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Same client we talked about on the 16th. Turns out he has

Same client we talked about...
Same client we talked about on the 16th. Turns out he has ahareholder loan of $570k on the books. He is not dissolving the S-Corp but will be declaring bankruptcy shortly. The S-corp will experience a loss of approx $250k on the sale of assets. Should this go against the shareholder loan? Then should he forgive the loan and if so would that not become income? What is the best strategy for the client?
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Answered in 2 hours by:
10/18/2013
jgordosea
jgordosea, Enrolled Agent
Category: Tax
Satisfied Customers: 3,161
Experience: I've prepared all types of taxes since 1987.
Verified
Greetings,

I did read the other question for background. Yes, this can get a bit complex.

The S Corp loss on the asset sale will flow to the shareholder.

This does not have to do anything in relation to the loan to shareholder.
I am presuming this is a corporate asset loan to shareholder (and not a loan form shareholder which would be a corporate liability)
Let me know if that is not a valid presumption.

Since the shareholder is declaring bankruptcy the best action may be include that loan from the corporation in the bankruptcy. He should check with the bankruptcy attorney to see if that loan can be included.
Even if the loan can not be included in the bankruptcy the shareholder does not have to include canceled debt in taxable income to the extent he is insolvent at the time of the debt forgiveness.

The issue behind the question is if these were actually loans to the shareholder or were distributions to the shareholder (returns of capital).

See http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Paying-Yourself
"A loan by a corporation to a corporate officer should include the characteristics of a loan made at arm's length. That is, there should be a contract with a stated interest rate, a specified length of time for repayment, and a consequence for failure to repay the loan. Collateral would also be an indication of a loan. A below-market loan is a loan which provides for no interest or interest at a rate below the federal rate that applies. If a corporation issues you, as a shareholder or an employee, a below-market loan, the lender's payment to the borrower is treated as a gift, dividend, contribution to capital, payment of wages, or other payment, depending on the substance of the transaction."

The primary determination as to whether or not the debt is bona fide hinges on a key question: When the loan was made,was there a genuine intent that the borrowed funds would be repaid?
See http://www.unclefed.com/SurviveIRS/MSSP/a8shloan.pdf for the IRS audit guide for Shareholder loans that lists the determinative factors.

So the determination if this is a valid loan to the shareholder will be made the loan can be discharged in the bankruptcy or forgiven when the taxpayer is insolvent and will not be included in income of the taxpayer.

Please ask if you need discussion or clarification.
Thank you.
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Customer reply replied 4 years ago

The S/H loan is a liability. The s/h invested over $600k in 2005 to get the restaurant opened.

Hello again,

In that case, there is no need to treat anything as canceled or forgiven debt.

The loan balance can be treated (or converted) to a capital contribution of the shareholder.

Two results of the additional contribution to capital are that the shareholder will have basis to be able to deduct the corporation losses that pass through and to the extent the basis in the stock is not reduced by the corporate losses that remaining basis will be claimed as a loss on the stock when the corporation is dissolved or sold.

Shareholder investment will be recorded as capital contribution to the corporation (which may have been more proper from the beginning).

Please ask if you need discussion or clarification.
Thank you.
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Customer reply replied 4 years ago

I think I get it. It sounds like the s/h loan needs to be converted to equity in order to deduct the loss generated from the sale of assets. Since the loan has been reported on previous returns, can reporting be as easy by just adding a statement to the new return to explain the change on Section L of the 1120s? After this discussion, could I get you to clarify the answer I was provided on my last question from the other expert?

Hello again,

 

Even easier, as there is no need to include a statement. Of course, you can if you like for your own reference.

Just make the journal entry to reposition the loan to capital contribution ("Additional paid in capital" or similar named account) in the current year. You can even make the entry at 1/1/ 2013 or whichever date you choose in the current year.

On the current year Schedule L just report the amounts in the categories after repositioning. This type of repositioning is not rare at all for clients that have done their own books in my experience.

 

As to the prior question I am glad to help,but I cannot post to this question unless you, the Customer, relists it. However, that question may then appear to all experts that anyone should answer.

 

The best way may be to direct another question to me as a new question and include my username in the question. For example, "For jgordosea only, please..."

You may wish to read and review the prior answer to develop any specific questions on the process as that answer does seem to include all that is needed, in general, on recording the sale at a loss in the corporation and the K-1 flowing to the shareholder to report the loss as part of their 1040.

 

Again, please ask if you need more help with the change from loan to capital.
Thank you.

 

 

 

 

 

 

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Customer reply replied 4 years ago

Sorry, I had to respond to a phone call. I will post the other question again specifically to you as we seemed to communicate clearly. Thanks

No problem, I will be on and off here all day (and more).

 

Thank you for the opportunity to be of service.

jgordosea
jgordosea, Enrolled Agent
Category: Tax
Satisfied Customers: 3,161
Experience: I've prepared all types of taxes since 1987.
Verified
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