Beware of financing S-corps with bank debt

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An S-corporation and a limited liability company (LLC) are both pass-through entities for federal income tax purposes. This means that the annual net profit or net loss of the entity is passed through to its owners to be reported by such owners on their respective personal income tax returns.

This article’s focus is on entities that generate taxable losses and the ability of an owner to utilize such losses to offset other types of taxable income. In particular, the rules of deductibility of losses coming from an LLC or S-corp is limited to a taxpayer’s “basis” in their ownership interest of the S-corp or LLC, as the case may be. Essentially, “basis” is the owner’s economic investment made and placed at risk, including making a loan directly to the business.

Accordingly, a taxpayer always wants to maximize his or her basis in a business. It’s a changing number that a) goes up when a taxpayer receives an allocable share of net profits, makes a loan or makes a capital contribution, and b) goes down when a taxpayer receives an allocable share of net losses or receives a distribution from the business. If losses exceed basis, then such losses will be carried forward to future years to be deducted when the taxpayer has additional basis.

Unfortunately, although an owner may be economically at risk for a third-party loan guarantee, such risk assumed does not mean the owner gets additional basis under the tax laws when it comes to an S-corp. In fact, therein lies the difference between an LLC and an S-corp, as an owner of an LLC is entitled to get a basis increase for the amount of a personal loan guarantee made to the third-party lender, whereas the S-corp owner does not. This distinction means that an owner of an S-corp should carefully evaluate the proposed structure for any potential financing to fund the business.

Under the tax laws, an S-corp owner would have to be the direct lender (not a third-party lender) to be able to get the basis increase for the amount of a loan. Also, if an S-corp owner used an affiliated entity instead of a third-party bank, the owner would still not be entitled to a basis increase even though the owner is directly at risk for the money lent. The only way to avoid this problem is to have the S-corp owner borrow funds directly from the bank and then, in turn, lend the same funds to the S-corp. This back-to-back loan structure would allow the owner to get a basis increase even though, in substance, third-party funds were used for the financing.

So, if an owner is entering into a business where there are going to be losses funded primarily with bank financing and a loan guarantee, then having an LLC structure in place is a much better choice than an S-corp structure if the owner is expecting to deduct the losses in the early years before becoming profitable.