Business Tax Preparation · Analysis of financial records

Loans to and from owners

Money moving between an owner and the business is the most examined item on a small company’s balance sheet, and for a good reason: whether it is a loan decides whether it is compensation, a distribution, or a contribution to capital — and the answer usually turns on documents nobody created at the time.

The rule

A loan at the wrong rate is recharacterised. a loan is below-market if, on a demand loan, interest is payable at less than the applicable federal rate, or, on a term loan, the amount loaned exceeds the present value of all payments due under it^TY2026 (IRC § 7872(e)(1)), the amount being forgone interest is the interest that would have been payable had it accrued at the applicable federal rate and been payable annually, over any interest actually payable and properly allocable to the period^TY2026 (IRC § 7872(e)(2)). on a below-market gift loan or demand loan the forgone interest is treated as transferred from the lender to the borrower and retransferred by the borrower to the lender as interest, deemed to happen on the last day of the calendar year^TY2026 (IRC § 7872(a)) — a deemed transfer and a deemed retransfer, both on the last day of the calendar year.

Which loans are caught. the section reaches gift loans, compensation-related loans between employer and employee or between an independent contractor and the person served, corporation-shareholder loans in either direction, tax avoidance loans, loans to qualified continuing care facilities, and to the extent regulations provide, any other below-market loan whose interest arrangements have a significant effect on federal tax liability^TY2026 (IRC § 7872(c)(1)). Note that the corporation-shareholder category runs in both directions.

Two de minimis exceptions, both at the same figure. $10,000 — the section does not apply to any day on which the aggregate outstanding loans between the borrower and lender do not exceed that figure, for compensation-related and corporation-shareholder loans alike, unless a principal purpose of the interest arrangements is the avoidance of federal tax^TY2026 (IRC § 7872(c)(3)), and for gift loans $10,000 for a gift loan directly between individuals, measured the same way — but unavailable where the loan is directly attributable to the purchase or carrying of income-producing assets^TY2026 (IRC § 7872(c)(2)). A further ceiling applies above that: on a gift loan directly between individuals not exceeding $100,000, the amount treated as retransferred to the lender as interest at the close of a year may not exceed the borrower’s net investment income for that year — unless a principal purpose of the interest arrangements is tax avoidance^TY2026 (IRC § 7872(d)(1)).

On the S corporation side, a loan from the shareholder is basis. It is the second tier of IRC § 1366(d)(1), and it is consumed before it is repaid: where losses, deductions, noncapital nondeductible expenses and the specified depletion deductions exceed stock basis, the excess reduces, but not below zero, the basis of any indebtedness of the S corporation to the shareholder held at the close of the corporation’s taxable year^TY2026 (IRC § 1367(b)(2)(A); Reg. § 1.1367-2(b)(1)). Recovery is ordered: a later net increase must restore any reduced debt basis before it may increase stock basis — and it restores first the basis in indebtedness repaid during the year, to the extent needed to offset gain that would otherwise arise on the repayment, then each outstanding debt in proportion to its unrestored reduction^TY2026 (IRC § 1367(b)(2)(B); Reg. § 1.1367-2(c)). And there is a timing trap: indebtedness satisfied by the corporation, or disposed of or forgiven by the shareholder, during the year is not held at the close of that year and is not subject to basis reduction at all^TY2026 (Reg. § 1.1367-2(b)(1)).

Informal advances have their own regime. open account debt means shareholder advances not evidenced by separate written instruments, and repayments on them, whose aggregate outstanding principal does not exceed $25,000 at the close of the corporation’s taxable year — netted as a single indebtedness rather than tracked advance by advance^TY2026 (Reg. § 1.1367-2(a)(2)(i)).

A partner is in a different position entirely. A loan from a partner is a partnership liability, and IRC § 752(a) treats an increase in a partner’s share of liabilities as a contribution of money — so it reaches outside basis directly, with no second tier and no separate debt basis account.

And on examination. credit balances in accounts receivable may represent deposits, advance payments or overpayments that are additional income or unrecorded sales^TY2026, with IRM 4.10.3.10.4 directing the examiner to test a related party loan in receivables for adequate stated interest under IRC § 7872 and for original issue discount under IRC § 1272 and § 1273 — the latter accruing into the lender’s income even where the lender is on the cash method.

Current figures

How it works in practice

Ask first whether it is debt at all. A genuine loan needs a note, a rate at or above the applicable federal rate, a maturity, and a pattern of actual payments. Without those, an advance from the corporation to the shareholder is a distribution and one from the shareholder to the corporation is a contribution to capital. Neither is neutral: the first is taxable under IRC § 1368 to the extent it exceeds basis, and the second gives stock basis where the shareholder wanted debt basis.

A shareholder loan is used up before it is repaid. This is the mechanic most often missed. Losses in excess of stock basis reduce debt basis under IRC § 1367(b)(2)(A). The note still shows its face amount on the balance sheet, but its tax basis has fallen, so a repayment at face produces gain equal to the difference. The gain is capital where the debt is evidenced by a note and ordinary where it is an open account advance, which is why the paperwork matters after the fact as well as before it.

Restoration has an order and it favours the repaid note. Under Reg. § 1.1367-2(c) a later net increase restores first the basis in indebtedness repaid during the year, to the extent needed to offset gain that would otherwise arise on the repayment, then the remaining outstanding debts in proportion to their unrestored reductions, and only then stock basis. A profitable year can therefore neutralise a repayment made in the same year.

Watch the year-end date. Debt reduced under § 1367(b)(2)(A) is only debt held by the shareholder at the close of the corporation’s taxable year. A note satisfied, disposed of or forgiven during the year escapes reduction entirely — a fact that cuts both ways and is easy to manipulate accidentally.

A shareholder guarantee is nothing. It creates no indebtedness of the corporation to the shareholder, so it produces no debt basis and no loss capacity. Only an actual economic outlay by the shareholder does. This is the single largest divergence from partnership treatment, where IRC § 752 can put a share of an entity-level liability into a partner’s outside basis without any outlay at all.

Run IRC § 7872 and IRC § 267 together on an interest accrual. An accrual method corporation accruing interest to a cash basis shareholder has its deduction deferred by IRC § 267(a)(2) to the shareholder’s year of inclusion; if the loan is also below-market, § 7872 manufactures interest that never moves in cash. Both can operate on the same arrangement in the same year.

Scenarios

Traps

How this has changed

IRC § 7872 was enacted in 1984 to answer Dickman, in which the Supreme Court held that an interest-free demand loan between family members was a taxable gift of the use of the money. Congress generalised the principle across income tax as well as gift tax, and built the deemed-transfer mechanism that still operates. The dollar figures in § 7872 — the two de minimis thresholds and the gift loan ceiling — were fixed in 1984 and have never been indexed, so they have eroded steadily in real terms and now catch arrangements Congress would probably have exempted at the time.

The subchapter S debt basis rules have moved more recently and in the taxpayer’s favour. The open account debt regime in Reg. § 1.1367-2(a)(2) was introduced in 2008 to stop the impossible bookkeeping of tracking every informal advance and repayment separately, netting them into a single indebtedness up to the stated ceiling. That ceiling has not been indexed either.

The most consequential recent movement is indirect. Bonus depreciation permanent at the full statutory rate means far more S corporations generate large early losses, which means far more shareholders reach beyond stock basis into debt basis — so the repayment trap that used to be occasional is now routine. Nothing in the post-2024 legislation changes IRC § 7872, § 1367 or the regulation.

Exam focus

Know the four things a shareholder loan must have to be respected: a note, an adequate stated rate, a maturity, and actual payments. Questions in this area usually supply an advance missing three of the four and ask for the consequence, which is IRC § 1368 treatment rather than § 7872 treatment.

Memorise the § 7872 categories and both de minimis figures, and be ready to say that the exception fails on a gift loan attributable to income-producing assets or where tax avoidance is a principal purpose of the interest arrangements.

Be able to run the debt basis mechanic in order: losses reduce stock basis first, then debt basis; a later net increase restores debt basis before stock basis, and within debt basis restores a repaid note first. Know that a repayment while basis is reduced produces gain, capital on a note and ordinary on an open account advance.

Keep the two entity regimes apart. S corporation: only direct shareholder debt, only on an actual outlay, guarantee worthless. Partnership: IRC § 752 puts liabilities into outside basis without any separate tier.

Finally, remember that a related party loan can trigger IRC § 267(a)(2) and IRC § 7872 at once, and that original issue discount under IRC § 1272 accrues into a cash basis lender’s income.

Check yourself

1. A shareholder lends her S corporation $80,000 on a note. Losses reduce her stock basis to zero and her debt basis to $30,000. The corporation repays the note in full while she has no other income from it. What does she recognise?

Answer: $50,000 of gain. The note’s basis is $30,000 against a face amount of $80,000, and full repayment realises the difference. Because the debt is evidenced by a written note the gain is capital; had the advances been open account debt the gain would be ordinary. The trap is that the balance sheet shows an $80,000 note throughout — the basis reduction under IRC § 1367(b)(2)(A) happened in the loss years and left no trace on the face of the accounts.

2. A corporation lends its shareholder $9,000 interest-free for six months. Does IRC § 7872 apply?

Answer: No, on those facts. IRC § 7872(c)(3) disapplies the section to any day on which the aggregate outstanding loans between the borrower and lender do not exceed $10,000, and this is a corporation-shareholder loan within § 7872(c)(1)(C). Two qualifications: the test is on aggregate loans, so a second advance pushing the total over the figure brings the whole arrangement into the section for those days, and the exception fails altogether if a principal purpose of the interest arrangements is the avoidance of federal tax.

3. A shareholder personally guarantees the corporation’s $200,000 bank borrowing and the corporation defaults on nothing. How much debt basis does the guarantee create?

Answer: None. IRC § 1366(d)(1)(B) counts only the shareholder’s adjusted basis in indebtedness of the corporation to the shareholder, and a guarantee creates an obligation to the bank, not to the shareholder. Debt basis would arise only on an actual economic outlay — if the shareholder were called on the guarantee and paid, or lent the money to the corporation directly so it could repay the bank. A partner guaranteeing a partnership recourse liability may, by contrast, take a share of it into outside basis under IRC § 752 without paying anything.

4. Why does a repayment of shareholder debt sometimes produce ordinary income and sometimes capital gain?

Answer: Because the character follows the form of the debt. Repayment of a debt evidenced by a written instrument is treated as a disposition of that instrument, producing capital gain to the extent the repayment exceeds the debt’s basis. An open account advance under Reg. § 1.1367-2(a)(2) is not evidenced by a separate written instrument, so its repayment produces ordinary income instead. The same economic transaction is taxed at different rates depending on whether anyone wrote a note, which is a strong practical argument for documenting advances even where the parties see no commercial need.

5. A partner and an S corporation shareholder each lend their entity $100,000, and each entity allocates them a $140,000 loss against zero equity basis. How much loss can each deduct?

Answer: $100,000 each, by different routes. The shareholder deducts against the second tier in IRC § 1366(d)(1)(B), the basis of indebtedness of the corporation to them, with the remaining $40,000 suspended indefinitely under § 1366(d)(2). The partner has no second tier: instead IRC § 752(a) treats the increase in their share of partnership liabilities as a contribution of money, raising outside basis by $100,000, and IRC § 704(d) then allows the loss to that extent. The answers coincide here, but they diverge as soon as the borrowing is from a third party rather than from the owner.