations, S1 and S2. In March 2013, S1 
made a loan to S2. In December 2013, S1 assigned its creditor 
position in the note to A by making a distribution to A of the note. 
Under local law, after S1 distributed the note to A, S2 was relieved 
of its liability to S1 and was directly liable to A. Whether S2 is 
indebted to A rather than S1 is determined under general Federal tax 
principles and depends upon all of the facts and circumstances. See 
paragraph (a)(2)(i) of this section. If the note constitutes bona 
fide indebtedness from S2 to A, the note increases A's basis of 
indebtedness in S2 under paragraph (a)(2)(i) of this section.
* * * * *


Sec.  1.1366-5  [Amended]

    Par. 5. Section 1.1366-5 is amended by:
    1. Removing the language ``Sections 1.1366-2(a)(5)(i), (ii) and 
(iii)'', and adding the language ``Sections 1.1366-2(a)(6)(i), (ii) and 
(iii)'' in its place.
    2. Adding two sentences to the end of the paragraph.
    The additions read as follows:


Sec.  1.1366-5  Effective/Applicability date.

    * * * Upon the publication of the Treasury decision adopting these 
rules as final regulations in the Federal Register, Sec.  1.1366-
2(a)(2) will apply to transactions entered into on or after the date 
these proposed regulations are published as final in the Federal 
Register. In addition, the revisions to Sec. Sec.  1.1366-0, 1.1366-2, 
and this section are applicable on and after the date these proposed 
regulations are published as final in the Federal Register.


Sec.  1.1367-1  [Amended]

    Par. 6. Section 1.1367-1(h) Example 5(iii) is amended by removing 
the language ``Sec.  1.1366-2(a)(2)'' in the third and fourth sentences 
and adding the language ``Sec.  1.1366-2(a)(3)'' in its place.


Sec.  1.1367-3  [Amended]

    Par. 7. Section 1.1367-3 is amended by adding one sentence to the 
end of the paragraph to read as follows:


Sec.  1.1367-3  Effective/Applicability date.

    * * * The revisions to citations to Sec.  1.1366-2(a) in Sec.  
1.1367-1(h) Example 5(iii) are applicable on and after the date these 
proposed regulations are published as final in the Federal Register.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2012-14188 Filed 6-11-12; 8:45 am]
BILLING CODE 4830-01-P