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Facing Non-Deductible Business Losses? Structuring a Back-To-Back Loan May Provide an Opportunity for Tax Benefits

Has your accountant told you that you have inadequate “basis” to deduct your business losses? Did you know that you can borrow monies and in turn loan the monies to your S corporation, which may create basis? A “back-to-back loan” may help S corporation shareholders create basis, which affords the shareholder with flexibility to deduct his or her otherwise suspended losses. While this may seem simple, it is important to remember that the deductible losses are limited to the amount of the shareholder's basis.

Has your accountant told you that you have inadequate “basis” to deduct your business losses? Did you know that you can borrow monies and in turn loan the monies to your S corporation, which may create basis? A “back-to-back loan” may help S corporation shareholders create basis, which affords the shareholder with flexibility to deduct his or her otherwise suspended losses. While this may seem simple, it is important to remember that the deductible losses are limited to the amount of the shareholder's basis.

What is a back-to-back loan?

A back-to-back loan involves a shareholder borrowing from an unaffiliated lender, typically a bank. The shareholder then loans those funds to the business. The loan from the shareholder to the corporation is evidenced by typical commercial loan documentation and similarly collateralized. The repayment of the indebtedness of the back-to-back loan should mirror the loan structure.

Using a back-to-back loan to create basis

There are certain requirements that must be met in order to use the back-to-back loan to create basis. The shareholder must obtain the loan from an unaffiliated third party, as obtaining the loan from a related party will not allow the shareholder to establish that he or she has made an economic outlay in the business. An economic outlay represents that the shareholder was made “poorer” in a material sense, which may allow the shareholder to then deduct losses which were suspended due to inadequate basis.

The corporation must repay the shareholder, and then the shareholder must then repay the third party lender. If the repayment order is not followed, the shareholder is in jeopardy of having his or her basis challenged. Without basis, the shareholder cannot deduct business losses. Moreover, the shareholder must be aware of potential income tax consequences when the loan is repaid.

Common mistakes in back-to-back loan structure

Case law has generally held that the indebtedness must be owed to the shareholder, not to a related entity. The IRS has not issued a definitive regulation on the use of back-to-back loans. In Miller v. Commissioner (in which the author of this article represented the taxpayer), the court provides direction for shareholders; Miller also addresses potential pitfalls.

Back-to-back loan mistakes

  • The loan to the shareholder was made by an affiliate of the shareholder or the company rather than an unaffiliated source.
  • The corporation did not pay market interest as documented in an interest bearing promissory note.
  • The loan repayment skipped the shareholder and went directly to the lender from the corporation.

The use of back-to-back loans can have significant benefits for your business. However, caution is appropriate as there is a trap for the unwary who fail to properly structure the loan or recognize the potential income tax consequences to the shareholder upon repayment of the loan. To learn more about how you can use back-to-back loans, contact Brett Miller, 

  • Partner

    Brett J. Miller serves as Co-Leader of the Federal Tax Team. He is a member of the firm's Tax & Employee Benefits Department and Real Estate Practice Group. Mr. Miller’s tax controversy practice focuses on both federal and state tax ...

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