USA S-Corp Debt Basis walk-away

[DavidCPA in San Jose]

I recently acquired a new client who has become the sole shareholder in his start-up S-Corp, due to the fact that the other shareholder wanted out, and sold his shares to my client for a nominal amount. The departing shareholder was the one financing the business through loans to the S-Corp, so he always had sufficient debt basis to take the distributed losses on his personal return. My client has a low stock basis and a relatively small loan to the S-Corp, which have been far exceeded by accumulated losses. When the departing shareholder left, he walked away from a significant amount of debt owed to him by the S-Corp. The previous CPA made a journal entry to move the shareholder debt to retained earnings at the end of the prior tax year, when the shares were sold to my client. That doesn't sound correct to me. My thought is that it should have been converted to paid-in capital, since the shareholder was effectively converting his debt into stock, then selling the stock at a substantial loss. He may have had personal tax reasons to not formally convert the debt to stock (business bad debt vs. capital loss?), and the prior S-Corp CPA was also his personal CPA, but I am not familiar with his personal tax situation. Perhaps it was done this way because the tax software wouldn't properly handle a conversion to paid-in capital without allocating basis to the remaining shareholder. My concern revolves around the proper treatment on the S-Corp books and what, if any, benefit my client obtains from this individually. I don't believe he gets any additional basis, except for the amount actually paid for the acquired shares (outside stock basis). At that point, his combined basis remains substantially negative, and he will continue to carry the suspended passive losses for future use on his personal return.

Is my approach correct? Does the converted debt move to paid-in capital, but not provide additional basis? Does my client receive any additional basis from the acquired shares, other than what he paid for them? Any input is greatly appreciated.

 

[The Finance Writer]

I think you are correct on both points: (1) your client does not get an increase in basis using the loans of the former shareholder and (2) the debt is converted to paid in capital.

 

[DavidCPA in San Jose]

Thank you very much. Now all I need to do is correct the presentation on the tax return, and educate my client a little more on the inherent restrictions of S-Corps.