The IRS has issued draft instructions[1] to go with the Draft Schedule K-1[2] issued in July and Draft Form 1120-S[3] issued in August. The draft instructions contain information on the new items G (related to stock ownership) and H (related to loans from shareholders) added to this year’s K-1, as well as a discussion of expenses paid with forgiven Paycheck Protection Program (PPP) loan proceeds.

The term shareholder should be taken to mean the shareholder of the corporation or members of the shareholders family. These rules exist to prevent shareholders of private companies from taking out a series of back-to-back loans and avoid personal income tax altogether. General Tax Rule For Shareholder Loans. Each month, the IRS provides various prescribed rates for federal income tax purposes. These rates, known as Applicable Federal Rates (or AFRs), are regularly published as revenue rulings. The list below presents the revenue rulings containing these AFRs in reverse chronological order, starting with January 2000. Enter a term in the Find Box. The mis-assignment as shareholder loan did not affect equity but created a false liability, actually lowering your balance sheet values If you started your business with $10,000 cash from personal funds you record as Member Contribution and your Equity is $10,000.

Schedule K-1, Item G, Number of Shares

In 2020 the shareholder’s K-1 will report the number of shares held by the shareholder at the beginning and the end of the year. The instructions provide the following information about reporting for this item on each shareholder’s K-1:

Report the number of shares for purposes of allocating items of income, loss, or deduction at the beginning and end of the S corporation’s tax year. An entity without stock, such as an LLC, should enter the number of units or other equivalent to S corporation stock (including ownership percentages).[4]

In this case, the IRS provides an example of reporting these amounts:

Example. If shareholders X and Y each owned 50 shares for the entire tax year, enter 50 in item G for both the beginning and ending amounts for each shareholder. However, if A and B each owned 50 shares of stock for the first half the tax year and C purchased 10 shares of A’s and B’s stock during the year, A’s and B’s beginning of tax year number of shares is 50, while C’s is 0, and the end of tax year number of shares for A and B is 40, while C’s is 20.[5]

Presumably the IRS will use this information to help identify situations where it appears that allocations have not been properly made on a per-share basis to the K-1s, as well as cases where there may have been a disposition of shares that the shareholder should have reported as a sale or exchange on their individual return.

Schedule K-1, Item H, Debt Owed to Shareholders

The Schedule K-1 will now ask for the balances for debts owed to the shareholder at both the beginning and end of the tax year. The instructions provide:

Report the amount of debt owed by the S corporation directly to the shareholder as of the beginning and end of the S corporation’s tax year. Generally, the amount reported on Schedule L, line 19, Loans from shareholder, should reconcile to the sum of all amounts reported on Schedules K-1. Do not include amounts for which the shareholder is a co-borrower or guarantor of corporate level debt. Also do not include any intercompany debt.[6]

This information will likely be used by the IRS to identify issues related to shareholder loans and basis in the S context. It also now explicitly tells those preparing the K-1 that the amounts on the individual K-1s should reconcile to the total shareholder loans reported on Schedule L, as well as reminding those preparing the K-1 that the loans do not include loans from a third party that the shareholder has guaranteed or is listed as a co-borrower on.

Expenses Related to PPP Loans

The instructions for preparing the Form 1120-S also bring up the IRS’s position, found in Notice 2020-32, that a taxpayer is not allowed to deduct expenses paid with proceeds from a forgiven PPP loan.

Expenses related to a forgiven Paycheck Protection Program (PPP) loan. If the corporation received a PPP loan under section 7(a)(36) of the Small Business Act, no deduction is allowed for an expense if the payment of the expense results in forgiveness of all or part of the loan and the income associated with the forgiveness is excluded from gross income. Reduce any deductions reported on Form 1120-S, including deductions being passed through to shareholders using Schedule K, by the amounts that can’t be deducted as a result of a forgiven PPP loan. For more information, see Notice 2020-32, 2020-21 I.R.B. 837, available at IRS.gov/irb/ 2020-21_IRB#NOT-2020-32.

The IRS does not explicitly address the situation when a return is being prepared and no PPP forgiveness final decision had been obtained from the Small Business Administration prior to the end of the tax year of the corporation. However, the wording is not inconsistent with the position it is reported that the IRS plans to take regarding such payments—that they are not to be deducted if the taxpayer expects such a payment to result in forgiveness of a portion of the PPP loan, regardless of whether such forgiveness has been requested or received by the end of the tax year.

[1] 2020 Instructions for Form 1120-S (Draft), November 17, 2020, https://www.irs.gov/pub/irs-dft/i1120s--dft.pdf (retrieved November 18, 2020)

[2] Schedule K-1 (Form 1120-S) (Draft), July 2, 2020, https://www.irs.gov/pub/irs-dft/f1120ssk--dft.pdf (retrieved November 18, 2020)

[3] Form 1120-S (Draft), August 31, 2020, https://www.irs.gov/pub/irs-dft/f1120s--dft.pdf (retrieved November 18, 2020)

[4] 2020 Instructions for Form 1120-S (Draft), November 17, 2020, p. 23

[5] 2020 Instructions for Form 1120-S (Draft), November 17, 2020, p. 23

[6] 2020 Instructions for Form 1120-S (Draft), November 17, 2020, p. 23

Author: LegalEase Solutions

Introduction

You have asked us to research how the Internal Revenue Service treats loans made to an officer/shareholder of a company in which the loan is not supported by a promissory note, and whether the IRS deems such a transfer to be compensation, rather than as a loan receivable. You have also asked us to research what criteria are used by the courts to determine whether such a transfer can be classified as a loan rather than compensation, as well as the nature of the burden and proofs necessary for that result. These issues require discussion of:

The Internal Revenue Code
Applicable case law/Tax Court Memos

Discussion

The Internal Revenue Code

26 USCS § 61 sets forth the Internal Revenue Service’s definition of gross income:

Irs Loans From Shareholders Pay

(a) General definition. Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(4) Interest;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Alimony and separate maintenance payments;
(9) Annuities;
(10) Income from life insurance and endowment contracts;
(11) Pensions;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust.

Thus, loans or advancements do not constitute gross income as the term is specifically defined by the Internal Revenue Code. Likewise, a return of capital invested in a corporation by a stockholder does not constitute gross income as articulated by the Code. It is therefore necessary to examine case law to determine the standard used to classify a transfer of funds from a company to an officer/shareholder as either a loan or as compensation, which in turn dictates whether the amount must be included in the taxpayer’s gross income.

Applicable Case Law