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New Regulations Governing S Corp Open Account Indebtedness
Stuart Freeland November 2, 2007 — 1,522 views
Historically, under Treasury Regulations, S corporation indebtedness held by shareholders that is not evidenced by an instrument (open account indebtedness) has been treated as a single indebtedness for tax purposes, although the result of separate advances and repayments. This has allowed taxpayers to net advances and repayments thereby avoiding recognition of income on repayment of earlier advances that have reduced bases as the result of the pass through of losses. In Brooks v. Commissioner, the taxpayers made substantial open account advances at the end of three consecutive years that enabled them utilize losses incurred by an S corporation of which they were shareholders that reduced their basis in the indebtedness accordingly. Each debt was repaid shortly after the beginning of the next year; however no gain was recognized because each taxpayer made a further advance at the end of the year sufficient to increase his basis in the indebtedness by the amount repaid and provide additional basis that enabled him to recognize losses incurred in that year as well. The same process was followed in year three. The Service argued that the borrowings and advances should be treated as separate transactions with the result that each repayment would be a taxable transaction. The Tax Court held for the taxpayers, finding that these transactions were properly treated as an open account indebtedness under the existing Treasury regulations.
In order to combat this strategy, which it regards as an abuse of its regulations governing open account indebtedness, the Service has proposed an amendment to limit the amount of open account indebtedness that may be treated as a single obligation. Under a proposed amendment to Treasury Regulation §1.1367-2, an open account indebtedness of an S corporation consisting of multiple advances will no longer be treated as a single obligation unless the amount outstanding at the end of each day of the taxable year does not exceed $10,000. Otherwise, effective on the date that the balance of open account indebtedness exceeds $10,000, the amount must be determined and thereafter treated as a separate indebtedness as if evidenced by an instrument. Further advances may be treated as open account indebtedness subject to the same rule.
In addition to the foregoing, the regulations specify that, where a corporation has more than one outstanding shareholder indebtedness, any net increase in the basis of shareholder debt for the year will first be applied to any indebtedness repaid during the year to the extent necessary to prevent recognition of gain by the shareholder, and the balance will be apportioned among each outstanding indebtedness, including an open account indebtedness and a former open account indebtedness treated as a separate debt under the amended regulations in proportion to the amount that its basis has been reduced by losses and other items passed through to the shareholder.
These amended regulations will prevent a taxpayer from creating a large open account debt at the end of the year in order to pass losses through for that year and deferring recognition of gain on its repayment in the following year by making a further advance of open account debt at the end of the year.
The proposed amendments will become effective with respect to any shareholder advances made on or after the date of publication of a Treasury decision adopting them in the Federal Register and repayments of those advances by the S corporation.
To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding U.S. tax penalties.
Mr. Freeland represents businesses and institutions both as outside general counsel and in a broad range of transactions, particularly real estate related activities. His clients include a major Boston area university, real estate development firms and organizations involved in a variety of business activities. Mr. Freeland assists clients to organize and operate their businesses in a tax efficient manner.