Shareholders of an S Corporation that has a loss from operations are often concerned with whether or not they have basis in the stock and debt in order to use this loss on their tax returns. A critical issue that is often not considered is whether shareholders have a sufficient amount at risk with regard to the loans made to the S Corporation. Both the basis rules and the at-risk rules must be met in order for a shareholder to deduct business losses from an S Corporation. This article will address certain key elements of the at-risk rules which are contained in Section 465 of the Code.
Section 465(c)(3) states that for tax years beginning after December 31, 1978, the rules of the section apply to each activity engaged in by a taxpayer in carrying on a trade or business. Therefore, the rules apply to any S Corporation shareholder engaged in a trade or business. Often practitioners presume that the at-risk rules apply only to partnerships and therefore do not give the application of the rules to S Corporations sufficient consideration.
Contribution of Cash or Other Property
Sec. 465 states that a taxpayer is at-risk in an activity for the amount of money and the adjusted basis of other property contributed to the activity (Section 465(b)(1)(A)). If a shareholder contributes property that is subject to a debt, the amount at-risk depends upon whether the shareholder is personally liable for the repayment of the debt. If the shareholder is personally liable, the amount at risk is increased by the full amount of the property’s adjusted basis. However, if the shareholder is not personally liable, the amount at risk is increased by the adjusted basis of the property contributed and decreased by the nonrecourse debt (Prop. Regs. Sec. 1.465-23(a)).
What About Loans From The Shareholder to the S Corporation?
A very significant difference often arises between a shareholder’s basis and at-risk amount with regard to loans made by a shareholder to an S Corporation. Section 1366 and 1367(b) provide that a shareholder’s basis is increased by loans made to the S Corporation. However, under the at-risk rules of Sec. 465, these loans might not increase the shareholder’s atrisk amount. Section 465(b)(2) states that an S Corporation shareholder is atrisk only with respect to amounts borrowed for use in the corporation to the extent that the shareholder:
A) is personally liable for the repayment of such amounts; or (B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the fair market value of the taxpayer’s interest in such property).
Under item (A) above, if a shareholder of an S Corporation borrows money from a bank and lends those funds to the S Corporation, the terms of the note between the bank and the shareholder will determine the shareholder’s liability.
Item (B) applies when a shareholder borrows money from an unrelated party, uses as collateral property of an S Corporation as security, and lends the funds to the S Corporation. This loan from the shareholder to the S Corporation gives the shareholder basis in debt but does not increase his or her at-risk amount. Both tests must be met in order for the shareholder to be able to deduct the loss on their personal return.
Company assets are often security for a loan the shareholder takes out in order to loan funds to the S Corporation. The shareholder’s guarantee of a loan made directly from the bank to the S Corporation would not create basis. As a result, the back-to-back loan described above is often used to create basis. However, practitioners often neglect to consider the atrisk issue. In order to avoid the claws of Sec. 465, collateral other than assets used by the activity must be utilized. It must be noted that if the shareholder pledged S Corporation stock as collateral, the shareholder would again not be at-risk.
Exception for Qualified Non-recourse Financing
There is an exception to the at-risk issue discussed in the case of qualified nonrecourse financing under Section. 465(b) (6). A shareholder is at risk with regard to qualified nonrecourse financing that is:
• Borrowed with respect to the activity of holding real property;
• Borrowed from a qualified person;
• Financing for which no person is personally liable for repayment; and
• Not convertible debt.
Borrowing from Persons Having an Interest in the Activity
This is another very significant trap for S Corporation shareholders. Under Section 465(b)(3) a shareholder is not at risk with regard to amounts borrowed from any person who has an interest in the activity or from a person who is related to a person with such an interest. Regs. Sec. 1.465-8, provides that even if an S corporation shareholder is personally liable for repayment of a loan for use in the S corporation, the shareholder will not be considered at risk if the money is borrowed from a person who has a capital interest in the S corporation. A fellow shareholder of the S corporation is considered to have a capital interest in the entity.
Section 465(b)(3) also states that a shareholder is not at risk with regard to money borrowed from an individual who has an interest in the net profits of the entity. Therefore a shareholder would not be at-risk for money borrowed from an employee of the S corporation whose annual bonus was fixed as a percentage of the corporation’s net profits.
Basis is not enough! Separate considerations must be taken into account to determine the at-risk amount of S corporation shareholders. Section 465 contains many traps that will limit or even prevent S corporation shareholders from deducting their pro-rata share of the company’s losses on their current year tax returns. Practitioners must be fully cognizant of the Section 465 rules in order to properly plan for the impact of the S corporation’s year-end results.
Lewis Taub is a Managing Director in the New York City office of CBIZ MHM, LLC and an active contributor to the S Corporation Technical Resource Committee of the AICPA. Lewis has been an Adjunct Professor at Fordham University’s Graduate School of Business.