There is really nothing new here but it goes to show why year-end income tax planning for S corporations is so important. In a recent Appeals Court case (Nathel, 2nd Cir.) the owners of an ailing S corporation lent money to the S corporation. Since before the loan the company’s losses exceeded the owners’ basis in the corporation’s stock, they would not have been able to deduct the loss. By making a loan they created basis and the owner was able to deduct the loss. Think of it like this, you lend $100,000 to your S corporation but the loss is $40,000, so now your basis in the loan is $60,000 - not $100,000. Under IRS rules, the excess loss is applied to reduce the tax basis in the loans.
When the corporation repaid the owners’ loans, the owners’ basis in the loans was still less than the principal amount. The court ruled that the owners owed ordinary income tax on the difference between the loan payoff amount and their tax basis in the loans. This recoups the extra S firm losses that their advances allowed them to deduct.
With a little tax planning at the end of the year, this problem could have been anticipated and quite possibly planned around.
