No Basis for Capital Contributions to S Corps

6/9/2011

By Mark Corey, CPA

In 2010, the Second Circuit Court of Appeals affirmed a Tax Court case that denied restoration of basis in shareholder loans to an S-corporation after the shareholders contributed capital to the S-corporation. The Supreme Court has declined to review the case. Code section 1367 says that a shareholder's basis in their stock or debt to the S-corporation is adjusted for "their share of income, losses, deductions and credits" of the S-corporation. The shareholder's basis in stock and loans to the S-corporation are reduced (but not below zero) for their share of losses and deductions. In later years, if the S-corporation shareholder has income, it goes to restore the basis in their loans before increasing the basis in their stock.

In this case, the S-corporation shareholders treated capital contributions made to the corporation as income to the S-corporation, which restored their debt basis in loans they had made to the corporation. The shareholders then used the restored debt basis to offset the ordinary income from the S-corporation making payments to them on their loans.

The IRS disagreed with this treatment, taking the position that the contributed capital increased the shareholder's basis in their S-corporation stock, did not restore their debt basis and it was not income to the S-corporation. The shareholders tried to argue that the capital contributions were tax-exempt income and thus could restore debt basis in loans to the corporation. The Tax Court disagreed, stating that Regulation 1.118-1 does not allow capital contributions to be treated as income to the S-corporation.

On appeal, the S-corporation shareholders tried to argue that capital contributions were items of income per §1366(a)(1)(A). The shareholders relied on a reading of §118 that excludes capital contributions from income, arguing that there would be no need for this exclusion if capital contributions were not some type of tax exempt income under §61. The Appeals Court stated that a reading of that code section in that way was a stretch, and not in keeping with case law that firmly stands for the principle that capital contributions are not income to the S-Corporation.

Since the Supreme Court chose not to review the Appeals Court case, it appears that the issue of capital contributions not being income to the S-Corporation is now settled law - even though most people thought it was settled before this case.