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Line up back-to-back loans for your S corp

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With an S corporation, the company’s gains and losses are your gains and losses. Reason: The company passes income and expense items through to shareholders.

But any loss you may claim on your return is limited to the basis in the stock plus any outstanding debt incurred from you lending money to the corporation. So, you may need to give yourself more breathing room to absorb losses.

You can make a capital contribution, for instance, or arrange to lend money directly to the corporation. But if you borrow money personally to inject cash into your S corp, you’ll need to plan ahead to increase the basis.

Strategy: Do the S corp two-step. First, borrow the money from the bank personally. Second, lend the same amount to the S corp, with the corporation guaranteeing the loan. The back-to-back loans can increase your basis in the S corp stock, according to a new Tax Court case. (Miller, TC Memo 2006-125)

Here’s the drill: To boost your basis in S corp stock, the money must come out of your pocket. You can’t create tax losses merely by arranging a loan from another party. The IRS and courts have consistently denied loss deductions for third-party loans.

Facts of the new case: An S corp took out a loan from a third-party lender, with the founder/shareholder giving a full-recourse promissory note in satisfaction of the debt. Then, on the advice of his tax pro, the founder borrowed money again from the lender and lent those funds to the corporation.

The S corp went bankrupt and defaulted on the loans. The founder also had become insolvent, and the guarantor became responsible for the loans.

The Tax Court ruled that the restructuring transactions created an enforceable obligation on behalf of the S corp’s founder. He had made an economic outlay by becoming the full-recourse obligor on the debt. By re-lending the money to the S corp, he created indebtedness.

Furthermore, the founder was “at risk” with respect to the loans because he bore the risk of economic loss. The lender probably didn’t seek recovery from the S corp founder because of his bankruptcy. Result: The Tax Court said the loans increased the founder ’s basis in the S corp stock.

Note: The S corp founder also received cancellation of debt (COD) income as a result of the guarantor’s waiving the right to indemnification or repayment. But the COD income was excluded from the founder’s taxable income because he was insolvent at the time.

If you’re just getting your S corp up and running, any tax losses may be more valuable to you in the future when you earn higher income.

You can carry forward nondeductible losses indefinitely, until you have sufficient basis to absorb them.

Tip: Postpone capital contributions or loans if you don’t need additional basis for losses this year. Keep the money in your own pocket for as long as you can.

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