Category: Corporations
Subject: S Corporation
Title: Basis of Bad Debt, Restoration of; Distribution Issues
IRC Sections: 1367(b)(2)(B), 1368
Filename: 1320.html
Date Produced: 05/94

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Taxpayer (TP) is an automobile dealership organized as an S corporation the stock of which is owned by two individuals in the proportions 85% and 15%. TP's S election was effective 1/1/86. TP has retained earnings from C corporation years of $600,223. The assets of TP were sold in 1993. In previous years, the shareholders had made loans to TP, and the loans were used by the shareholders to support losses in excess of their bases in TP stock. 1993 taxable income is approximately $1,193,000 which will be passed through to the shareholders. At the end of 1992, the 85% shareholder's basis in stock and debt was $1,029, and TP owed the 85% shareholder $551,000. The 15% shareholder's basis in stock and debt was $46,282, and TP owed the 15% shareholder $125,000. Substantially all the proceeds of the asset sale were distributed in 1993. $787,500 was distributed to the 85% shareholder, and $187,500 to was distributed to the 15% shareholder. TP is in the process of winding up its affairs, and another $70,000 should be distributed to the shareholders when that process is completed.

Issues

1. Is it possible to avoid recapture of the basis reduction with respect to loans made by the shareholders to TP?

2. Should the 1993 distributions be treated as part of a complete liquidation of TP which began in 1993?

Answers

1. The gain recognized on the sale of corporate assets will first increase the shareholder's debt basis in an amount necessary to restore the basis to the face amount of the indebtedness outstanding at the beginning of the tax year. Thereafter, the gain increases the basis of the shareholder's stock. Given that the basis of the debt will be restored to face, the repayment of the debt in 1993 should not give rise to recapture income.

2. Unless the distributions are treated as part of a complete liquidation of TP commencing in 1993, part of the distributions will be taxed to the shareholders as ordinary dividends assuming that TP's retained earnings from C corporation tax years is a reasonable measure of its earnings and profits.

Discussion: Issue 1
IRC Section 1367(b)(2)(B) provides that income recognized by an S corporation first goes to increase the basis of any debt which has previously been reduced by losses. TP has ample income in 1993 to restore the basis of the shareholder debt back to its face amount. Given the shareholder debt will at the time of repayment have a basis equal to the face amount of the debt, repayment of the shareholder debt in 1993 will not give rise to income. Since the characterization of amounts paid to shareholders in 1993 is a question of fact, every effort should be made to ensure that the books and records as well as the tax filings are consistent with a finding that debt was repaid in 1993. Obviously, the offsetting entry for the appropriate amount of monies distributed in 1993 should be shareholder loans. In addition, care should be taken to ensure that all ancillary facts are also consistent with debt repayment in 1993. For example, interest accrual on the debt should stop at the date on which the distributions were made to the shareholders.

Discussion: Issue 2
Section 1368(c) provides the rules under which non-liquidating distributions will be treated in the event the distributing corporation has earnings and profits. First, distributions are treated as a nontaxable reduction of the accumulated adjustments account (AAA). Second, distributions are considered dividends to the extent of current or accumulated earnings and profits. Third, distributions are treated as a nontaxable return of capital up to the amount of the shareholder's stock basis. Finally, distributions are taxed as capital gain from the deemed disposition of the shareholder's stock.

§1368(a) provides that only distributions subject to §301 are treated under the multi-tier system set forth above. Distributions in complete liquidation are not subject to §301 and are therefore excluded from the rule of §1368(c).

If all 1993 distributions after repayment of debt are treated under §1368(c), the shareholders will be treated as having received an ordinary dividend to the extent of the lesser of their share of accumulated earnings and profits or the amount of the distribution in excess of AAA. Given the magnitude of the 1993 distributions and the probable existence of earnings and profits, the shareholders would recognize significant dividend income if all 1993 distributions in excess of debt repayments were treated under §1368(c). Of course, the effect of recognizing dividend income is the conversion of what would otherwise have been capital gain into ordinary income.

In order to avoid dividend income and the concomitant conversion of capital gain into ordinary income, it is necessary to remove the 1993 distributions from the reach of §1368(c) by treating 1993 as the year of liquidation.