January 08, 2014
Owners of pass through entities should be careful about the use of shareholder debt to capitalize a business because the failure of the company to repay or service the indebtedness can cause problems for both the owners and the company. If the company is a pass through entity, one of these problems is cancellation of indebtedness income attributed to the company if the debt is forgiven or the company is dissolved without repaying the debt in accordance with section 61(a)(12) of the Internal Revenue Code of 1986 as amended. Section 108(a) of the code provides an exemption from recognition of C.O.D. income to bankrupt debtors and to insolvent debtors to the extent of their insolvency; however, as described below, it does not provide complete protection, and there is a price to be paid for the protection that is provided.
The failure of a partnership to repay a debt may be particularly difficult for its partners because the availability of the exemptions for bankruptcy and insolvency mentioned above are determined at the partner level. Therefore, C.O.D. income will pass through to the partners from an insolvent or bankrupt partnership or other eligible entity that is taxed as a partnership and impose an immediate tax burden on partners that are not insolvent. Because the at-risk rules set forth in Section 465 of the code would cause all of the tax basis provided by the unpaid debt to be allocated to the lending partner, the other partners could be allocated C.O.D. income with respect to an unpaid debt from which they had received no basis or tax benefit. The allocation problem could be avoided or ameliorated by specially allocating the profit and loss attributable to the indebtedness to the lending partner when the loan is made. The consequences of employing this strategy should be carefully thought out and understood by all partners before it is implemented and should be built in to the partnership or limited liability agreement of the company.
The problem for S corporation shareholders is different because the insolvency exemption for an S corporation is determined at the company level, and C.O.D. income does not pass through to the shareholders. Instead, the tax attributes of the corporation are reduced in accordance with Section 108(b) of the code. The problem for shareholders is that the reduction in basis can result in the recognition of future income at the corporate level that would pass through to them even though there is no cash flow to make distributions. A possible solution to S corporation debt that cannot be repaid is offered by Section 108(e)(6), which, in appropriate circumstances, would enable the shareholders to contribute the indebtedness to the corporation without recognition of income. The usefulness of this provision is significantly limited however because the Tax Court has held that an indebtedness contributed to an insolvent corporation must be treated as C.O.D. income to the extent of the insolvency.
The use of pro rata shareholder debt to capitalize an S corporation should generally be avoided. Because distributions received by shareholders from an S corporation are not taxed to the extent of shareholder basis there is no tax benefit to issuing shareholder debt instead of shares. It may be necessary for an S corporation to issue shareholder debt to the extent that funds will be invested by shareholders on a non pro rata basis in order to preserve their respective ownership percentages and provide priority to the lending shareholder; however debt that is unlikely to be repaid or serviced should be avoided. For members of partnerships or limited liability companies taxable as partnerships, the choice is more complicated because partner debt does increase the basis of the partnership interest of the lending partner, and the ability to specially allocate income and loss may enable the partnership to allocate the tax benefits and liabilities resulting from the indebtedness to the lending partner. Because of the complexity of the treasury regulations governing special allocations of profit and loss such arrangements should only be entered into with the assistance of expert tax advice.
Although a shareholder or partner creditor will generally have a deductible loss for an unpaid company debt, there will almost always be a mismatch of income and deduction at the owner level. C.O.D. income is taxed as ordinary income while the loss to the owner creditor will, in most cases, be treated as a capital loss, subject to the $3,000 dollar annual limit as a deduction against ordinary income. In rare circumstances, where a shareholder has been able to demonstrate that the dominant purpose for making a shareholder loan was to protect his salary as an employee of the company, the courts have allowed the owner to treat a resulting loss as a business bad debt deductible against ordinary income.
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.
 Code Section 108A(d)(7)(A). Presumably this is because third party indebtedness does not provide a basis increase to S corporation shareholders that would enable them to avoid gain recognition from current distributions.
 Section 108(b) also applies to partners that benefit from the exemptions in §108(a).
 Mayo v. Commissioner, T.C. Memo 1957-9; See also FSA 199911003.
 See e.g. Harry Litwin, 983 F2d 997 (10th Cir. 1993).
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.