Isabella Carter
The topic of whether related entity loans constitute the basis for S-chapter status is a complex one, with many factors to consider. S-corporations are considered passthrough entities, where income and losses are passed to shareholders, who are then taxed on their individual tax returns. Shareholders can deduct losses up to their basis in loans personally made to the S-corporation. Bona fide debt is a key consideration, and while this is straightforward when funds are sourced from an unrelated third party, it is less clear-cut when loans are made between related parties. In these cases, intent, economic reality, and expectation of repayment are important factors. The IRS has specific regulations regarding basis for S-corporation loans, and careful loan structuring is required to maximize deductible passthrough losses and lower shareholder tax liability.
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What You'll Learn
Bona fide debt
For an advance to be considered a bona fide loan, the creditor must expect the debtor to repay the debt. The Ninth Circuit has identified 11 factors to determine whether an advance of funds constitutes a bona fide debt or an equity investment. These factors include the labels on the documents, the presence or absence of a maturity date, the source of payment, the right of the lender to enforce payment, and whether the lender participates in the management of the borrower.
In the context of interest and bad debt deductions, the Tax Court has analysed whether bona fide debt exists in several cases. For example, in the case of Rutter, the Tax Court determined that the advances were not debt but equity contributions, and thus, the taxpayer was not entitled to a bad debt deduction. Similarly, in the case of Moore, the Tax Court examined seven factors, including the presence of promissory notes and how the transactions were treated, to determine whether bona fide loans existed.
Additionally, bona fide debt is relevant in the context of debt service funds. A debt service fund must meet specific requirements to be considered "bona fide," such as ensuring proper matching of revenue and debt service payments within each bond year and maintaining a reasonable carryover amount. School districts, for instance, may invest money in a bona fide debt service fund without yield restrictions for a temporary period, allowing them to make debt service payments without violating arbitrage limitation rules.
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Shareholder loans
Loans from shareholders to the business involve shareholders providing financing to the company, often with a guaranteed specific rate of return. This type of loan carries less risk than common equity in the event of default, as preferred equity holders are prioritised. However, shareholder loans rank lower in priority than other senior forms of debt, making them more vulnerable in the event of financial distress. In the case of default, preferred equity investors may not receive any recovery if there is significant outstanding debt.
Loans from the business to shareholders involve shareholders borrowing money from the company and being responsible for paying it back with interest. This allows shareholders to take out personal loans from the business instead of a financial institution, while the corporation benefits from the interest income. It is important for these loans to be structured as arms-length" transactions, treating the shareholder and corporation as separate parties. A written loan agreement is necessary, outlining the exact loan amount, interest rate, and repayment terms.
In the context of S corporations, understanding the basis rules enables practitioners to assist clients in maximising deductible passthrough losses and lowering the shareholder's tax liability. Careful loan structuring allows shareholders to utilise passthrough losses in the current year rather than suspending them to future years. Additionally, the IRS has adopted "bona fide debt" provisions to determine whether a shareholder is entitled to debt basis, focusing on the intent of the parties and the expectation of repayment.
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Tax consequences
The characterisation of a transfer of funds between related entities can have significant income tax consequences. For instance, a transfer of funds to a closely held business that is intended to be treated as a loan must meet certain criteria to be considered a bona fide debt. These include evidence of indebtedness, adequate security for the debt, a repayment schedule, business records reflecting the transaction as a loan, and adequate interest charges.
In the case of loans between related entities, the Internal Revenue Service (IRS) will examine related-party transactions for any conflicts of interest according to Internal Revenue Code 267. If conflicts are found, the IRS will disallow any tax benefits claimed from the transaction. The IRS often scrutinises property sales and deductible payments between related parties. Related-party transactions must be disclosed, and the International Financial Reporting Standards Foundation (IFRS) has developed global accounting and sustainability disclosure standards, known as IFRS Standards, to ensure that an entity's financial statements contain the necessary disclosures.
In the United States, there is a federal mandate for a business to charge interest on loans to or from its owners, usually targeting corporation/shareholder loans. This was enacted to prevent owners from taking loans from their businesses without any cost to borrow. Loans between certain related parties, usually exceeding $10,000, are required to bear a minimum amount of interest, as outlined in Sec. 7872 of the 1984 tax overhaul (Deficit Reduction Act of 1984, P.L. 98-369).
The tax consequences of related entity loans can also depend on the specific structure of the business. For example, in an S corporation, a shareholder can deduct losses up to their basis in loans personally made to the S corporation. If an S corporation repays a reduced basis debt to the shareholder, part or all of the repayment may be taxable to the shareholder.
Additionally, a taxpayer is entitled to a deduction for any bona fide debt that becomes worthless within the tax year, provided that the debt was incurred in connection with a trade or business rather than as an investment.
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Related party transactions
Related-party transactions refer to deals or arrangements made between two parties with a pre-existing business relationship or common interest. These transactions are not inherently illegal but can lead to conflicts of interest, as they may indicate favourable treatment for close associates of the hiring business. Regulatory agencies such as the Securities and Exchange Commission (SEC) in the United States scrutinize these transactions to ensure they are conflict-free and do not negatively impact shareholders' value or the corporation's profits.
Public companies must disclose related-party transactions, and the SEC requires publicly traded companies to report all transactions with related parties, such as executives, associates, and family members, in their quarterly and annual reports. The SEC also requires the disclosure of significant related-party compensation arrangements that result in below-market compensation expenses.
To comply with related-party disclosure requirements, reporting entities must identify all transactions with related parties and determine the appropriate presentation and disclosure based on guidelines such as the ASC 850. Common related-party transactions include sales, purchases, transfers of property, services received or provided, and the use of property and equipment.
Related-party debt transactions may require additional disclosures beyond lending terms, such as commitment fees or circumstances surrounding unused commitments for long-term financing arrangements. The definition of "bona fide debt" is met when the source of funds is an unrelated third party, such as a bank. When the loan is between related parties, it is crucial to document the intent of the parties, characterizing the transaction as a loan with a fixed repayment schedule and a fair market rate of interest.
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Loan structuring
When structuring a loan, lenders consider the underlying assets being financed and the borrower's ability to repay. The loan structure may include specific characteristics such as interest-only payments or regular reductions in the principal outstanding. The loan term, interest rate, collateral, and repayment method are also crucial elements. For instance, a longer repayment term may result in lower monthly payments but potentially higher overall interest costs.
The nature of the collateral also plays a significant role in loan structuring. Collateral is a tangible asset or collection of assets pledged by the borrower as security for the loan. Lenders assess the value of the collateral and consider the historical and expected cash flows to determine the likelihood of repayment. Higher-quality collateral, such as real estate, tends to result in more flexible loan structures, including higher loan-to-value ratios, lower interest rates, and longer amortization periods.
Additionally, the borrower's risk profile is a key consideration in loan structuring. Lenders use complex risk rating models to understand the borrower's likelihood of defaulting on the loan. A higher-risk profile generally leads to higher interest rates, more restrictive loan structures, and more frequent financial reporting requirements.
Well-structured loans offer benefits to both borrowers and lenders. They can provide tax advantages, protect the lender's assets, and facilitate easier loan restructuring if circumstances change. By effectively identifying and managing risks, lenders can price loans appropriately while achieving acceptable yields.
In the context of S corporations, loan structuring is particularly important for shareholder basis planning. Shareholders can acquire debt basis through loans made to the S corporation, and thoughtful loan structuring allows them to maximize deductible passthrough losses and lower their tax liability.
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Frequently asked questions
S corporations are considered passthrough entities that pass income and losses to the shareholders, who are then taxed on the business's income and losses on their individual tax returns.
A bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money. The definition of a bona fide debt is met when the source of the funds is an unrelated third party, such as a bank.
There are several factors that are indicative of a bona fide debt, including evidence of indebtedness (e.g. a promissory note), adequate security for the debt, a repayment schedule, business records reflecting the transaction as a loan, and enforcement of loan terms.
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