AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Proposed Section 1367(b)(2) Regulations
Developed by
S Corporation Taxation Technical Resource Panel
Laura Howell-Smith, Chair
Michael R. Gould, Primary Drafter
Approved by
S Corporation Taxation Technical Resource Panel
and
Tax Executive Committee
Submitted to
The Department of the Treasury
and
The Internal Revenue Service
September 6, 2007
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Proposed Section 1367(b)(2) Regulations
EXECUTIVE SUMMARY
The Internal Revenue Service has proposed amending the section 1367(b)(2) regulations with respect to the application of open account debt between shareholders and their S corporations.[1] The proposed regulations would narrow the definition of open account debt and change how basis adjustments are made to such open account debt.
Specifically, the proposed regulations define open account debt as shareholder advances not evidenced by separate written instruments for which the principal amount of the aggregate advance (net of repayments on the advances) does not exceed $10,000 at the close of any day during the S corporation’s tax year. If this “running balance” does not exceed $10,000 on any day of the S corporation’s tax year, then the debt will remain classified as an open account debt. If the running balance exceeds $10,000 at the close of any day during the tax year, the entire principal amount of that indebtedness would be re-classified – for purposes of reg. section 1.1367-2 – from an open account debt to indebtedness evidenced by a written instrument effective at the close of the day the running balance exceeds $10,000. This re-classification effectively prohibits the netting of open account debt in excess of $10,000 at the close of the tax year, as illustrated by Brooks v. Commissioner, TC Memo 2005-204 (August 25, 2005).
We respectfully submit that, if finalized as proposed, the proposed regulations would present a significant tax compliance burden to a vast number of S corporation shareholders and place many of these shareholders in a very complex and costly situation. In our experience, most shareholders do not use open account debt in a manner similar to that described in Brooks. We suggest rather than adding more complexity to an already complex system, the Service should instead use the tools already at its disposal to prevent the result in Brooks. Specifically, the Service could challenge taxpayers who use tax planning techniques similar to those used in Brooks by evoking economic substance, business purpose and evidentiary arguments. Use of such readily available legal tools to guard against such infrequent techniques would help fight perceived abuses while allowing most compliant shareholders to conduct business in the most business-efficient manner. In the alternative, the Service should consider raising the “running balance” threshold to at least $250,000 (preferably to $1,000,000), and creating grandfather and/or transitional rules for open account debt already outstanding. Finally, the current examples should be changed to better illustrate the results of adopting the proposed regulations.
COMMENTS
I. BACKGROUND
On April 12, 2007, the Service and the Treasury Department issued a Notice of Proposed Rulemaking (REG-144859-04) proposing to amend the regulations under section 1367 of the Code.[2] These proposed regulations employ a two-pronged remedy for the deferral allowed by Brooks v. Commissioner, TC Memo 2005-204 (August 25, 2005).
First, prop. reg. section 1.1367-2(a)(2)(i) and (ii) would narrow the definition of open account debt to include only unwritten advances that are equal to or less than $10,000. To monitor whether an open account debt has crossed the $10,000 threshold, shareholders must maintain a “running daily balance” to determine whether their open account debt exceeds $10,000. If this “running balance” does not exceed $10,000 on any day of the S corporation’s tax year, then the debt will remain an open account debt. Alternatively, if the running balance exceeds $10,000 at the close of any day during the tax year, the entire principal amount of that indebtedness would be re-classified – for purposes of reg. section 1.1367-2 – from an open account debt to a separate (deemed written instrument) debt beginning at the close of that day.
Second, prop. reg. section 1.1367-2(d)(1) and (2) would require each shareholder at the end of the S corporation’s tax year to calculate the amount of any net advance or net repayment on open account debt. As such, if a net repayment or advance exists on the open account debt, it must comply with the established general debt basis rules of reg. sections 1.1367-2(b) and (c). As stated above, prop. reg. section 1.1367-2(d)(2)(ii) provides that once an open account debt advances and repayments exceed the $10,000 threshold, the re-classification prohibits the netting of open account debt at the close of the tax year for that debt.
The proposed regulations apply to any shareholder advances to an S corporation and repayments on those advances made after the final regulations are published in the Federal Register.
II. ANALYSIS AND COMMENTS
A. The Preamble to the Proposed Regulations
The preamble to the proposed regulations makes several observations as either background or explanation, including the following:
· The preamble provides that the taxpayers in Brooks could have permanently avoided income tax related to open account debt: “[Brooks] and the S corporation made these repayments and advances for several taxable years and deferred indefinitely the recognition of income on any repayment of his open account debt.” (Emphasis added.)
· “The Treasury Department and the IRS believe that the concept of ‘open account debt’ as defined in Sec. 1.1367-2(a) was intended to provide administrative simplicity for S corporations but was not intended to permit the deferral allowed in Brooks. The IRS and Treasury Department are proposing these adjustments to narrow the definition of open account debt and to modify the rules for adjustments of basis in indebtedness for the more narrowly defined open account debt.”
B. Historical Development of Relevant Provisions
A synopsis of the relevant provisions of Subchapter S and its related regulations would be helpful in illuminating the workings of S corporation debt basis, and, in turn, our comments regarding prop. reg. section 1.1367-2. As such, the following four topics will be discussed:
· Origins of debt basis;
· Restoration of debt basis;
· Repayment of reduced debt basis; and
· Brooks v. Commissioner
1. Origins of Debt Basis
Since 1958, millions of S corporations have passed through items of income, loss, deduction, or credit to their shareholders who report these items at the end of the tax year. These pass-through rules, inspired by the partnership taxation rules, occur by means of a complex, interdependent statutory framework primarily codified in sections 1366, 1367, and 1368. Because the proposed regulations focus on the loss and deduction aspects of S corporation pass-through items, this explanation will take a similar focus.
An S corporation’s aggregated losses and deductions may be deducted by an S corporation shareholder only to the extent of the shareholder’s basis in the S corporation.[3] For this purpose, basis may be separated into (1) stock basis and (2) debt basis.
To obtain a functional understanding of debt basis, it is first necessary to explain stock basis. A shareholder’s initial stock basis may be determined by several factors. For example, stock basis might be determined by:
· the initial payment for the stock;[4]
· the amount contributed to the capital of the corporation;[5]
· the fair market value of the stock received from a decedent;[6] or
· the basis in the hands of the donor when acquired as a gift.[7]
An S corporation shareholder’s initial stock basis is similar to how a C corporation shareholder obtains a basis in his shares. This, however, is where the S corporation’s stock basis similarities with C corporations end and begin to resemble, with certain exceptions, partnership tax rules. Similar to section 705 for partnerships, section 1367 provides for certain end of year adjustments to be made to a shareholder’s stock basis. Regulation section 1.1367-1 provides for the ordering of stock basis adjustments as follows:
1) increased for income items and the excess of the deductions for depletion;
2) decreased for distributions;
3) decreased for nondeductible, noncapital expenses and certain oil and gas depletion deductions; and
4) decreased for items of loss and deduction.
Thus, an individual’s stock basis typically changes every year as a result of pass-through items.
A shareholder’s initial basis in debt from the corporation is generally the lower of the amount loaned to the corporation or the purchase price of the debt.[8] Generally, the initial amount of this debt basis may be adjusted in three circumstances:
· Downward if payments are made on the loan;[9]
· Upward if an advance is made to an open account debt;[10] or
· Downward if stock basis has been reduced to zero and debt basis is used to allow loss and deduction items to pass-through to the shareholder.[11]
If the third circumstance occurs, subsequent “net increases” in stock basis are first used to restore the reduced debt basis to prior amount (discussed below)[12] and then to increase stock basis. Repayment (in whole or in part) of such a loan not only reduces the amount of debt basis available to allow loss and deduction items to pass-through to the shareholder, but also requires the shareholder to recognize income (discussed below).[13]
2. Restoration of Debt Basis
Regulation section 1.1367-2(c)(1) provides that if there has been a reduction in debt basis, any “net increase” in any subsequent tax year is first applied to restore that reduction. A net increase is defined as the amount by which the shareholder’s pro rata share of the items described in section 1367(a)(1) exceed the items described in section 1367(a)(2) for the tax year.[14] Subject to two exceptions, the restoration of debt basis is effective at the close of the corporation’s tax year.[15] However, if a shareholder has reduced debt basis, the basis restoration rules under prop. reg. section 1.1367-2(c)(1) are effective immediately before either the termination of the shareholder’s interest in the corporation or a disposition or repayment (in whole or in part) of the debt.[16] The result is an increased probability that shareholders will recognize less gain from the repayments of debt in tax years when their S corporation generates income.
3. Repayment of Reduced Debt Basis
An S corporation shareholder has an economic incentive to be concerned about whether debt basis will be restored under reg. section 1.1367-2(c)(1). This incentive comes from the character of income recognized upon (i) the repayment of a certain type of “reduced basis debt” as compared to (ii) the character of the income used to restore debt basis. To understand this nuance, it is necessary to make a distinction between the two categories of debt that create debt basis: open account debt and written instrument debt.
The hallmark identifying an open account debt is that it is an advance from a shareholder to such shareholder’s S corporation not evidenced by a separate written instrument.[17] As such, typically the only evidence of an open account debt is the corresponding debits and credits to bank accounts and corporate books. Shareholders will recognize ordinary income upon the repayment of a reduced basis open account debt.[18] Critical to this comment, the current law provides that open account debt is unique in that multiple shareholder advances and S corporation repayments are treated as a single debt rather than separate debt (discussed below).[19] The reason that the Service allows open account debt to be treated as a single debt may be found in the 1993 preamble to final reg. section 1.1367-2, which provides that, “[i]n response to comments, and for reasons of administrative simplicity, the final regulations provide that all open account debt held by a shareholder is to be treated as a single debt for purpose of reducing and restoring basis.”[20] Accordingly, S corporation repayment of reduced open account debt results in ordinary income to the shareholders, but the shareholder may mitigate this potential tax liability by netting the repayment of an advance with another open account advance.
In contrast to open account debt, the hallmark identifying written instrument debt is that it is memorialized by a formal written instrument. The repayment of a reduced basis written instrument debt will result in a capital gain[21] -- either long or short term depending on how long the shareholder held the debt. Repayments of written instrument debt may not be netted against separate advances.
When comparing open account debt and written instrument debt, the following advantages and disadvantages may be summarized:
· open account debt has the advantage of allowing the netting of advances and repayments at the end of the S corporation’s tax year and the disadvantage of having repayments on reduced open account debt being treated as ordinary income;
· written instrument debt has the advantage of repayments on reduced open account debt being treated as capital gain and the disadvantage of being treated as separate debt, without the ability to net advances and repayments.
4. Brooks v. Commissioner
Entering into 1997, the two shareholders (Fleming S. Brooks (51 percent) and Fleming G. Brooks (49 percent)) of the S corporation in question had no basis in their stock or debt. In 1997, the shareholders each lent $500,000 to the S corporation (the “$1 million advance”) and thereby increased their debt basis by such amount. By 1999, each of the shareholder’s debt bases had been used to free support loss flow-throughs. On January 5, 1999, the S corporation repaid the $1 million advance. On December 31, 1999, the shareholders, faced with income from the repayment of reduced open account debt basis and an approximately $600,000 suspended loss, each loaned $800,000 to the S corporation (the “$1.6 million advance”). On January 3, 2000, the S corporation repaid the $1.6 million advance. On December 29, 2000, the shareholders, again facing the dual problem of repayment recognition and suspended losses, decided each to make a $1.1 million loan to the S corporation (the “$2.2 million advance”). See Figure 1 below.
Figure 1