Open Account Debt & Form 7203
Introduction
Form 7203 places renewed emphasis on the proper calculation and reporting of S corporation open account debt. The Form is designed with a three-part format for calculating a shareholder’s stock and debt basis to properly report available tax losses and the tax effects of distributions and loan repayments. Proper stock and debt basis is essential in order to determine allowable loss utilization and the tax treatment of dividends and distributions. A shareholder’s pro rata share of S corporation losses is limited to the sum of the adjusted basis of the shareholder’s stock and the adjusted basis of any indebtedness of the S corporation to the shareholder.[1] Form 7203 is designed to track the underlying computations for this requirement. This article concentrates on the unique characteristics of open account debt and proper reporting on Form 7203.
The instructions to Form 7203 describe open account debt as “[l]oans made to the S corporation that aren’t evidenced by a written instrument. . . .”[2] The instructions correctly discuss that advances and repayments, made during the S corporation’s tax year with respect to open account debt, are netted and reviewed at the end of the tax year. The net advance or repayment may have tax consequences. A net advance must be added to the balance of the open account debt to determine whether the classification threshold has been exceeded. Once the year-end principal amount of open account debt exceeds $25,000, the open account debt is treated as “a formal note for purposes for calculating the gain on loan repayment.”[3] As discussed more fully in this article, the proper order and timing of the calculations are critical. Close attention must be paid to the proper calculation of any basis adjustments allocated to open account debt. After a shareholder’s stock basis has been reduced to zero, losses are next applied to reduce the basis of taxpayer loans to the corporation. Ordering rules require proportionate debt reduction if a shareholder has multiple loans.[4]
As described in more detail below, gain to the shareholder will result if the S corporation repays any of the reduced basis debt to the shareholder. The IRS has specifically designed Part II of Form 7203 to properly report and segregate open account debt, and to highlight and alert the IRS of any gain resulting from the repayment of reduced basis debt. The form requires that the loan balance at the beginning of year be placed on line 16 and the basis in such debt be reported on line 21—thereby alerting the IRS that any repayment of reduced basis debt (where basis is lower than the reported loan balance) will trigger gain. The instructions to Form 7203 require that any recognized gain, with respect to open account debt, be treated as ordinary income.
Reporting Requirements
The IRS finalized the open account debt regulations in order to curb abuses in debt structuring and repayment. The S corporation and its shareholders must keep proper track of loans and open account debt in order for the shareholder to deduct losses subject to basis limitations, which include shareholder loans to the corporation. [5] The final regulations and Form 7203 require each debt that is evidenced by a written instrument to be treated as a separate debt. Likewise, open account debt whose principal balance exceeds $25,000 at year end, will also be treated as a separate debt.[6] In contrast, the proposed regulations would have required a threshold of only $10,000. Under the proposed regulations, open account debt balances exceeding only a $10,000 threshold would have been required to be classified as separate debt—if the excess arose at any time during the S corporation’s taxable year. These proposed regulations were widely criticized. The final regulations increased the threshold to $25,000 to be determined at the close of the tax year.
Pursuant to the final regulations, Form 7203 is reported and filed by the shareholder. It is the shareholder’s burden to properly isolate and report each debt obligation according to the above rules. Form 7203 contains three columns for three separate debt calculations; the instructions require the use of additional forms if needed. Although the day-to-day monitoring provisions of the proposed regulations were not implemented, the $25,000 threshold has not been increased since the original final regulations were implemented; this results in a reporting burden for many taxpayers. As discussed below, repayment of reduced basis open account debt results in ordinary income.
Debt Characterization
The final regulations declined to address the characterization of income or gain recognized upon repayment of open account debt exceeding the $25,000 reporting threshold. For example, if a shareholder with zero stock basis, loans $100,000 to her S corporation in order to have sufficient basis to deduct $100,000 of S corporation losses, the shareholder would have a zero basis in the debt. If the debt were repaid in the next year, it was unclear whether the shareholder recognizes ordinary income or capital gain on the repayment. The final regulations declined to comment and stated that the issue was under consideration. Without further regulatory comment and procedure, the IRS stated in the Form 7203 instructions that the gain shall be ordinary income.[7] In contrast, repayment of a reduced basis loan, evidenced by a note from the corporation to the shareholder, will generate a capital gain—not ordinary income.[8] Therefore, it may be advisable that all shareholder debt be evidenced by a written instrument, in order to preserve the tax benefits on repayment. In certain instances, it may be advisable to defer or avoid repayments on reduced basis open account debt; as discussed later, it is possible to restore basis previously reduced. Also, prior to year-end, repayments on open account debt may be netted against advances made during the tax year and only the net repayment is utilized to calculate the appropriate income recognition. Another interesting consideration is to evidence all current open account debt by preparing a formal note; however, great care must be taken when considering this option.[9] Further, it may also be possible to contribute the reduced debt to equity of the corporation.[10]
Basis Restoration
Restoration of reduced basis debt may occur only when there has been a “net increase” for the S corporation tax year. For example, this generally occurs where the taxable income of the corporation and the positive basis adjustments related thereto, exceed all negative adjustments. Such debt basis is restored until the original principal amount of the debt is recovered.[11]
Conclusion
Open account debt plays an important role in S corporation taxation, and tax practitioners must be aware of the numerous intricate rules which govern these loans. Detailed accounting requirements have been implemented and will now be more closely monitored by the IRS. Form 7203 has been designed to track stock and debt basis and to alert the IRS when corporate losses must be suspended and when taxable distributions or repayments have occurred. This article highlights some of the more important considerations for CPAs to consider when advising clients and preparing tax returns.
Robert S. Barnett, JD, MS (Taxation), CPA is a founding partner at Capell Barnett Matalon & Schoenfeld LLP, Attorneys at Law, in Syosset, N.Y. His practice areas include business tax planning, estate planning, tax dispute resolution, and Tax Court representation. He can be reached at rbarnett@cbmslaw.com.
[1] IRC § 1366(d).
[2] IRS, Instructions to Form 7203 (Dec. 2022). Treas. Reg. § 1.1367-2(a)(2)(i).
[3] Id.
[4] Treas. Reg. § 1367-2(b)(3) applies the reduction in proportion to debt basis.
[5] See IRC § 1366(d)(1). Partnerships have similar provisions provided in IRC § 704(d).
[6] Treas. Reg. § 1.1367-2(a)(2)(ii). The regulations impose this requirement to eliminate the abuse that occurred in Brooks v. the Commissioner, 2005 T.C. Memo. 204. In Brooks the taxpayer advanced funds, to the S Corporation, at the close of the tax year and repaid those loans at the beginning of the next year. By virtue of this continued circular netting, the taxpayers were able to avoid reporting of income on the repayment of the reduced basis debt.
[7] See Rev. Rul. 68-537, 1968 – 2 CB 372. See also, Cornelius v. Commissioner, 58 TC 417 (06/01/1972).
[8] Rev Ruling 64-162, CB 1964-1 (part 1), 304. The repayment of the note is considered an amount received in exchange for a capital asset.
[9] Tres. Reg. § 1.1001-3, contains many considerations which must be reviewed so the open account debt is not modified to cause immediate gain. Such considerations are beyond the scope of this article.
[10] Although a detailed discussion of the various tax considerations are beyond the scope of this article, shareholder contribution of outstanding debt, for stock of a corporation may be possible. Cancellation of indebtedness rules provide an exception in IRC § 108(e)(6) for shareholder contributions of indebtedness to the S corporation. Similarly, IRC § 108(d)(7)(C), provides that the reduced basis of the S corporation debt shall not be taken into account for these purposes.
[11] IRC § 1367(b)(2)(B); Tres. Reg. § 1.1367-2(c)(1). After the debt basis is fully restored a shareholder’s net increase will be applied to increase the shareholder’s basis in stock of the Corporation. It is important to note that capital contributions cannot increase debt basis, and correspondingly, distributions do not reduce debt basis.