Single-Shareholder S Corporation: Debt Basis, an Over-Distribution, and No Salary

Ordering rules (Reg. 1.1367-1 and 1.1366-2): income increases basis; distributions reduce basis; losses and deductions reduce basis last. Basis cannot go below zero. Losses limited by stock basis flow to debt basis (only bona fide loans the shareholder actually made - basis is restored only to the extent of the debt's face, and reduced only by losses actually allowed). Distributions in excess of stock basis are gain from the sale or exchange of property, not dividends, because there is no accumulated E&P.

Basis roll-forward

Year	Event	Stock basis	Debt basis	Suspended
20X1	Contribution / loan	100,000	150,000	-
20X1	Loss 60,000	40,000	150,000	0
20X2	Loss 90,000	0 (40,000 absorbed)	100,000 (50,000 absorbed)	0
20X3	Distribution 40,000	0	100,000	0
20X3	Loss 110,000	0	0 (100,000 absorbed)	10,000
20X4	Income 80,000	80,000	0	0
20X4	Suspended loss released	70,000	0	0

Key conclusions.

1. The 20X3 loss is deductible only to the extent of $100,000 of remaining debt basis; $10,000 is suspended and carried forward.
2. The $40,000 November 20X3 distribution was made when stock basis was already zero, so it is $40,000 of capital gain, not a tax-free return of capital.
3. The 20X4 income first increases stock basis to $80,000, permitting the $10,000 suspended loss to be deducted; ending stock basis is $70,000. Debt basis is not restored by income while stock basis is being rebuilt.
4. The personal guarantee does not create basis. A shareholder guarantee of a third-party loan is a contingent obligation; basis arises only when the shareholder actually pays and the debt becomes worthless.

The substantive issue. Distributions to a shareholder-employee who performs substantial services are recharacterized as wages to the extent of reasonable compensation. Courts apply the intent and reasonableness tests, and the IRS has consistently prevailed where a shareholder took only distributions. The compensation study sets reasonable compensation at $120,000 per year, so the IRS will treat roughly $120,000 of what Priya received (and, if distributions were less than that, will still assert the wage obligation) as wages.

Exposure by year. Exposure runs for each open year - generally three years from the return due date or filing date, but six years where gross income was understated by more than 25%, and the employment tax assessment period under section 6501 is also extended in failure-to-file situations. Because no Forms 941 were ever filed, there is no statute running on the unfiled returns; the exposure effectively reaches back to the first year of operations and any year the corporation failed to file.

Amounts.

• FICA: 15.3% of $120,000 = $18,360 per year (12.4% Social Security capped at the wage base; 2.9% Medicare with no cap), split between employer and employee shares, plus Additional Medicare Tax withholding on wages above $200,000.
• FUTA at 0.6% net of the state credit on the first $7,000 = $42 per year.
• Federal income tax withholding that should have been withheld.

Penalties and collateral effects. Failure-to-deposit penalties under section 6656 (2% to 15% depending on lateness), failure-to-file and failure-to-pay penalties, and the section 6672 trust fund recovery penalty assessed personally against Priya for the employee share she willfully failed to withhold. W-2 penalties under sections 6721/6722 apply. Recharacterization reduces ordinary income passed through on the K-1 but increases wages and payroll tax cost, and it eliminates the basis for retirement plan contributions and payroll-taxed Social Security benefits. The corporation also loses the ability to deduct the amounts as wages unless paid and reported, and the deductions for the reclassified amounts offset only part of the FICA cost.

The guarantee does not create basis now. Section 1366(d) limits losses to the shareholder's basis in stock and in indebtedness of the corporation to the shareholder. A guarantee is not indebtedness of the corporation to the shareholder; it is an obligation to a third-party creditor. The shareholder obtains basis only when called upon to pay, and then only to the extent of the payment (Reg. 1.1366-2(a)(2)). Because the corporation is current and Priya has paid nothing, the $10,000 suspended loss remains suspended and the $200,000 guarantee contributes nothing to basis, nothing to the at-risk computation, and no passive activity relief.

If she pays $50,000 on the guarantee. Paying the bank creates $50,000 of basis in the corporation's debt to her - but only if the payment is not merely a voluntary capital contribution and she has subrogation or other rights against the corporation. The newly created debt basis allows the $10,000 suspended 20X3 loss to be deducted in the year of payment (subject to the at-risk and passive activity rules, which are satisfied for a working shareholder). The remaining $40,000 of basis stays available for future losses and is recovered tax-free as the corporation repays the debt, with any unrepaid amount deductible as a worthless debt under section 166(d) as a short-term capital loss for a noncorporate holder.

Practice point. The written note for the original $150,000 loan matters: a loan without a note, market interest, and repayment terms risks being recharacterized as a capital contribution, which would have eliminated the $100,000 of loss deductions taken in 20X2 and 20X3. Advise documenting future advances the same way.