Many small businesses, organized as S corporations, encounter the problem of cash shortfalls at some point in their existence.As a result, S corporation shareholders are commonly faced with the question, “what is the best way to inject cash into the business, a capital contribution or a shareholder loan?” The answer to that question will depend on the specific facts of the company as discussed below.
First, we must understand the terms “stock basis” and “debt basis” and how they affect the S corporation shareholder.
What is stock basis and how does it affect losses?
If a shareholder decides to make a capital contribution, then that contribution directly increases the shareholder’s basis. This allows the shareholder in an S corporation, a pass-through entity for tax purposes, to claim losses against his basis and avoid taxation to the extent of the basis in the stock. Under the Internal Revenue Code, a shareholder’s basis cannot be decreased below zero, which means that a shareholder cannot take a loss in the current tax year if his basis has been reduced to zero. However, that loss may be able to be carried backward or forward to offset previous or future gains.
An example of how a capital contribution affects stock basis and losses is as follows:
Shareholder has a basis in his stock of $1,000. The shareholder makes a capital contribution to the company in the amount of $2,000. The shareholder now has a basis in his stock of $3,000. This allows the shareholder to be allocated up to $3,000 in losses in the current tax year or the shareholder may receive a $3,000 distribution from the S corporation without incurring tax.
If the company were to incur $4,000 in losses in the current tax year, the shareholder would have the option of taking the loss in excess of their basis, in this case, $1,000, and applying in to previous tax years or carrying the loss forward to offset gains in future tax years.
What is debt basis?
While stock basis is relatively straightforward and understandable, debt basis is a little more difficult. If a shareholder decides to make a loan to the corporation, the shareholder now has two tax bases, one in his stock and the other in the debt. If a shareholder’s stock basis has been reduced to zero and the shareholder has debt basis, then losses and deductions are allowed to the extent of the debt basis. This basis is then called “reduced debt basis” and is restored by net increases over decreases in any given year. A net increase means the amount by which the shareholder’s pro rata share of items relating to income under IRC § 1367(a)(1) exceed items related to losses under § 1367(a)(2). The reduction in basis of indebtedness must be restored before any net increase is applied to restore the basis of a shareholder’s stock. To put it simply, items that increase stock basis will increase debt basis, however the taxpayer must restore his debt basis before he increases his stock basis.
If the debt is repaid before the basis is restored, all or part of the repayment is taxable. Partial repayments adjust the debt basis by a ratio of the loan amount less basis as the numerator and the loan amount as the denominator, with any remaining amount recognized as gain. However, unlike a gain on stock, which will always be a capital gain, a gain on the repayment of debt could be ordinary income. If the debt is evidenced by a promissory note, the repayment of the note may produce capital gains where the debt basis has not been restored. The capital gains will be long term if the note has been held over one year. If the debt is an “open account” debt, which means the debt is not evidenced by a note, the repayment of the debt will be considered ordinary income where the repayment is in excess of the debt basis.
Below is an example of how debt basis is calculated:
Shareholder has a stock basis of $1,000 and decides to loan the company $2,000. Unlike in the first example where the shareholder’s stock basis is increased to $3,000 through the capital contribution, Shareholder now has a stock basis of $1,000 and a debt basis of $2,000. If the corporation incurs $3,000 in losses in the current tax year, Shareholder may reduce his stock basis to zero and his debt basis to zero.
In the next year, if the company were to repay the full $2,000 to the shareholder, the shareholder would recognize $2,000 of gain. If the debt was evidenced by a note, Shareholder would recognize $2,000 of capital gains. If, however, the debt was not evidenced by a note, Shareholder would recognize $2,000 of ordinary income.
If, instead of a $3,000 loss, the company had a $2,000 loss, the shareholder would have a stock basis of zero and a debt basis of $1,000. If the company repaid the shareholder $500 on the $2,000 debt, the shareholder would receive a return to basis of $250 and would recognize $250 of gain. The character of the gain will depend on whether the debt is evidenced by a note or is considered an “open account” debt.
Why would you choose a shareholder loan over a capital contribution when making a cash contribution to the company?
Many tax advisors will recommend shareholder capital contributions as a way to inject capital into the business. Superficially, capital contributions and shareholder loans put the shareholder in a similar position, having increased their bases. However, without proper evidence of a shareholder loan, the repayment of the loan without the restoration of basis will cause the shareholder to recognize ordinary income.
Though it sounds like there is virtually no reason to make a shareholder loan instead of a capital contribution, in the scenario where there are multiple shareholders, a loan may be the best way for a single shareholder to inject money into the corporation and get that same amount out without having to disburse amounts to other shareholders. The Internal Revenue Code requires that disbursements from corporations be made pro rata. That means that a corporation cannot make special distributions to one shareholder but not the others. Therefore, if a shareholder who made a capital contribution then wanted the return of the cash contribution, the shareholder would have to wait until the corporation had enough money to disburse pro rata amounts to all shareholders. For example, if there are four shareholders in a corporation and one shareholder makes a $2,000 capital contribution, in order to receive $2,000 from the corporation, the corporation would need $8,000 in order to distribute $2,000 to each shareholder. If the corporation only had the $2,000 capital contribution and made a disbursement of the full $2,000, each shareholder would receive $500. In the case of a shareholder loan, the corporation can repay the loan directly to the shareholder without the necessity of disbursing pro rata portions to other shareholders.
While a capital contribution may be advisable in the majority of scenarios a shareholder in an S corporation might encounter, there are specific situations where a shareholder loan may be the best option for the shareholder. In either the capital contribution or shareholder loan scenarios, there is the chance of taxation where the shareholder does not have enough basis to render the distribution or repayment tax-free. However, only in the situation of a repayment of an open account debt, where there is a reduced basis in the loan, can the shareholder recognize ordinary income.
There is no one-size fits all approach. The best way to determine whether a loan or a capital contribution is advisable is to work with a tax professional and establish a course of action based on the company and the manner in which the stock in the S corporation is held.