The IRS has issued proposed regulations providing that S corporation shareholders increase their basis in the S corporation, for indebtedness of the S corporation to the shareholder, only if the indebtedness is bona fide. The proposed regulations are intended to clarify the requirements for increasing basis of indebtedness and to assist S corporation shareholders in determining with greater certainty whether their arrangement creates basis of indebtedness.

Code Sec. 1366(d)(1) generally provides that the aggregate amount of losses and deductions that a shareholder takes into account for any tax year cannot exceed the sum of that shareholder's adjusted basis in stock and adjusted basis of any indebtedness of the S corporation to that shareholder. The IRS explained that the Tax Code does not define basis of indebtedness. However, courts have interpreted Code Sec. 1366 to require an investment in the S corporation that constitutes an actual economic outlay by the shareholder to create basis of indebtedness. These cases, according to the IRS, have generated disputes over when a back-to-back loan would give rise to an actual economic outlay. The proposed regulations require that loan transactions represent bona fide indebtedness of the S corporation to the shareholder to increase basis in indebtedness; therefore, an S corporation shareholder need not otherwise satisfy the "actual economic outlay" doctrine for purposes of Code Sec. 1366(d)(1)(B).

Proposed regulations

The IRS expressly did not provide a different standard for purposes of Code Sec. 1366 as to what constitutes bona fide indebtedness. General federal tax principles and facts and circumstances, the IRS explained, determine whether indebtedness is bona fide. However, under the proposed regulations, an S corporation shareholder that merely acts as a guarantor or in a similar capacity has not created basis of indebtedness unless the shareholder actually makes a payment, and then only to the extent of the payment.

The IRS explained that an S corporation shareholder may attempt to obtain basis of indebtedness by borrowing from another person, such as a related entity, and subsequently lending the proceeds to the S corporation (a back-to-back loan transaction). Alternatively, an S corporation shareholder may seek to restructure an existing loan of the S corporation into a back-to-back loan by assuming the S corporation's liability on the loan and creating a commensurate obligation from the S corporation to the shareholder. The shareholder can obtain basis only if there is bona fide debt of the S corporation that runs directly to the shareholder.

The incorporated pocketbook theory has been used to claim an increase in basis of indebtedness in circumstances that involve a loan directly to the S corporation from an entity related to the S corporation shareholder. An S corporation shareholder claims that a transfer from the related entity directly to the shareholder's S corporation was made on the shareholder's behalf and is, in substance, a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corporation. A so-called incorporated pocketbook transaction increases basis of indebtedness only where the transaction creates a bona fide creditor-debtor relationship between the shareholder and the borrowing S corporation.

The proposed regulations apply to loan transactions entered into on or after the date the regulations are finalized.

Comment: The proposed regulations also leave unchanged the conclusion in Rev. Rul. 81-187 that a shareholder of an S corporation does not increase basis in stock for purposes of Code Sec. 1366(d)(1)(A) upon the contribution of the shareholder's own unsecured demand promissory note to the corporation.

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