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Lessons from the Tax Court: S corp loans must be legit

by on
in Small Business Tax,Small Business Tax Deduction Strategies

If you own an S corporation, the company’s income and expenses are passed through to you personally. But any tax return loss from the activity is limited to your basis in the stock plus the amount of any loans that you make directly to the S corp. In other words, if you make bona fide loans to the S corp, or you borrow funds from an unrelated party and turn around and lend them directly to the S corp, your basis for loss deduction purposes is increased accordingly.

New case: A taxpayer owned 80% of the stock in an S corp providing respiratory and home health care services. (Her husband owned the other 20%.) She claimed to have borrowed funds from a doctor and lent those funds to the corporation. However, all the funds were either paid directly by the doctor to the S corp or represented amounts that the doctor charged to his credit card as payment for the corporation’s expenses. The doctor didn’t write any checks to the shareholder nor did she contribute any personal funds to the corporation or execute any loan agreements or notes evidencing loans from her.

The shareholder signed 27 promissory notes in favor of the doctor, totaling almost $600,000. The notes had varying maturity dates (none of which were for more than a year after execution) and were secured by receivables from the S corp. The shareholder didn’t provide any personal collateral. The corporation made several payments on the notes directly to the doctor, but the shareholder didn’t report any interest income or constructive dividends relating to the payments.

Finally, the Court noted that it could not reconcile the asserted basis with the company books due to shoddy record-keeping. Bottom line: The purported loans were not actually made by the shareholder to the S corp, so she could not increase her basis for loss deduction purposes. (Welch, TC Memo 2012-179)

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