If a loan is not being treated as a loan (documented, repayment with interest, etc.) the loan can be reclassified as a distribution to the shareholder.  If the shareholder does not have enough tax basis in their stock, the taxable gain will result when the loan is reclassified as a distribution.  Further, it is important to note that if a loan is reclassified as a distribution and there are multiple shareholders, the distribution could create disproportionate distributions amongst the shareholders.  Not only could the disproportionate distribution be a violation of certain law/business acts, but the Internal Revenue Service could also determine that the disproportionate distributions created or indicated the second class of stock.  As an S corporation, there can only be one class of stock, and thus, the second class of stock could/would result in the termination of the S corporation election, which could have ill-intended tax consequences and other business consequences.

Given the above, what can be done in an attempt to prevent payments or disbursements to a shareholder from being treated as a distribution, but rather a loan to the shareholder?  Generally speaking, the key is proving intent, that the disbursements were intended to be a loan or loans.  Below is a list of the issues and factors a court would likely consider when making a determination of whether or not a shareholder loan was in fact created.

• Was the shareholder paying interest? It is also important to note, that the IRS can impute interest under the Internal Revenue Code.
• Is the amount/loan being repaid by the shareholder?
• Is the debt evidenced by a written instrument such as a promissory note, with stated interest, payment terms & conditions, and maturity date?
• How has the disbursement to the shareholder been recorded and reflected within the S corporation’s books?
• If the shareholder was in arrears of any payment, did the corporation attempt to enforce or require payment?
• Did the shareholder have the financial wherewithal to repay the note when the loan was provided by the corporation?

Of all the above issues & factors, perhaps the most important is whether or not the shareholder was actually repaying the loan.  Courts have determined a loan existed even without documentation and promissory notes given the shareholder was making payments.

The above article has been prepared by John McGuire of The McGuire Law Firm for informational purposes.  John focuses his practice on tax matters before the IRS, advising individual & business clients on tax planning and tax-related issues and business transactions from business formation and contracts to the sale of a business or business interest.

To be eligible for an S corporation election and to maintain the status as an S corporation the Internal Revenue Code mandates the S corporation allow only a certain number and types of shareholders.  For example, currently, I believe an S corporation can have only 100 shareholders and only one class of stock.  This differs from a C corporation as C corporation can or could have many more shareholders and many different types of stock.  For example, a C corporation can have multiple classes of stock, such as common stock, preferred stock, A shares, B shares etc.  Additionally, generally only individuals can be a shareholder in an S corporation.  Some exceptions apply for specific types of trusts (QSSTs).

A corporation will initially file their articles of incorporation with the secretary of state and thereafter file the election with the IRS to be taxed as an S corporation.  Form 2553 can be filed with the IRS to make the S election.  If the S corporation violates the Internal Revenue Code with a disallowed shareholder, the corporation can lose its S corporation status and be taxed as a C corporation, which could be very disadvantageous to the corporation and the shareholders.

In addition to the allowable shareholders and related issues, a corporation that operated as a C corporation for some time and then made the S corporation election must consider additional issues such as built in gain matters, which refer to the gain in certain assets at the time the corporation made the S corporation election.

If you have questions related to your choice of entity, entity structure or the taxation of your business or certain business transactions, speak with a Denver business attorney and tax attorney at The McGuire Law Firm.  The McGuire Law Firm offers a free consultation where you can meet with an attorney and discuss your current business operations, business questions and tax questions.

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A corporation that meets the requirements of Internal Revenue Code section 1361 may make the election to be taxed as an S corporation.  The requirements are: the corporation must have no more than 100 shareholders; all shareholders must be individuals (other than nonresident aliens), estates, qualified trusts, electing small business trusts or certain tax exempt organizations; the corporation may only have one class of stock; the corporation may not be a financial institution, insurance company, possessions corporation or DISC.

An S corporation may also own 80% or more of the stock in a C corporation, and the liquidation of a C corporation  into an S corporation is governed by the rules of Subchapter C, specifically Internal Revenue Code Sections, 332 and 337.

An S corporation that has a wholly owned subsidiary can make an election to treat the subsidiary as a qualified subchapter S subsidiary.  Under such circumstances the subsidiaries assets, liabilities and items of income, deduction and credit are treated as those of the parent S corporation.  Thus, the separate existence and status of the subsidiary is ignored for tax purposes.  When such election is made, the subsidiary is deemed to have liquidated in a tax free liquidation under Internal Revenue Code sections 332 and 337 immediately before the election was effective.  The built in gains rule under Internal Revenue Code 1374 will apply

Certain types of trusts can also own stock in an S corporation.  To qualify, the trust is treated as owned by an individual who is a citizen of the United States; the trust is a trust with respect to stock transferred pursuant to a will; the trust was created primarily to exercise the voting power of stock transferred to it; or an electing small business trust.  An electing small business trust is a trust that has no beneficiary other than an individual, an estate,  or certain charitable organizations.

The make the S corporation election, the corporation will likely file Form 2553.  All shareholders must consent to the S election and the election is filed with the Internal Revenue Service on or before the 15^th day of the third month of the Corporation’s taxable year.  Taxpayer’s may be allowed relief for certain late filings of the election under certain revenue procedures.

A new corporation that makes the S election is not subject to tax at the entity level.  An S corporation is a pass through entity where by the profits, losses, credits and deductions are passed through to the individual shareholders and claimed on their 1040 Individual Income Tax Returns.  The amounts passed through to shareholders are passed through pro rata per the shareholders ownership interest.  Because an S corporation can only have one class of stock, an S corporation does not have the flexibility of an LLC or partnership in allocating income or losses.  Losses from an S corporation may be deducted only to the extent of the shareholder’s basis in their stock and any indebtedness of the corporation to the shareholder.

A shareholder’s basis in their stock will reflect their capital contributions to the corporation and will be increased by their pro rata share of corporate income and decreased by their pro rata share of losses and distributions to the shareholder.  The basis cannot decrease below zero.  Losses or deductions that exceed a shareholder’s basis can be applied to reduce the basis in indebtedness of the S corporation to the shareholder under Internal Revenue Code section 1367(b)(2).  A shareholder’s basis is not increased by corporate level obligations to third parties.  When the distributions are made to a shareholder that do not exceed the shareholder’s basis in the stock, are not taxed to the shareholder under Internal Revenue Code Section 1368(b).

It is important to know that certain states do not recognize S corporations and thus will tax the entity as a C corporation.  You can speak with a Denver business attorney at The McGuire Law Firm to discuss your business law questions and issues.  A Denver business attorney can assist you with forming and structuring your business, the tax implications of your business, business operations and the eventual sale, transfer or disposition of business assets or interests.

Schedule your free consultation with a Denver business attorney at The McGuire Law Firm!  Offices in Denver and Golden Colorado.