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Internal Revenue Bulletin - August 11, 2014 - TD 9682
Internal Revenue Bulletin: 2014-33 August 11, 2014 TD 9682
§ 1.1367–1 [Amended]
Internal Revenue Service	26 CFR Part 1
This document contains final regulations relating to basis of indebtedness of S corporations to their shareholders. These
final regulations provide that S corporation shareholders increase their basis of indebtedness of the S corporation to the
shareholder only if the indebtedness is bona fide, which is determined under general Federal tax principles and depends upon
all of the facts and circumstances. These final regulations affect shareholders of S corporations.
Applicability Date: These final regulations apply to indebtedness between an S corporation and its shareholder resulting from any transaction
occurring on or after July 23, 2014.
The final regulations contain amendments to the Income Tax Regulations (26 CFR part 1) under section 1366 of the Internal
Revenue Code (Code). On June 12, 2012, the Treasury Department and the IRS published in the Federal Register (77 FR 34884) a notice of proposed rulemaking (REG–134042–07) (the proposed regulations) relating to when shareholders have
basis in indebtedness that the S corporation owes to the shareholder (basis of indebtedness). The proposed regulations provide
that basis of indebtedness of the S corporation to the shareholder means the shareholder’s adjusted basis in any bona fide
indebtedness of the S corporation that runs directly to the shareholder. No requests to speak at the scheduled public hearing
were received and the hearing was canceled. Comments responding to the notice of proposed rulemaking were received. After
consideration of all the comments, the proposed regulations are adopted without substantive change by this Treasury decision,
except for changes to the effective/applicability date of the regulations and minor clarifying revisions. The comments, which
are available at www.regulations.gov or upon request, are discussed in this preamble.
Courts developed the actual economic outlay standard, which requires that shareholders be made “poorer in a material sense”
to increase their bases of indebtedness. Some courts concluded that an S corporation shareholder was not poorer in a material
sense if the shareholder borrowed funds from a related entity and then lent those funds to his S corporation. See, for example,
Oren v. Commissioner, 357 F.3d 854 (8th Cir. 2004), aff’g, T.C. Memo. 2002–172. Instead of applying the actual economic outlay standard, the proposed
regulations provided that shareholders receive basis of indebtedness if it is bona fide indebtedness of the S corporation
One commentator suggested that language be added to the regulations providing that actual economic outlay is no longer the
standard used to determine whether a shareholder obtains basis of indebtedness. After considering this comment, the Treasury
Department and the IRS believe that the proposed regulations clearly articulate the standard for determining basis of indebtedness
of an S corporation to its shareholder, and further discussion of the actual economic outlay test in the regulations is unnecessary.
Accordingly, the final regulations adopt the rule in the proposed regulations without change.
With respect to guarantees, however, the final regulations retain the economic outlay standard by adopting the rule in the
proposed regulations that S corporation shareholders may increase their basis of indebtedness only to the extent they actually
perform under a guarantee. The final regulations make some minor changes to clarify the treatment of guarantees, including
changing the heading to reiterate that the rule for guarantees is distinguished from the general rule adopting a bona fide
indebtedness standard and moving the guarantee example after the examples illustrating the general rule consistent with the
order of the regulations.
2. Regulation Examples and “Circular Flow of Funds” One commentator requested a change to the fact pattern presented in proposed regulations § 1.1366–2(a)(2)(iii), Example 4. In Example 4, a loan that originally was made by S1 to S2, two related S corporations wholly-owned by the same shareholder, is restructured
to be a loan from the shareholder. The restructuring involved S1 distributing the debt to the shareholder and S2 being relieved
of its liability to S1 so that S2 is only liable to the shareholder on the debt. The commentator recommended that Example 4 not require that S2 be relieved of its liability to S1. As stated in the proposed regulations and finalized in these regulations,
whether indebtedness is bona fide indebtedness to a shareholder is determined under general Federal tax principles and depends
upon all of the facts and circumstances. Whether S2 is relieved of the original liability is an appropriate fact to consider
in determining whether the transaction is a restructuring of a debt that results in a bona fide debt that runs directly from
S2 to the shareholder. See, for example, Rev. Rul. 75–144 (1975–1 CB 277) (holding that a shareholder increases the shareholder’s
basis of indebtedness when the shareholder, who had guaranteed a liability of his S corporation, executed his own promissory
note in full satisfaction of the S corporation’s note to the bank, the bank relieved the S corporation of its liability, and
the S corporation became obligated to the shareholder under the doctrine of subrogation). See also Gilday v. Commissioner, T.C. Memo. 1982–242 (holding that shareholders increased their bases of indebtedness when the shareholders gave a bank their
notes, the bank canceled the S corporation’s note to the bank, and the facts indicated that the S corporation became indebted
to the shareholders, regardless of whether subrogation occurred under state law). Accordingly, this comment is not adopted.
This commentator also requested that an example be added to the regulations addressing a “circular flow of funds.” The commentator
described a circular flow of funds as including a restructuring of a loan originally made by an S corporation owned by the
shareholder to another S corporation owned by that shareholder (for purposes of this discussion, S1 and S2, respectively).
This loan is restructured by one of two alternative methods: (i) S1 lends money to the shareholder, the shareholder lends
that money to S2, and S2 uses that money to repay S1; or (ii) S2 repays S1, S1 lends money to the shareholder, and the shareholder
lends that money back to S2.
The Treasury Department and the IRS recognize that there are numerous ways, including certain circular cash flows, in which
an S corporation can become indebted to its shareholder. The proposed regulations included Example 4 as an example of a loan originating between two related entities that is restructured to be from the S corporation to the
shareholder to show that the debt need not originate between the S corporation and its shareholder, provided that the resulting
debt running between the S corporation and the shareholder is bona fide. The Treasury Department and the IRS are aware, however,
of cases involving circular flow of funds that do not result in bona fide indebtedness. See, for example, Oren v. Commissioner, 357 F.3d at 859 (purported loans, although meeting all the proper formalities, lacked substance); Kerzner v. Commissioner, T.C. Memo. 2009–76, at *5 (transaction lacked substance because money wound up right where it started and shareholder was
merely a conduit through which the money flowed). Whether a restructuring results in bona fide indebtedness depends on the
facts and circumstances. Because the Treasury Department and the IRS believe that the examples in the proposed regulations
adequately illustrate that a restructuring of a debt that did not originate between the shareholder and the S corporation
may result in basis of indebtedness as long as the resulting debt is bona fide, these final regulations do not contain additional
Another commentator requested that an example be added to the regulations concerning a fact pattern in which bona fide indebtedness
is present, but the shareholder has zero basis in that indebtedness. The commentator concluded that the shareholder would
have zero basis of indebtedness in the shareholder’s S corporation because the shareholder’s basis in the debt is zero. The
Treasury Department and the IRS believe that the regulations are clear that shareholders only increase their basis of indebtedness
to the extent of the shareholder’s adjusted basis (as defined in § 1.1011–1 and as specifically provided in section 1367(b)(2))
in that bona fide indebtedness of the S corporation that runs directly to the shareholder. If the shareholder’s basis in the
indebtedness is zero, then the shareholder’s basis of indebtedness is increased by zero. As such, an additional example illustrating
a zero basis of indebtedness has not been added to the final regulations.
The preamble to the proposed regulations requested comments regarding the basis treatment when an S corporation shareholder
or a partner contributes the shareholder’s or partner’s own note to an S corporation or a partnership. An S corporation shareholder
does not increase his basis in the stock of his S corporation under section 1366(d)(1)(A) from a contribution of his own note.
See Rev. Rul. 81–187 (1981–2 CB 167) (holding that a shareholder who (i) merely executed and transferred the shareholder’s
demand note to the shareholder’s wholly owned S corporation, and (ii) made no payment on the note until the following year
had a zero basis in the note until the following year when the shareholder made a payment on the note). The preamble to the proposed regulations described as one potential model § 1.704–1(b)(2)(iv)(d)(2), which provides that a partner’s capital account is increased with respect to non-readily tradable partner notes only (i)
when there is a taxable disposition of such note by the partnership, or (ii) when the partner makes principal payments on
such note. One commentator recommended consideration of, and consistency with, § 1.166–9(c) (regarding contributions of debt
to capital). Another commentator noted that courts have applied the “actual economic outlay” standard to determine when shareholders
increase their bases in their S corporation stock. See, for example, Maguire v. Commissioner, T.C. Memo. 2012–160. This commentator requested that the final regulations provide that actual economic outlay does not
apply to determinations of a shareholder’s stock basis under section 1366(d)(1)(A). To expedite finalization of the proposed
regulations, the scope of these final regulations is limited to basis of indebtedness. The Treasury Department and the IRS
continue to study issues relating to stock basis and may address these issues in future guidance.
One commentator stressed that, because S corporations are passthrough entities, allowing shareholders to claim S corporation
losses if they have basis of indebtedness could allow shareholders to claim losses that are not bona fide. This commentator
recommended that the IRS require that shareholders provide information to the IRS that all claimed S corporation losses are
bona fide. The proposed regulations, however, do not affect the normal substantiation rules for the validity of claimed losses.
See sections 6001 and 6037. See also INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992) (providing that “an income tax deduction is a matter of legislative grace and that the burden of
clearly showing the right to the claimed deduction is on the taxpayer” (quoting Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943))). Accordingly, this comment is beyond the scope of these final regulations.
Commentators also suggested that the Treasury Department and the IRS should permit retroactive application of the regulations.
These commentators suggest that, pursuant to section 7805(b)(7), final regulations should allow taxpayers to elect to apply
the rules in the regulations retroactively.
The proposed regulations provided that these regulations apply to transactions entered into on or after the regulations are
published as final in the Federal Register. Upon further consideration of the applicability date, the Treasury Department and the IRS believe that allowing taxpayers
to rely on these regulations will provide greater certainty for determining when shareholders have basis of indebtedness.
As such, taxpayers may rely on these regulations with respect to indebtedness between an S corporation and its shareholder
that resulted from any transaction that occurred in a year for which the period of limitations on the assessment of tax has
not expired before July 23, 2014.
12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Because
6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking that preceded these final regulations
The IRS revenue rulings cited in this preamble are published in the Internal Revenue Cumulative Bulletin and are available
from the Superintendent of Documents, United States Government Printing Office, Washington, D.C. 20402.
The principal author of these regulations is Caroline E. Hay, Office of the Associate Chief Counsel (Passthroughs and Special
Par. 2. Section 1.108–7 is amended by:
1. Removing the language “§ 1.1366–2(a)(5)” in paragraph (d)(2)(iii) and adding “§ 1.1366–2(a)(6)” in its place.
2. Adding two sentences to the end of paragraph (f)(2).
§ 1.108–7 Reduction of attributes.
(2) * * * Paragraph (d)(2)(iii) of this section applies on and after July 23, 2014. For rules that apply before that date,
see 26 CFR part 1 (revised as of April 1, 2014).
Par. 3. Section 1.1366–0 is amended:
1. By redesignating the entries in the table of contents for § 1.1366–2(a)(2), (a)(3), (a)(4), (a)(5), and (a)(6) as § 1.1366–2
(a)(3), (a)(4), (a)(5), (a)(6), and (a)(7), respectively, and adding new entries for § 1.1366–2 (a)(2) and (a)(2)(i) through
2. By revising the heading in the table of contents for § 1.1366–5.
§ 1.1366–0 Table of contents.
§ 1.1366–2 Limitations on deduction of passthrough items of an S corporation to its shareholders.
§ 1.1366–5 Effective/applicability date.
Par. 4. Section 1.1366–2 is amended by:
1. Removing the language “(a)(3)(i)” in paragraph (a)(1)(i), and adding the
language “(a)(4)(i)” in its place.
2. Removing the language “paragraph (a)(3)(ii)” in paragraph (a)(1)(ii), and
adding the language “paragraphs (a)(2) and (a)(4)(ii)” in its place.
3. Redesignating paragraphs (a)(2), (a)(3), (a)(4), (a)(5), and (a)(6) as
paragraphs (a)(3), (a)(4), (a)(5), (a)(6), and (a)(7) respectively, and adding a new paragraph (a)(2).
4. Removing the language “(a)(3)(i) and (ii)” in newly designated paragraph
(a)(3), and adding the language “(a)(4)(i) and (ii)” in its place.
5. Removing the language “paragraphs (a)(1)(i) and (2)” in newly designated
paragraph (a)(4)(i), and adding the language “paragraphs (a)(1)(i) and (3)” in its place.
6. Removing the language “paragraphs (a)(1)(ii) and (2)” in newly designated
paragraph (a)(4)(ii), and adding the language “paragraphs (a)(1)(ii) and (3)” in its place.
7. Removing the language “(a)(3)(i)” and “(a)(3)(ii)” in newly designated
paragraph (a)(5), and adding the language “(a)(4)(i)” and “(a)(4)(ii)”, respectively, in their place.
8. Removing the language “(a)(5)(ii)” in newly designated paragraphs (a)(6)(i)
and (a)(6)(iii), and adding the language “(a)(6)(ii)” in its place.
9. Removing the language “(a)(4)” in newly designated paragraph (a)(6)(ii),
and adding the language “(a)(5)” in its place.
10. Removing the language “paragraphs (a)(1)(i) and (2)” in newly designated
paragraph (a)(7), and adding the language “paragraphs (a)(1)(i) and (3)” in its place.
(2) Basis of indebtedness—(i) In general. The term basis of any indebtedness of the S corporation to the shareholder means the shareholder’s adjusted basis (as defined in § 1.1011–1 and as specifically provided in section 1367(b)(2)) in any
bona fide indebtedness of the S corporation that runs directly to the shareholder. Whether indebtedness is bona fide indebtedness
to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.
(ii) Special rule for guarantees. A shareholder does not obtain basis of indebtedness in the S corporation merely by guaranteeing a loan or acting as a surety,
accommodation party, or in any similar capacity relating to a loan. When a shareholder makes a payment on bona fide indebtedness
of the S corporation for which the shareholder has acted as guarantor or in a similar capacity, then the shareholder may increase
the shareholder’s basis of indebtedness to the extent of that payment.
Example 1. Shareholder loan transaction. A is the sole shareholder of S, an S corporation. S received a loan from A. Whether the loan from A to S constitutes bona
fide indebtedness from S to A is determined under general Federal tax principles and depends upon all of the facts and circumstances.
See paragraph (a)(2)(i) of this section. If the loan constitutes bona fide indebtedness from S to A, A’s loan to S increases
A’s basis of indebtedness under paragraph (a)(2)(i) of this section. The result is the same if A made the loan to S through
an entity that is disregarded as an entity separate from A under § 301.7701–3 of this chapter.
Example 2. Back-to-back loan transaction. A is the sole shareholder of two S corporations, S1 and S2. S1 loaned $200,000 to A. A then loaned $200,000 to S2. Whether
the loan from A to S2 constitutes bona fide indebtedness from S2 to A is determined under general Federal tax principles and
depends upon all of the facts and circumstances. See paragraph (a)(2)(i) of this section. If A’s loan to S2 constitutes bona
fide indebtedness from S2 to A, A’s back-to-back loan increases A’s basis of indebtedness in S2 under paragraph (a)(2)(i)
Example 3. Loan restructuring through distributions. A is the sole shareholder of two S corporations, S1 and S2. In May 2014, S1 made a loan to S2. In December 2014, S1 assigned
its creditor position in the note to A by making a distribution to A of the note. Under local law, after S1 distributed the
note to A, S2 was relieved of its liability to S1 and was directly liable to A. Whether S2 is indebted to A rather than S1
is determined under general Federal tax principles and depends upon all of the facts and circumstances. See paragraph (a)(2)(i)
of this section. If the note constitutes bona fide indebtedness from S2 to A, the note increases A’s basis of indebtedness
in S2 under paragraph (a)(2)(i) of this section.
Example 4. Guarantee. A is a shareholder of S, an S corporation. In 2014, S received a loan from Bank. Bank required A’s guarantee as a condition
of making the loan to S. Beginning in 2015, S could no longer make payments on the loan and A made payments directly to Bank
from A’s personal funds until the loan obligation was satisfied. For each payment A made on the note, A obtains basis of indebtedness
under paragraph (a)(2)(ii) of this section. Thus, A’s basis of indebtedness is increased during 2015 under paragraph (a)(2)(ii)
of this section to the extent of A’s payments to Bank pursuant to the guarantee agreement.
Par. 5. Section 1.1366–5 is revised to read as follows:
(a) Sections 1.1366–1, 1.1366–2(a)(1), and 1.1366–2(b) through 1.1366–4 apply to taxable years of an S corporation beginning
on or after August 18, 1998.
(b) Section 1.1366–2(a)(2) applies to indebtedness between an S corporation and its shareholder resulting from any transaction
occurring on or after July 23, 2014. In addition, S corporations and their shareholders may rely on § 1.1366–2(a)(2) with
respect to indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a
year for which the period of limitations on the assessment of tax has not expired before July 23, 2014.
(c) Sections 1.1366–2(a)(3) through (7), and this section apply on and after July 23, 2014. For rules that apply before that
date, see 26 CFR part 1 (revised as of April 1, 2014).
Par. 6. Section 1.1367–1(h) Example 5(iii) is amended by removing the language “§ 1.1366–2(a)(2)” in the third and fourth sentences and adding the language “§
1.1366–2(a)(3)” in its place.
Par. 7. Section 1.1367–3 is amended by adding two sentences to the end of the paragraph to read as follows:
§ 1.1367–3 Effective/applicability date.
* * * Section 1.1367–1(h), Example 5(iii) applies on and after July 23, 2014. The rules that apply before July 23, 2014 are contained in § 1.1367–3 in effect prior to July 23, 2014 (see 26 CFR part 1
revised as of April 1, 2014).
Approved May 27, 2014.
(Filed by the Office of the Federal Register on July 22, 2014, 8:45 a.m., and published in the issue of the Federal Register
for July 23, 2014, 79 F.R. 42675)