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Why I Like Credit Card Debt in a Small S Corporation

downloadThe tax advantages of organizing as an S corporation or an LLC electing to be treated as an S corporation are significant. Self-employment taxes disappear with the corporate structure and with an S corporation there is no income tax either as all profit flows to the owners. As with all good things, there are pitfalls. The S corporation is no different.

Most small businesses in my office use the S corporation structure. There are a few rules that need to be followed, like the owners paying themselves a reasonable wage. The wage issue is easy to handle; I require S corporation clients to do their payroll in my office. Problem solved.

The other major issue with S corporations is basis. Before your eyes roll back in your head, hear me out. Basis is one of those animals many accountants screw up on or fail to track accurately. You need to have a fundamental understanding of basis if you are business owner. If your accountant messes it up the IRS still sends you the bill, not the accountant.

What is Basis?

Before we manage basis we need to know what it is. In this instance we are not talking about basis in a single asset. Our discussion focuses on your basis in your business. Basis in this instance is:

Initial investment

+Additional investments

+ Profits

– Distributions

– Losses.

It gets a bit more complicated, but we are a family blog so we will not talk dirty. There are two types of basis you need to understand in an S corporation: stock basis and debt basis.

Stock basis in its most basic form is the formula above. Debt basis comes from money you personally lend to the S corporation; loans by the S corporation guaranteed by an owner does not increase debt basis. Partnerships gain debt basis when the business takes out a loan and the owner is liable for the debt. It is common for businesses to get a bank loan where the bank demands a personal guarantee. With partnerships and sole proprietorships there are no issues doing this.

Example: Let’s say you are one of two partners in a partnership. Each partner owns 50% of the business with a stock basis of $10,000 for each partner. The partnership has an opportunity to promote the company with lots of potential, but it is expensive. By growing your firm the partnership will incur a loss of $25,000 in year one. To cover the loss the partnership gets a bank loan for $5,000 and each partner guarantees the loan.

Each partner will have a $12,500 loss to report on their personal return. Because each partner is liable for their portion of the debt, they can use the complete loss against other income on their personal return. If they don’t have other income to reduce they may have a net operating loss (NOL) which can be carried back two years and forward twenty years to offset other income.

Problems with S Corporations

S corporations suffer from the way debt basis is handled. The above example is simplified. Sole proprietors are indistinguishable from the owner and therefore there is technically no debt basis; debt acquired by the business is a debt of the owner. That is not always the case with S corporations or partnerships.

Non-dividend distributions from an S corporation are made from equity basis without regard to debt basis. At first glance it might be hard to see the problem. Time for an example:

The two partners above instead decide to organize as an S corporation (or are an LLC electing to be treated as an S corporation). The first year is the same as the above example for the S corporation with the exception of the debt being lent personally from the owners equally. The next year the company breaks even. (I’m keeping this simple for illustration.) Since the owners have personal bills they decide they will have the company borrow an extra $50,000 and distribute $25,000 to each owner. The owners guarantee the loan.

Each owner has no debt basis or stock basis! Distributions are made from equity basis only in an S corporation. After the company suffered a loss the prior year sending each owner’s equity basis to zero, all distributions are now taxed as a long-term capital gain (assuming they owned the company longer than one year)! In effect, you are taxed on borrowed money!

There are other issues (suspended losses, et cetera) we will not discuss today. My point is small business owners can save a lot of taxes with an S corporation, but handled incorrectly can create some nasty tax problems. Let me say it this way: Never, ever, ever have your S corporation borrow money from anyone other than you. It solves all the problems.

img_20160928_075441The Right Way to Fund an S Corporation

Okay, not all problems. Businesses need working capital or loans for capital equipment or improvements. Few companies, especially in the early year, are self funding. So how does an S corporation beat the problems of distributions and equity basis?

Simple. Well, simple in theory, difficult in practice. The easiest way around the basis issue in an S corporation is to borrow the money from the bank yourself and then turn around and borrow the S corporation the money. Now you have debt basis. After profits/gains are added to stock basis, distributions are subtracted, then losses. Since distributions are applied to stock basis before certain losses we don’t have long-term capital gain taxes to pay in most cases or other nasty tax surprises.

Then tax time comes around and you bring in your books with new bank debt. I explain the situation and with a million dollar smile you tell me it is okay, you guaranteed the loan. It’s not okay!

The lesson to learn up to this point is: Your S corporation should only borrow money from you, the owner. Each owner wanting to increase debt basis needs to borrow to the firm directly, not a loan guarantee. Bank loans to an S corporation guaranteed by owners does not increase debt basis so losses are suspended once stock basis is used up and further distributions are taxed as a capital gain.

Credit Cards

The problem described above seems to crop up every year. It has gotten to a point I need to find solutions clients will understand. Basis workshops for accountants usually extend for two or three days; the topic is that intense. I have to boil this complexity down into something digestible for my clients.

For my smallest S corporations I have stumbled onto a solution that helps a few clients stay on the straight and narrow. When the owner goes to the bank the bank wants to lend to the business with the owner’s guarantee by default. Credit cards are usually different. Most credit cards are in the name of the owner only. Since many credit cards now offer interest free loans with only a 2% fee, the cost of short-term borrowing is low. By using the credit card for working capital or as a line of credit, the owner gets funding for her S corporation by borrowing to her S corporation directly via the credit card, thereby increasing her debt basis and avoiding negative tax consequences.

Of course, the same goal is reached if the business owner takes out the loan and the S corporation guarantees the loan. This is a foreign concept to many bankers. It shouldn’t be. It protects their interests, too. (Reread the first sentence. Instead of the S corporation taking the bank loan guaranteed by the owner, turn it around. Have the owner take the loan and if the bank wants a guarantee from the business it is okay.)

Many business owners use credit cards for day-to-day expenses and bills. I am always relieved when the credit card is in the individual’s name and not the S corporation’s. It gives me an out when preparing their taxes. Bills paid on a personal credit card are really a de facto loan to the S corporation. I like that. Now we need to have some paperwork to account for the loan to the S corporation which we can prepare in-house.

Parting Shot

Basis calculations are extensive. I run basis worksheets on every business in my office. In some cases, money borrowed by the S corporation causes no problems. Sometimes it only causes suspended losses to be used later unless the stock is sold; then the losses are lost, never deductible. (There are ways to avoid that too.) If I were an IRS auditor I would pull every S corporation with a loss. It is low-hanging fruit for the IRS. Too many accountants and virtually no taxpayers understand the S corporation consequences of equity and debt basis.

There is one take-away from this post: Never let your S corporation borrow money from anyone other than owners. The owners borrow from the bank and in turn lend to the S corporation. It makes your accountant’s job much easier. And your life less taxing.


Note: If you are prone to insanity you can dig deeper into S corporation basis issues here. I focused on one issue today; basis is far more involved than one simple issue. Even the IRS link provided is a simplification. I have a book on my shelf at the office on S corporation basis; it is over two inches thick.


Sunday 9th of February 2020

Keith, i have a s corp.i own 100% myself,i use 0% loans from my personal credit cards to my personal checking first,then write a check to my company as a loan from me.Example $20,000 @3% fee $600 ok cost of doing business for 18 to 24 month @ 0%. The company pays back the loan principal only every month until the due date and then pays off the balance to $0.i have been doing this for 18 years it's a cheep loan principal only minimum only or more if i want to. Enjoyed your article on s corp. THANKS MICHAEL

Harvey Greenfield

Monday 5th of November 2018

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Keith Taxguy

Tuesday 6th of November 2018



Friday 3rd of August 2018

Thank you for addressing this issue! It is all too common for S-corp owners with cash flow issues to pull funds from wherever they can, for the lowest cost, without regard to how it affects their debt basis. My question is: does the shareholder have to make the payments to the credit card personally? The IRS guidelines state that it is not enough for a shareholder to personally guarantee the debt, they must also make the payments. If this is the case, how would the book entries work?

For example, the personal credit card is added to the S-corp's balance sheet. Deductible expenses on the card are categorized as business expenses, and the balance on the card grows. Then the shareholder makes a payment to the card personally. How do you reflect this payment on the books? You will need to enter the payment in order to reconcile and show an accurate account balance. Would the payment be categorized as a loan from shareholder? If so, then wouldn't their debt basis at the end of the year be limited to the amount they actually paid to the card personally? (and not the actual credit card balance, if different). And if so, how does the s-corp repay the loan correctly?

Thanks for any help. Unfortunately there doesn't seem to be a lot of guidance on this issue even though almost every S-corporation I prepare uses shareholder's personal credit cards. (everyone wants their credit card rewards - very few of them actually gain anything from the rewards after annual fees and finance charges, but that's a separate frustration)

Keith Taxguy

Friday 3rd of August 2018

Aaron, S-corp debt basis is an incredible problem virtually everyone misses, including the professionals. On to your questions.

Payments to the credit card must be made by you! Here is how to record transactions: Expenses put on the credit card are a loan from shareholder and should be recorded as such on the balance sheet as a liability of the entity. The S-corp then reimburses you for the expense which pays off the S-corp's liability in the loan from shareholder account. Then you make the credit card payment. This gives you a squeaky clean paper trail for tax purposes. The credit card isn't listed on the books of the S-corp; it's on your personal financial statement! You lend personally to the S-corps, no one else, ever. That guarantees basis for any situation and avoids the distributions and tax related problems, including restoring basis.

Juda Weber

Tuesday 3rd of July 2018

Thanks Keith for the informative article.

"unless the stock is sold; then the losses are lost, never deductible. (There are ways to avoid that too.)"

Can you please provide some info how we can avoid not to lose the suspended loses from an S Corp when the stocks are being transferred?

Keith Taxguy

Tuesday 3rd of July 2018

Juda, I think you are referring to basis issues; correct me if I'm wrong. Losses are never really lost. When profits show up the accumulated unused losses are taken. If the business shuts down without a gain to offset, you have a capital loss (Schedule D limited to $3,000 per year or 4797 limited to $50,000 per year, depending on the facts and circumstances). I assume suspended losses occurred because the S corp took a loan. If you guaranteed the loan you deduct the capital loss as you make payments on the guaranteed loan for the S corp, increasing your basis in the process.

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[…] for employers. Business credit cards usually don’t report on individual credit reports. However, many small business owners use personal credit cards and in my opinion should to avoid a nasty tax surprise connected to basis […]