Final regulations have been released regarding the treatment of open account debt between S corporations and their shareholders. The regulations provide rules regarding the definition of open account debt and adjustments in basis of any indebtedness of an S corporation to a shareholder under Code Sec. 1367(b)(2) for shareholder advances and repayments on advances of open account debt.
CCH Comment. The regulations were originally proposed in response to F.G. Brooks, Dec. 56,127(M), TC Memo. 2005-204, 90 TCM 172, in which advances of open account debt by taxpayers to their closely held S corporation provided the taxpayers with basis to offset repayments of open account debt made by the company prior to each advance. Because the multiple advances by the taxpayers and repayments by the corporation constituted open account indebtedness, they were treated as a single indebtedness rather than separate indebtedness. The basis of the indebtedness was, therefore, computed by netting, at the close of the year, the advances and repayments of open account debt during the year. As a result, by restoring the basis in their debts, the advances that the taxpayers made to the S corporation shielded them from the realization of gain on debt repayments made during the years at issue. In the preamble to the final regulations, the IRS rejected as inadequate practitioner suggestions that it could adequately address its concerns regarding
Brooks through established judicial doctrines such as substance over form, business purpose, sham transaction, and economic substance or through a narrowly drawn anti-abuse rule targeting open account debt.
Under the proposed regulations, open account debt was defined as shareholder advances not evidenced by separate written instruments for which the principal amount of the aggregate advances (net of repayments on the advances) does not exceed $10,000 at the close of any day during the S corporation's tax year. Separate advances under a line-of-credit agreement not evidenced by a separate written instrument would be included in the definition.
Commentators expressed concerns that the proposed $10,000 aggregate principal threshold was too low for most businesses. The American Institute of Certified Public Accountants (AICPA) recommended that the threshold be "at least $250,000 but preferably $1 million" (TAXDAY, 2007/11/06, I.6). In response, the final regulations adopted a $25,000 aggregate principal threshold amount per shareholder for open account debt. For example, the IRS pointed out, an S corporation with 10 shareholders could receive up to $250,000 of open account debt as long as no single shareholder advanced more than $25,000. Nevertheless, despite the $25,000 threshold amount, the provisions under Code Sec. 7872 and related regulations for corporate-shareholder loans in excess of $10,000 separately apply to open account debt in excess of $10,000 for each advance if the corporation is not required to pay a market rate of interest on the advances.
Commentators also expressed concerns that day-to-day monitoring of open account debt would impose an unreasonable burden on shareholders. In response, the final regulations provide that a determination of whether the threshold balance of $25,000 is exceeded will be made at the end of the S corporation's tax year. However, if open account debt is disposed of in whole or in part prior to the end of the S corporation's tax year, the determination of whether the advances and repayments have exceeded the designated aggregate principal amount must be made immediately before the disposition of the debt during that tax year. Further, if a shareholder with open account debt is no longer a shareholder at the end of the S corporation's tax year, the determination must be made immediately before the shareholder's interest in the S corporation is terminated.
The final regulations apply to any and all shareholder advances to the S corporation made on or after October 20, 2008, and repayments on those advances by the S corporation. The regulations, however, clarify that, if a shareholder has open account debt (net of prior repayments in the tax year) outstanding prior to the effective date, the rules under prior final regulations (T.D. 8508), published on January 3, 1994, and amended on December 22, 1999 (T.D. 8852), apply to any repayments on such pre-effective date open account debt. Accordingly, that pre-effective date open account debt will not be subject to any aggregate principal threshold dollar amount. The shareholder may not make additional advances with respect to the pre-effective date open account debt since all shareholder advances made on or after the effective date constitute new open account debt subject to the final regulations.
T.D. 9428, 2008FED ¶47,060
Other References:
Code Sec. 1367
CCH Reference - 2008FED ¶32,100C
CCH Reference - 2008FED ¶32,100D
Tax Research Consultant
CCH Reference - TRC SCORP: 408
CCH Reference - TRC SCORP: 410.10