• Capital Contribution Does Not Increase Tax Basis of Loans to S Corporation
  • August 24, 2010
  • Law Firm: Loeb Loeb LLP - Los Angeles Office
  • In a recent case involving the tax basis of a loan made by shareholders to an S corporation, the taxpayers made a very clever argument but could not get the court to go along. In Nathel v. Commissioner, the taxpayers owned shares in an S corporation to which they had also made loans. The corporation sustained losses which were passed through to the taxpayers as the shareholders. Under the applicable tax rules, the losses reduce the basis of the shareholder’s stock. When that basis reaches zero, further losses reduce the tax basis of any loans the shareholder has made to the corporation. When the basis of the loans reaches zero, the shareholder cannot deduct any further losses from the S corporation until he builds his basis back up. Further, if the basis of a loan has been reduced and the loan is repaid, the shareholder recognizes taxable income. If the S corporation earns income after suffering losses, the income first restores the tax basis of the shareholder’s loans to its original amount and thereafter increases the tax basis of the shareholder’s stock.

    In Nathel, the losses had reduced the shareholders’ stock basis to zero and their debt basis to nearly zero. The shareholders subsequently made capital contributions to the corporation and then the loans were repaid. Normally a capital contribution would increase the tax basis of the shareholders’ stock and would not affect the tax basis of their loans. The taxpayers here tried to get around that problem by arguing that the capital contributions represented income to the corporation that was not subject to tax. If the capital contribution was income, even if not taxable income, then the debt basis would be restored first. The result would be that the debt basis would equal its face amount at the time the loans were repaid and no taxable income would result to the shareholders.

    While the argument was very clever, the court quickly rejected it. First the Tax Court, and more recently in June, 2010, the Court of Appeals for the Second Circuit, pointed out that Section 118 of the Internal Revenue Code says that capital contributions are not income. Therefore, the contributions made by the shareholders only increased the basis of their stock. Their loans still had a reduced basis when they were repaid and the taxpayers did recognize income on such repayment.

    One might ask, could they have converted their loans to stock and been able to get money out of the corporation without paying tax? That would most likely have caused the S corporation to recognize cancellation of indebtedness income that would have passed through to the shareholders. IRC Section 108(e)(6) provides that when a shareholder contributes debt of a corporation to its capital, the debtor corporation is deemed to have satisfied the debt for an amount equal to the shareholder’s tax basis in the debt. Since the shareholders’ basis was less than the face amount of the debt, the corporation would have recognized income under Section 108. If the shareholders had known the magnitude of the expected losses, they probably would have been better off contributing the debt to capital before the losses began to reduce the loans’ tax basis.