Open Account Debt: Relaxed But No Reason To Relax

Do you remember the Brooks case? That was the one involving open account debt in which the Tax Court held that repayments could be simply netted against the advances made to the S corporation shareholder. This in turn could lead to a simple, tax-free repayment of the loan, dollar for dollar. The alternative characterization of a repayment against a debt is as a pro rata retirement of the debt. Now no real problem arises when the shareholder has a basis in the debt equal to the unpaid advance, but because a shareholder may apply current losses against the basis of debt after reducing the stock basis to zero, this is not always the case. A payment on the debt consists then of a proportionate share of basis recovery and a portion representing the disparity between basis and face; while the debt may not be appreciated in an economic sense, the shareholder can recognize gain in a tax sense on this differential.

For example, if a shareholder has a debt with a face amount of $30,000 and an adjusted basis of $20,000, each payment would consist two-thirds ($20,000/$30,000) of basis and one-third (($30,000 - $20,000)/$30,000) of “tax appreciation.” If a $12,000 payment is made on the debt with these factors in effect, the shareholder recovers without tax $8,000 of debt basis, reducing it to $12,000, and recognizes $4,000 of taxable gain; the face amount is now $18,000.

What happens when the shareholder has multiple debts with the S corporation? The reduction in basis from the current loss is applied to each indebtedness in the same proportion that the basis of each indebtedness bears to the aggregate bases of the indebtedness to the shareholder. The regulations provide that for purposes of debt basis adjustment, shareholder advances not evidenced by separate written instruments and repayments on the advances (open account debt) are treated as a single indebtedness. If a shareholder holds more than one indebtedness as of the beginning of a corporation's taxable year, any net increase is applied first to restore the reduction of basis in any indebtedness repaid (in whole or in part) in that taxable year to the extent necessary to offset any gain that would otherwise be realized on the repayment.

One of the marvels of open account indebtedness is that it is treated as a single indebtedness. In the Brooks case, the Tax Court determined that advances and repayments on open account debt are taken into account on a net basis; so where the advance exceeds the repayment, the shareholder has no net repayment that would trigger gain where there was a disparity in basis and face amount of the debt. A different result ensues when the debts are considered separate. Then the new advance coupled with a repayment of another earlier advance would not insulate the shareholder from recognition of gain.

The Service’s reaction to the tactic of making year-end advances on an open account basis to cover both losses that further reduced debt basis and any repayment made during the year was to propose a change in its regulations to limit open account debt of a shareholder to advances not in writing but only to the extent that the principal sum did not exceed $10,000 on any day during the taxable year. This of course required substantial record-keeping in order to monitor the extent of the net advance; once the total of such unwritten advances exceeds the dollar threshold, the aggregate of open account debt is deemed a separate written debt for every day thereafter.

The Service has finalized the new regulations effective only to advances (and the repayments on them) made on or after October 20, 2008; the proposed regulations do not apply to any advances or repayments. Thus, existing open account debt (which under the prior final regulations was not limited in dollar amount) is grandfathered under the liberal rules outlined in Brooks. The major differences between the proposed regulations and the final regulations are (1) the dollar threshold has been increased to $25,000, and (2) the threshold determination is made solely at the end of the S corporation tax year. This latter modification not only reduces the administrative monitoring but also allows tax planning for shareholders to bring unwritten advances under the threshold by repayments.

What open account debt treatment does is to appropriate an “average debt basis” rather than an “actual debt basis” into the calculations for determining the gain on the repayment of the debt. If the debt basis of the debt actually being repaid is higher than the average, the open account treatment causes more recognition of gain; conversely, if the average debt basis is lower than that of the actual debt, open account treatment reduces the amount of gain the shareholder will recognize on the repayment of the actual debt.

Interestingly, the regulations took a pass on the characterization of repayments, but this should not be taken to mean the Service is considering this an open issue. Prior law (and §1271) established that the retirement of a corporate indebtedness is not a sale or exchange unless it is in writing. The Service has previously issued revenue rulings that treat gain from a written debt instrument as capital and that from an open account as ordinary.

For further discussion of the basis issue, see upcoming versions of Surgent McCoy’s Advanced Critical Tax Issues for S Corporations (ACTS), The Best S Corporation, Limited Liability, and Partnership Update Course By Surgent McCoy (BCPE), or The Best Federal Tax Update Course by Surgent McCoy (BFTU).