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New S Corporation Open-Account Regulations Require Careful Taxpayer Planning

The IRS has just imposed a $25,000 per-shareholder threshold limit on open-account debt for S corporations. Unless S corporations properly plan and document shareholder advances to the company, the new regulations will mean more administrative work and different tax results.

How does the new $25,000 limit work?

Generally, if the net principal amount of shareholder advances and repayments is more than $25,000 on the last day of the S corporation's taxable year, the debt will be treated as debt evidenced by written instrument—not open-account debt—unless the debt is paid off or the shareholder is no longer a shareholder.

When is the new regulation effective?

The new regulation applies to all S corporation open-debt accounts beginning October 17, 2008. Taxpayers can also elect to apply the new regulations to open-account debt existing before that date.

How did the previous regulation work?

Shareholders could deduct losses from their S corporation to the extent of their basis in the stock plus any debt the corporation owed them. Advances to an S corporation that are not documented by a separate written instrument were considered a single debt.

Repayment of shareholder loans in excess of their debt basis did not trigger any taxable income as long as the shareholder made additional advances to cover the shortfall before the end of the year.

Why did the IRS change the regulation?

The IRS challenged the above position on several occasions, arguing that the open-account debt was for the purpose of simplicity, not to defer income. After the IRS was defeated in the Brooks case (TC Memo 2005-204), the IRS issued proposed new regulations to narrow the definition of "open-account debt" and modify the rules on basis adjustments of S corporation debt to shareholders.

The final regulations are not as harsh as what the IRS proposed. The Treasury did not rule on the character of income or gain recognition pertaining to repayment of open-account debt or debt evidenced by a written instrument.

Questions about S corporation open-account debt? Contact Madhuri Thaker at 312-980-2931.
 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.