AICPA Comments on OPen-Account Debt Proposed …：美国注册会计师协会评开帐了…

AICPA Comments on OPen-Account Debt Proposed …：美国注册会计师协会评开帐了… AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS Comments on Proposed Section 1367(b)(2) Regulations Developed by S Corporation Taxation Technical Resource Panel Laura Howell-Smith, Chair Michael R. Gould, Primary Drafter Approved by S Corporation Taxation Technical Resource Panel and Tax Executive Committee Submitted to The Department of the Treasury and The Internal Revenue Service September 6, 2007 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS Comments on Proposed Section 1367(b)(2) Regulations EXECUTIVE SUMMARY The Internal Revenue Service has proposed amending the section 1367(b)(2) regulations with 1respect to the application of open account debt between shareholders and their S corporations. The proposed regulations would narrow the definition of open account debt and change how basis adjustments are made to such open account debt. Specifically, the proposed regulations define open account debt as shareholder advances not evidenced by separate written instruments for which the principal amount of the aggregate advance (net of repayments on the advances) does not exceed $10,000 at the close of any day during the S corporation?s tax year. If this “running balance” does not exceed $10,000 on any day of the S corporation?s tax year, then the debt will remain classified as an open account debt. If the running balance exceeds $10,000 at the close of any day during the tax year, the entire principal amount of that indebtedness would be re-classified – for purposes of reg. section 1.1367-2 – from an open account debt to indebtedness evidenced by a written instrument effective at the close of the day the running balance exceeds $10,000. This re-classification effectively prohibits the netting of open account debt in excess of $10,000 at the close of the tax year, as illustrated by Brooks v. Commissioner, TC Memo 2005-204 (August 25, 2005). We respectfully submit that, if finalized as proposed, the proposed regulations would present a significant tax compliance burden to a vast number of S corporation shareholders and place many of these shareholders in a very complex and costly situation. In our experience, most shareholders do not use open account debt in a manner similar to that described in Brooks. We suggest rather than adding more complexity to an already complex system, the Service should instead use the tools already at its disposal to prevent the result in Brooks. Specifically, the Service could challenge taxpayers who use tax planning techniques similar to those used in Brooks by evoking economic substance, business purpose and evidentiary arguments. Use of such readily available legal tools to guard against such infrequent techniques would help fight perceived abuses while allowing most compliant shareholders to conduct business in the most business-efficient manner. In the alternative, the Service should consider raising the “running balance” threshold to at least $250,000 (preferably to $1,000,000), and creating grandfather and/or transitional rules for open account debt already outstanding. Finally, the current examples should be changed to better illustrate the results of adopting the proposed regulations. 1 Unless stated otherwise, all references to the “Code” or “section” refer to the Internal Revenue Code of 1986, as amended. “Reg. section” and “prop. reg. section” respectively refer to Treasury Regulations and Proposed Treasury Regulations promulgated thereunder. 1 COMMENTS I. BACKGROUND On April 12, 2007, the Service and the Treasury Department issued a Notice of Proposed Rulemaking (REG-144859-04) proposing to amend the regulations under section 1367 of the 2Code. These proposed regulations employ a two-pronged remedy for the deferral allowed by Brooks v. Commissioner, TC Memo 2005-204 (August 25, 2005). (a)(2)(i) and (ii) would narrow the definition of open account First, prop. reg. section 1.1367-2 debt to include only unwritten advances that are equal to or less than $10,000. To monitor whether an open account debt has crossed the $10,000 threshold, shareholders must maintain a “running daily balance” to determine whether their open account debt exceeds $10,000. If this “running balance” does not exceed $10,000 on any day of the S corporation?s tax year, then the debt will remain an open account debt. Alternatively, if the running balance exceeds $10,000 at the close of any day during the tax year, the entire principal amount of that indebtedness would be re-classified – for purposes of reg. section 1.1367-2 – from an open account debt to a separate (deemed written instrument) debt beginning at the close of that day. Second, prop. reg. section 1.1367-2(d)(1) and (2) would require each shareholder at the end of the S corporation?s tax year to calculate the amount of any net advance or net repayment on open account debt. As such, if a net repayment or advance exists on the open account debt, it must comply with the established general debt basis rules of reg. sections 1.1367-2(b) and (c). As stated above, prop. reg. section 1.1367-2(d)(2)(ii) provides that once an open account debt advances and repayments exceed the $10,000 threshold, the re-classification prohibits the netting of open account debt at the close of the tax year for that debt. The proposed regulations apply to any shareholder advances to an S corporation and repayments on those advances made after the final regulations are published in the Federal Register. II. ANALYSIS AND COMMENTS A. The Preamble to the Proposed Regulations The preamble to the proposed regulations makes several observations as either background or explanation, including the following: , The preamble provides that the taxpayers in Brooks could have permanently avoided income tax related to open account debt: “[Brooks] and the S corporation made these repayments and advances for several taxable years and deferred indefinitely the recognition of income on any repayment of his open account debt.” (Emphasis added.) 2 This Notice was published in the Federal Register at 72 Fed. Reg. 18417 (Apr. 12, 2007) and Correction, 72 Federal Register 260111 (May 8, 2007). 2 , “The Treasury Department and the IRS believe that the concept of „open account debt? as defined in Sec. 1.1367-2(a) was intended to provide administrative simplicity for S corporations but was not intended to permit the deferral allowed in Brooks. The IRS and Treasury Department are proposing these adjustments to narrow the definition of open account debt and to modify the rules for adjustments of basis in indebtedness for the more narrowly defined open account debt.” B. Historical Development of Relevant Provisions A synopsis of the relevant provisions of Subchapter S and its related regulations would be helpful in illuminating the workings of S corporation debt basis, and, in turn, our comments regarding prop. reg. section 1.1367-2. As such, the following four topics will be discussed: , Origins of debt basis; , Restoration of debt basis; , Repayment of reduced debt basis; and , Brooks v. Commissioner 1. Origins of Debt Basis Since 1958, millions of S corporations have passed through items of income, loss, deduction, or credit to their shareholders who report these items at the end of the tax year. These pass-through rules, inspired by the partnership taxation rules, occur by means of a complex, interdependent statutory framework primarily codified in sections 1366, 1367, and 1368. Because the proposed regulations focus on the loss and deduction aspects of S corporation pass-through items, this explanation will take a similar focus. An S corporation?s aggregated losses and deductions may be deducted by an S corporation 3 For this purpose, shareholder only to the extent of the shareholder?s basis in the S corporation.basis may be separated into (1) stock basis and (2) debt basis. To obtain a functional understanding of debt basis, it is first necessary to explain stock basis. A shareholder?s initial stock basis may be determined by several factors. For example, stock basis might be determined by: 4, the initial payment for the stock; 5, the amount contributed to the capital of the corporation; 6, the fair market value of the stock received from a decedent; or 3 Section 1366(d)(1). 4 Section 1012. 5 Sections 351 and/or 118. 6 Section 1014. 3 7. , the basis in the hands of the donor when acquired as a gift An S corporation shareholder?s initial stock basis is similar to how a C corporation shareholder obtains a basis in his shares. This, however, is where the S corporation?s stock basis similarities with C corporations end and begin to resemble, with certain exceptions, partnership tax rules. Similar to section 705 for partnerships, section 1367 provides for certain end of year adjustments to be made to a shareholder?s stock basis. Regulation section 1.1367-1 provides for the ordering of stock basis adjustments as follows: 1) increased for income items and the excess of the deductions for depletion; 2) decreased for distributions; 3) decreased for nondeductible, noncapital expenses and certain oil and gas depletion deductions; and 4) decreased for items of loss and deduction. Thus, an individual?s stock basis typically changes every year as a result of pass-through items. A shareholder?s initial basis in debt from the corporation is generally the lower of the amount 8loaned to the corporation or the purchase price of the debt. Generally, the initial amount of this debt basis may be adjusted in three circumstances: 9, Downward if payments are made on the loan; 10, Upward if an advance is made to an open account debt; or , Downward if stock basis has been reduced to zero and debt basis is used to allow loss and 11deduction items to pass-through to the shareholder. If the third circumstance occurs, subsequent “net increases” in stock basis are first used to restore 12the reduced debt basis to prior amount (discussed below) and then to increase stock basis. Repayment (in whole or in part) of such a loan not only reduces the amount of debt basis available to allow loss and deduction items to pass-through to the shareholder, but also requires 13the shareholder to recognize income (discussed below). 7 Section 1015. 8 Section 1012. 9 Sections 1366(d)(1)(B) and 1012. 10 Brooks v. Commissioner, TC Memo. 2005-204 (2005). 11 Section 1367(b)(2)(A). 12 Id and reg. section 1.1367-2(c)(1). See also, section 1367(a)(2) and sections 1368(b)(1) and (c)(1) (tax-free distributions may only decrease stock basis, not debt basis). 13 See Klein v. Commissioner, 75 T.C. 298 (1980). 4 2. Restoration of Debt Basis Regulation section 1.1367-2(c)(1) provides that if there has been a reduction in debt basis, any “net increase” in any subsequent tax year is first applied to restore that reduction. A net increase is defined as the amount by which the shareholder?s pro rata share of the items described in 14 Subject to section 1367(a)(1) exceed the items described in section 1367(a)(2) for the tax year.two exceptions, the restoration of debt basis is effective at the close of the corporation?s tax 15year. However, if a shareholder has reduced debt basis, the basis restoration rules under prop. reg. section 1.1367-2(c)(1) are effective immediately before either the termination of the shareholder?s interest in the corporation or a disposition or repayment (in whole or in part) of the 16debt. The result is an increased probability that shareholders will recognize less gain from the repayments of debt in tax years when their S corporation generates income. 3. Repayment of Reduced Debt Basis An S corporation shareholder has an economic incentive to be concerned about whether debt basis will be restored under reg. section 1.1367-2(c)(1). This incentive comes from the character of income recognized upon (i) the repayment of a certain type of “reduced basis debt” as compared to (ii) the character of the income used to restore debt basis. To understand this nuance, it is necessary to make a distinction between the two categories of debt that create debt basis: open account debt and written instrument debt. The hallmark identifying an open account debt is that it is an advance from a shareholder to such 17shareholder?s S corporation not evidenced by a separate written instrument. As such, typically the only evidence of an open account debt is the corresponding debits and credits to bank accounts and corporate books. Shareholders will recognize ordinary income upon the repayment 18of a reduced basis open account debt. Critical to this comment, the current law provides that open account debt is unique in that multiple shareholder advances and S corporation repayments 19are treated as a single debt rather than separate debt (discussed below). The reason that the Service allows open account debt to be treated as a single debt may be found in the 1993 preamble to final reg. section 1.1367-2, which provides that, “[i]n response to comments, and for reasons of administrative simplicity, the final regulations provide that all open account debt held 20by a shareholder is to be treated as a single debt for purpose of reducing and restoring basis.” Accordingly, S corporation repayment of reduced open account debt results in ordinary income 14 Reg. section 1.1367-2(c)(1). 15 Id. 16 Id. 17 Reg. section 1.1367-2(a). 18 See section 1275(a)(1); Rev. Rul. 68-537, 1968-2 C.B. 372; Cf. Rev. Rul. 64-162, 1968-2 C.B. 372. 19 Brooks, at 7; Rev. Rul. 68-537, 1968-2 CB 372; Cornelius v. Commissioner, 494 F2d 465, 74-1 USTC ? 9,446 (5th Cir 1974), aff'g 58 TC 417 (1972); Barr v. Commissioner, 39 TCM 834 (1980); Brown v. Commissioner, 42 TCM 1460 (1981). 20 T.D. 8508, 1994-1 CB 219, 220. 5 to the shareholders, but the shareholder may mitigate this potential tax liability by netting the repayment of an advance with another open account advance. In contrast to open account debt, the hallmark identifying written instrument debt is that it is memorialized by a formal written instrument. The repayment of a reduced basis written 21 -- either long or short term depending on how long instrument debt will result in a capital gain the shareholder held the debt. Repayments of written instrument debt may not be netted against separate advances. When comparing open account debt and written instrument debt, the following advantages and disadvantages may be summarized: , open account debt has the advantage of allowing the netting of advances and repayments at the end of the S corporation?s tax year and the disadvantage of having repayments on reduced open account debt being treated as ordinary income; , written instrument debt has the advantage of repayments on reduced open account debt being treated as capital gain and the disadvantage of being treated as separate debt, without the ability to net advances and repayments. 4. Brooks v. Commissioner Entering into 1997, the two shareholders (Fleming S. Brooks (51 percent) and Fleming G. Brooks (49 percent)) of the S corporation in question had no basis in their stock or debt. In 1997, the shareholders each lent $500,000 to the S corporation (the “$1 million advance”) and thereby increased their debt basis by such amount. By 1999, each of the shareholder?s debt bases had been used to free support loss flow-throughs. On January 5, 1999, the S corporation repaid the $1 million advance. On December 31, 1999, the shareholders, faced with income from the repayment of reduced open account debt basis and an approximately $600,000 suspended loss, each loaned $800,000 to the S corporation (the “$1.6 million advance”). On January 3, 2000, the S corporation repaid the $1.6 million advance. On December 29, 2000, the shareholders, again facing the dual problem of repayment recognition and suspended losses, decided each to make a $1.1 million loan to the S corporation (the “$2.2 million advance”). See Figure 1 below. 21 Rev. Rul. 64-162, 1964-1 CB (pt. I) 304; Brown v. Commissioner, 38 TCM 886 (1979); Section 1271(a). See thalso Cornelius v. C.I.R., 494 F.2d 456 (5 Cir. 1974). 6 Figure 1 981/5/9912/31/991/3/0012/29/0097 19992000 1997-1998$600K debt basis $600K debt basis $1M debt basis used for lossesused for lossesused for losses $1M $1M $1.6M $1.6M $2.2M RepayLoanRepayLoanLoan The issue at hand is whether the December 31, 1999, loan of $1.6 million and the December 29, 2000, loan of $2.2 million provided sufficient basis to offset the January 5, 1999, repayment of $1 million and the January 3, 2000, repayment of $1.6 million. Writing for the Tax Court, Judge Thomas B. Wells, after summarizing the repayment and debt basis issues, focused on whether the $1.6 million and $2.2 million advances were a single open account debt or two separate debts. Because the parties in Brooks stipulated that the advances were open account debt and the Commissioner failed to contend that any advance and repayment constituted a separate and closed transaction, the court distinguished Cornelius v. 22 and held the taxpayers were permitted to net advances and repayments to the Commissioner open account at the close of the tax year. Thus, the shareholders did not recognize gain on the receipt of the 1999 and 2000 repayments, and they were allowed to take losses to the extent of their debt basis. C. Description of the Proposed Regulations On April 12, 2007, the Treasury Department and the Service released proposed regulations amending Reg. 1.1367-2 (REG-144859-04). The preamble to the proposed regulations provides that the Service believes “that the concept of „open account debt? as defined in Sec. 1.1367-2(a) was intended to provide administrative simplicity for S corporations but was not intended to permit the deferral allowed in Brooks.” Accordingly, the proposed regulations narrow the definition of “open account debt” and change the rules for how open account debt is adjusted. Under prop. reg. section 1.1367-2(a)(2)(i), open account debt is defined as shareholder advances not evidenced by separate written instruments for which the aggregate principal amount of the advances (net of repayments) does not exceed $10,000 at the close of any day during the S 22th 494 F.2d 465 (5 Cir. 1974). 7 corporation?s tax year. If this “running balance” does not exceed $10,000 on any day of the S corporation?s tax year, then the net advances will remain classified as a single open account debt. Alternatively, if the running balance exceeds $10,000 at the close of any day during the tax year, the entire principal amount of that indebtedness is re-classified from an open account debt to a separate (deemed written instrument) debt, effective at the close of the day the running balance exceeds $10,000. This reclassification has the effect of prohibiting the netting of advances and repayments at the close of the tax year on open account debt in excess of $10,000. If the $10,000 limitation is exceeded, new shareholder advances of open account debt constitute a new open account debt and as such starts a new $10,000 running balance. Proposed reg. section 1.1367-2(d)(2) provides new rules requiring that at the close of an S corporation?s tax year, each shareholder must calculate all open account debt advances and repayments during the year to determine if he has received a net advance or repayment. If there is a net repayment, the shareholder must recognize the payment under the general basis adjustment rules of reg. section 1.1367-2. Alternatively, if there is a net advance, it is combined with the prior year?s open account debt basis balance and carried forward to the next tax year. If on the close of any day on which the shareholder?s running balance exceeds the $10,000 threshold (discussed above), the entire open account debt is re-classified as a separate debt, effective at the close of the day when the threshold is crossed and for the remainder of that tax year and any subsequent tax year. proposed regulations include two examples (discussed below). The The preamble provides that included within the definition of open account debt are separate advances under a line of credit agreement if the advances are not evidenced by a separate written instrument. Also, the preamble explains that the $10,000 limitation was modeled after section 7872(c)(3) and the prop. reg. section 1.7872-9 $10,000 de minimis exception to the treatment of compensation-related or corporate-shareholder loans with below-market interest rates. III. RECOMMENDATIONS We believe the proposed regulations should be withdrawn. If the Service and the Treasury Department do not withdraw the proposed regulations, then they should modify the regulations to (1) significantly raise the running balance threshold and/or change the daily monitoring requirement to a quarterly or yearly period; (2) clarify the effective date; and (3) clarify the treatment of debt repayments, both in terms of the recognition event and the character of that income. A. Primary Recommendation – The Proposed Regulations Should Be Withdrawn The proposed regulations potentially place a tremendous administrative burden on S corporations and their shareholders by complicating compliance. We acknowledge that the Service believes this burden is necessary to shut down a perceived abuse, but this could be addressed through less burdensome means. In that regard, we encourage the Service and the Treasury Department to withdraw the proposed regulation. 8 According to the Treasury Inspector General for Tax Administration?s August 28, 2006, report titled, Filing Characteristics and Examination Results for Partnerships and S Corporations, there were 3.45 million S corporation returns processed in 2004. This makes S corporations the most popular form of corporate entity. Of these 3.45 million returns processed, 54 percent were owned by a single shareholder and 99 percent had assets less than $10 million. Part of this popularity stems from small businesses being attracted to the simple rules of Subchapter S in comparison to those of Subchapter K. Unfortunately, the addition of a complex set of open account debt basis rules will only further burden millions of S corporations and their shareholders. This complexity is ironic considering that the 1993 preamble to final reg. section 1.1367 provides that open account debt would be considered to be a single debt “for reasons of 23 Rather than simplicity, with a low $10,000 threshold, potentially administrative simplicity.” millions of S corporation shareholders will be forced to monitor their “running balance” at the close of every day. We suggest the Service use already available options to address what they perceive as an abuse to prevent the potentially tremendous burden prop. reg. section 1.1367-2 places on small business owners. For example, the Service could have made substance over form arguments in Brooks and any similar case. This is a basic tenet considered by courts. Though the form of a transaction may technically meet the criteria in the Code to qualify for a tax benefit, the court may inquire as to whether the taxpayer has, in other ways, acted consistently with the criteria. Some of the other judicially created doctrines which might be relevant in Brooks include the 2425business purpose doctrine, the sham transaction doctrine, and the economic substance 26doctrine. B. Alternate Recommendations 1. Raise de minimis running balance threshold and/or change requirement of daily monitoring If the Service and the Treasury Department intend to finalize the proposed regulations, we recommend that the “running balance” threshold be increased from $10,000 to at least $250,000 but preferably to $1,000,000. A threshold in this range may be justified based on (1) the numbers in the Brooks case and (2), perhaps more significantly, by the reality that the Service should make it clear to taxpayers falling below the threshold that it will enforce the current open account debt rules in light of the judicial doctrines mentioned above. We also recommend that the daily monitoring requirement be changed to a quarterly or yearly requirement – a much more realistic expectation to place on small business owners. Of the 54 percent of all S corporations that are owned by a sole shareholder, their average operating profit in 2004 was $34,683 after 23 T.D. 8508, 1994-1 CB 219, 220. 24 See, e.g. Gregory v. Helvering, 293 U.S. 465 (1935). 25 See, e.g. Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989). 26 See, e.g. Sheldon v. Commissioner, 94 T.C. 738 (1990). 9 27 Among this particular group of taking an average deduction of $33,853 for officers salaries. shareholders, $10,000 represents just under 15 percent of the combination of yearly profit and officers? salaries. Thus, the $10,000 threshold dictates that the majority of S corporation shareholders may only advance a small portion of their S corporation gross operating revenue to open account debt or else they are burdened with daily monitoring duties and the looming threat and corresponding disadvantages of open debt to separate debt conversion. A threshold of between $250,000 and $1,000,000 presents a sensible balance between furthering the administrative simplicity of open account debt while reducing the risk for abuse perceived by the Service. 2. Provide clarification regarding the applicability of sections 1271 and 1275 to open account debt that exceeds the running balance threshold Although the proposed regulations appear clear as to how it converts open account indebtedness over $10,000 into a separate written instrument, it is not entirely clear whether the deemed written instrument is a debt instrument for purposes of section 1271 and thus achieves exchange treatment. A capital asset, in order to benefit from capital gains treatment, generally must also 28be sold or exchanged. 3. Effective date clarification The proposed regulations provide for the following effective date, “Section 1.1367-2(a), (c)(2), (d)(2), and (e) Example 6 and Example 7 apply to any shareholder advances to the S corporation made on or after the date these regulations are published as final regulations in the Federal Register and repayments on those advances by the S corporation” (emphasis added). It is unclear whether the proposed regulations (in their final form) only apply if two qualifications are met: (i) there is a shareholder advance after the day the final regulations are published; and (ii) there is a repayment of that same advance. If this is the intended reading of the effective date language, the results appear to be that all open account debt prior to the publication of the final regulations would be outside its scope. As such, certain shareholders with open account debt basis would need to create a method to identify and track “new” and “old” open account debt to delineate those open account debts that came before and after the publication of the final regulations. Guidance is needed to clarify how taxpayers should transition between pre- and post-effective date open account debt. The regulations should include an example of pre-effective date open account debt being repaid after the effective date of the regulations in the situation where a post-effective date advance has also been made. We recommend that repayments made after the 27 Filing Characteristics and Examination Results for Partnerships and S Corporations Report Date: Jul 28, 2006 (No. 2006-30-114), 28 See proposed reg. section 1.1367-2(a)(2)(ii). 10 effective date be permitted to be applied to either pre- or post-effective date advances at the parties? discretion. 4. Change the examples to clarify the taxability of certain debt repayments and the character of income upon recognition Prop. reg. section 1.1367-2(e), Examples 6 and 7 should implement the following changes to provide readers with a better understanding of how this proposed regulation would work. Prop. reg. section 1.1367-2(e), Example 6 illustrates how netting principals still apply to open account debt at or under the $10,000 threshold. [See Appendix A for text of Example 6.] Although this example is helpful, prop. reg. section 1.1367-2(e), Example 6(iv) stops short of the most critical fact taxpayers want to know: If I have a transaction like this, how will I be taxed? To answer this question, prop. reg. section 1.1367-2(e), Example 6, should provide an analysis under Rev. Ruls. 64-162 and 68-537. When an S corporation repays part of a shareholder held debt, and that debt?s face amount is greater than its basis, Rev. Ruls. 64-162 and 68-537 provide 29that the basis is apportioned ratably over the full amount due under the note. Here, the conclusion in prop. reg. section 1.1367-2(e), Example 6 should illustrate that $500 of the $1,000 repayment is recognized as capital gain or ordinary income, and the shareholder?s See Figure 2. open account debt basis is reduced from $4,000 to $3,500. Figure 2 Similar to the above example, prop. reg. section 1.1367-2(e), Example 7 ignores important tax consequences to the shareholder/creditor of the advances and repayments. [See Appendix A for text of Example 7.] Proposed reg. section 1.1367-2(e), Example 7 illustrates what happens when a shareholder crosses prop. reg. sections the $10,000 threshold. Although helpful, prop. reg. section 1.1367-2(e), Example 6(iv) misses a significant point: Due to the March 1, 2008, conversion, the April 1, 2008, $3,000 repayment causes the shareholder to recognize $1,000 of 30capital gain or ordinary income and reduce his basis to $5,000. See Figure 3. 29 Certain exceptions apply for speculative notes (see, e.g., Wingate E. Underhill, 45 TC 489 (1966); Joseph J. Weiss, P-H TC Memo ? 65,020 (1965); Neil S. McCarthy, P-H TC Memo ? 63,033 (1963)). 30 Id. 11 Figure 3 Nontaxable return of basis $2,000 $12,000 - $8,000 * $3,000 = $1,000 Gain (ordinary or capital?) $1,000 $12,000 This income recognition and basis reduction occurs because when the March 1, 2008 $5,000 advance is added to the $7,000 open account debt, it exceeds the $10,000 threshold. The open account is therefore converted into (deemed written instrument) separate debt. Although Example 7(v) does illustrate how shareholders may not offset the repayment of a shareholder advance with the basis of another separate shareholder advance, it should go further and provide taxpayer guidance that the $3,000 repayment is generally considered to be a recognition event that will create ordinary (or perhaps capital gain) income recognition and reduce the separate 3132debt?s basis under Rev. Ruls. 64-162 and 68-537. Without these amendments to Examples 6 and 7, the Service fails to fully inform S corporation shareholders of the potential hazards brought about by prop. reg. section 1.1367-2. 31 Rev. Rul. 64-162, 1964-1 C.B. 304 32 Rev. Rul. 68-537, 1968-2 C.B. 372 12 Appendix A Proposed Regulation Section 1.1367-2(e), Example 6: Treatment of open account debt. (i) A has been the sole shareholder in Corporation S since 2000. In 2007, A advances S $8,000, which is not evidenced by a written instrument. The $8,000 advance is open account debt and remains outstanding at that amount during 2007. On December 31, 2007, the basis of A's stock is zero; and the basis of the open account debt is reduced under paragraph (b) of this section to $4,000. On April 1, 2008, S repays $3,000 of the open account indebtedness. On September 1, 2008, A advances S an additional $2,000, which is not evidenced by a written instrument. There is no net increase under paragraph (c) of this section in year 2007 or 2008. (ii) At no time during the 2007 taxable year does the running balance of A's open account debt exceed $10,000. As of December 31, 2007, A's basis in the open account debt is reduced under paragraph (b) of this section to $4,000. (iii) At no time during the 2008 taxable year does the running balance of A's open account debt exceed $10,000. On April 1, 2008, S's $3,000 repayment is applied to A's running balance for open account debt carried forward from 2007 in the amount of $8,000 to reduce the running balance to $5,000. On September 1, 2008, A's advance to S of $2,000, which is not evidenced by a written instrument, is applied to A's running balance to bring A's aggregate outstanding principal on A's open account indebtedness to $7,000. (iv) At the close of the 2008 taxable year, the $3,000 April repayment S makes to A and A's $2,000 September advance are netted to result in a net repayment of $1,000 for the taxable year on A's $8,000 open account debt carried forward from 2007. Because there is no net increase in 2008, no basis of indebtedness is restored for the 2008 taxable year. 13 Appendix B Proposed Regulation Section 1.1367-2(e), Example 7: Treatment of shareholder indebtedness not evidenced by a written instrument which exceeds $10,000. (i) The facts are the same as in Example 6, in addition to which, on February 1, 2008, S repays $1,000 of the open account debt and on March 1, 2008, A advances S $5,000, which is not evidenced by a written instrument. (ii) At no time during the 2007 taxable year does the running balance of A's open account debt exceed $10,000. As of December 31, 2007, the basis of the open account debt is reduced under paragraph (b) of this section to $4,000. (iii) The running balance of A's open account debt does exceed $10,000 during the 2008 taxable year. On February 1, 2008, S's $1,000 repayment is applied to A's running balance for open account debt carried forward from 2007 in the amount of $8,000 to reduce the running balance to $7,000. On March 1, 2008, A's advance to S of $5,000, which is not evidenced by a written instrument, is applied to A's running balance to bring A's aggregate outstanding principal on A's open account debt to $12,000. Because this amount exceeds the $10,000 threshold amount, effective at the close of the day on March 1, 2008, A's running balance must be reconciled to determine an aggregate principal amount of indebtedness. (iv) As of March 1, 2008, S had made a $1,000 repayment on A's open account debt, and A had advanced an additional $5,000 which was not evidenced by a written instrument. To reconcile A's running balance, the $1,000 repayment and $5,000 advance are netted first to result in a $4,000 net advance that is then added with A's existing principal amount of open account debt of $8,000 to determine the aggregate principal amount of indebtedness of $12,000. As of March 1, 2008, S's indebtedness to A that is not evidenced by a written instrument has a principal balance of $12,000 and a basis of $8,000 ($4,000 basis on December 31, 2007 + $4,000 net advance). On April 1, 2008, S repays $3,000 of that new indebtedness. (v) On September 1, 2008, A advances S an additional $2,000, which is not evidenced by a written instrument. The $2,000 advance is considered new open account debt. On December 31, 2008, A's basis in his stock is zero and the outstanding principal in the two remaining debts are as follows: 3/1/08 4/1/08 9/1/08 12/31/08 principal repayment advance principal Indebtedness treated as if evidenced by written instrument $12,000 $3,000 $9,000 Open account debt $2,000 $2,000 14