When somebody repays a loan, that’s not income to the lender, is it? It can be when a shareholder loans money to an S corporation. New York businessmen Ira and Sheldon Nathel learned that the hard way in court this week. Ira and Sheldon each owned shares in food distributors that were set up as S corporations. When you own an S corporation you may deduct corporate losses on your 1040, but only if you have basis in your S corporation stock or in loans you have made to the corporation (guarantees of corporate debt don’t work).

Yes, there’s a catch. When you take S corporation losses, they reduce your basis — first in your stock, then in your loans. Subsequent income, including tax-exempt income, restores your basis in your debt andr. If you repay a loan with reduced basis, you have taxable income to the extent the repayment exceeds your basis.

At the end of 2000, IRA and Sheldon each loaned $649,775 to one of their S corporations. That enabled them to take losses of $537,228 or so, leaving them with $112,547 in remaining loan basis. That would have been fine if they had waited patiently until S corporation income had restored their basis. Their patience ran out in February 2001, when they repaid the loan in full.

They may have had second thoughts. In August 2001 Ira and Sheldon each made a capital contribution to the S corporation — $537,228, coincidentally. They then took a novel position on their 2001 tax returns. The Second Circuit Court of Appeals takes up the story:

In calculating their 2001 taxes, the Nathels treated their capital contributions… as constituting “tax-exempt income” to the corporations for the purposes of § 1366(a)(1)(A). Therefore, because the Nathels’ bases in their stock previously had been reduced to zero and because their bases in the loans they made to the corporations were also reduced, the Nathels used their capital contributions to restore their bases in the loans pursuant to § 1367(b)(2)(B). Without such an increase in their bases, the petitioners would have been taxed on the ordinary income that would have resulted from the corporations’ repayment of the petitioners’ loans in amounts above the petitioners’ previously reduced bases.

The IRS didn’t buy the idea that a capital contribution was some sort of income. They said a capital contribution increases capital, not debt, and is allocable to stock basis. That meant $537,228 in ordinary taxable income. Unfortunately for Ira and Sheldon, the Tax Court, and now the Second Circuit, continue to recognize the capital/income distinction that has been around for approximately forever.

The economy being what it is (still crappy), lots of S corporation shareholder are going to have basis problems at year end. They should keep a few points in mind:

• Basis is necessary to deduct losses, but it isn’t sufficient – Your basis has to be “at-risk” and you have to clear the maze of the “passive loss” rules.

• Use caution when repaying loans – When you make a year-end loan to your S corporation to enable you to deduct losses, repaying the loan will trigger taxable income until the loan basis is restored by subsequent S corporation income.

• “Open account” loans can be tricky – Regulations split “open account” debt into separate “loans” when the loan amounts exceed $25,000. That means fluctuating open account balances during the tax year can lead to taxable income, even if the balance ends up higher at year end than it was at the start of the year.

• Related party issues – It’s dangerous to borrow from one S corporation you control and loan the funds to another one. The IRS likes to attack such loans as lacking substance.

So Ira and Sheldon get to write some big checks to the IRS. They have the consolation of having $537,228 more basis in their stock, to offset other income somewhere, somehow, someday.

Joe Kristan is a shareholder of Roth & Company, P.C. in Des Moines, Iowa, author of the Tax Update Blog and Going Concern contributor. You can see all of his posts for GC here.