United States

Proposed regulations could affect subchapter S status


Corporate inversions and the related erosion of the domestic tax basis have been hot topics recently. In an attempt to address the issue, the Treasury released proposed regulations that would in certain circumstances give the IRS the ability to recast related-party debt as equity (or as part debt and part equity).

Although these rules are meant to address inversions, they could have serious implications for S corporations that have borrowed money from related parties, even if the S corporation has no international activity.

Consider a situation where an S corporation borrows money from a related S corporation. If any portion of the loan were recast as equity, the borrower’s subchapter S status would be jeopardized because it would then have an ineligible shareholder and likely a second class of stock. In the case of large S corporations, these proposed regulations would require extensive recordkeeping to avoid reclassification. But even for smaller S corporations, these proposed rules would give the IRS the ability to recharacterize debt without regard to whether the entity has any international operations.

This proposal has caused significant angst within the S corporation community. Fortunately, recent indications from the Treasury suggest the regulations may not be finalized until later this year because of a desire to take some of these concerns into account, including the issues related to S corporations.

As these regulations take final form, S corporations will need to assess whether any related party debt could be impacted and possibly restructure that debt accordingly to avoid putting the entity’s S election at risk.

Jerry Kissell