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Steer clear of new IRS limit on S corporation loans

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The IRS has just issued new proposed regulations limiting the tax benefits for certain S corporation debts. (NPRM REG-144859-04)

Strategy: Consider making capital contributions to your S corp instead of loans. Otherwise, be careful to stay below the new threshold.

The new regs close a loophole that allowed S corp owners to defer taxable income indefinitely through timing of advances and repayments.

Here’s the whole story: You can deduct S corp losses only to the extent of your total basis in the stock plus outstanding debt owed by the corporation to you. If the S corp repays a debt after a basis reduction, you may have to recognize taxable income. Generally, S corps make basis adjustments at the end of the tax year.

S corp owners often make informal loans to their corporations, referred to as “open-account debt.” Under existing regulations, open-account debt is attributable to a single indebtedness, no matter how many loans the S corp makes. In contrast, S corp owners must treat debts evidenced by written instruments as separate transactions.

Key change: Under the new proposed regulations, the IRS limits treating open-account debt as a single debt to $10,000 for any business day during the S corp’s tax year. The IRS requires you to keep a “running balance” of advances and repayments.

If the balance exceeds the $10,000 limit, the IRS no longer considers the entire principal balance open-account debt. Instead, the agency treats it as debt evidenced by a written document. Any repayments reduce your basis in that particular debt at the end of the tax year. That eliminates your ability to restore basis through sequential borrowing and repayment.

The new regs also require S corp owners to net all repayments and advances on open account debt to determine if a net repayment has been made.

Tip: This is a potential minefield for some. Consult your tax pro concerning your circumstances.

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