Only 2 Shareholders in this S-Corp. Shareholder #1 81%, Shareholder #2 19%.
Shareholder #2 dies leaving $82,000 note receivable on the balance sheet. Shareholder has no basis. Shares of Shareholder #2 are transferred to Shareholder #1. Shareholder #1 will now be 100% Shareholder. How should this uncollectible Note Due to this S-Corp be handled???

On the death of your S corp shareholder, the shareholder's estate . the deceased's heirs will get a step-up in basis in the N/R to the fair market value of the N/R as of the date of death. While this occurrence can create some significant tax benefits, the situation can also create some significant problems.
These problems stem from the difference between the corp's inside basis in its assets and the outside basis in the shareholder's . If, after the shareholder's death, there is a sale of S corp's assets, unfortunate tax problems may arise unless the corp liquidates in the same year.
While it is clear that the basis in a deceased shareholder's stock gets stepped-up to the date of death FMV( in this case the deceased's inside basis is Zero as you said there is no basis for the deceased shareholder), what happens to the S corp's basis in the corporate assets is "nothing." Because the corp does not die, there is no step-up in the corporation's basis in its assets. Hence, there is a potentially substantial difference between the corp's basis ,the "inside" basis, in its assets and the shareholder's stock basis ,the "outside" basis. A sale of all or part of the corporation's assets can create a potential problem.

Thanks so much for the reply. It is unclear as to how can I remove the Uncollectable Note Receivable from the balance sheet. Will it now be considered a bad debt? Is it considered income to the deceased shareholder? The company has very little value, been in business since 2008 and they are just hanging on. Did make a small profit in 2014.
How do I resolve this? Appreciate your help!

Thanks so much for the reply. It is unclear as to how can I remove the Uncollectable Note Receivable from the balance sheet. Will it now be considered a bad debt?=========>it is Uncollectible N/R, sorry my bad;

Is it considered income to the deceased shareholder? ======>Not income as it is uncollectible; it is a loss to the heirs/beneficiaries; the S corp assets can be used to repay the deceased shareholder’s loans!
You generally cannot deduct loans made to an S Corp on your personal tax returns. But, if the corp has been dissolved, and the loans cannot be repaid, these loans can be treated as bad debts on your personal tax return with the limitation for capital loss deductions applied , for example, maximum of $3k per year.

Upon death of the principal owner of the S corp, ownership of the deceased owner's N/R is determined by the law of the state in which that owner's estate is administered. The deceased owner's N/R may be transferred according to the terms of a will or by operation of general state inheritance law . Ultimately, the deceased owner's, N/R is transferred to individual heirs or trusts established by the owner ; it is likely either the owner's estate will also qualify as an S corp owner while the estate is being administered Or the heirs of the deceased owner will qualify as S corp owners once they receive N/R from the owner's estate. In both cases, the S corp status of the company is retained. So, Shares of stock , N/R in the S corp are the deceased shareholder's personal property. As the owner dies, his shares become part of his estate and pass to his beneficiaries. The new owner of the stock steps into the shoes of the deceased shareholder. Business can go on as usual because a corp is an independent legal entity that continues to exist even as shareholders change. Proper upfront planning can prevent the deceased shareholder's stock, uncollected N/R from passing to a third party who you don't want to be in the S corp with or who is an ineligible S corp shareholder under the federal tax code.

Thanks, I think I am understanding "somewhat". So in my case the S-Corp loaned the 19% shareholder $82,000 - Shareholder dies before paying back the Note - the Note is now passed on to the estate. The $82,000 stays on the books and will now become a debt to whoever is the beneficiary. I don't see any reason that the beneficiary will be willing to pay this debt which was incurred by another party? If any assets of the S-Corp are sold they can be used to pay down this debt. Then possibly, at some time in the future this Shareholder Loan may be deemed uncollectable to the S-Corp. and at that point be written off as uncollectable?

The estate of the deceased Shareholder will be transferring over all shares to the remaining 81% Shareholder and he will now have ownership of 100% of all shares of the S-Corp. The shares will not be going to a third party.

Have I re-caped this correctly? I can't thank you enough for helping me understand this sticky situation!!

nks, I think I am understanding "somewhat". So in my case the S-Corp loaned the 19% shareholder $82,000 - Shareholder dies before paying back the Note - the Note is now passed on to the estate. The $82,000 stays on the books and will now become a debt to whoever is the beneficiary. I don't see any reason that the beneficiary will be willing to pay this debt which was incurred by another party?======>>Oh I see you mean the S-Corp loaned the 19% shareholder $82,000? I assumed the 19% deceased shareholder LOANED the money to the S corp NOT loaned to the deceased shareholder form the S corp. Misunderstood. Baiscally, I guess the most common way that a shareholder becomes liable for the S corp's debts is by guaranteeing the debt; i guess the S corp is a closely held corp. That guarantee is a contractual agreement that makes the guarantor personally liable to the S corp's creditor on that debt. In your particular case, it is the bad debt for the S corp NOT for the Shareholder; however, IN GENRAL, the deceased shareholder’s guarantee of the S corp's debt/loan will not give the shareholder "basis,"I mean debt/loan basis which is defined as contributions in the form of cash, property, or loans to the S corp ,I mean an amount that becomes the basis against which the shareholder can deduct losses. In this case the IRS will view this as the corp's debt /loan as said above; The tax courts have usually denied a basis increase for the shareholder on debt that is personally guaranteed / co-signed on behalf of the corp and I do not know what the deceased shareholder’s situation was. However, when the deceased shareholder-guarantor pays the S corp's debt in satisfaction of his obligation as a guarantor, he steps into the creditor's shoes and the S corp becomes obligated to the shareholder. In this case, there will be a debt from the S corp to the shareholder when the deceased shareholder makes a payment of the corp's debt to the lender under his guarantee.But as you said, the shareholder did not pay the debt.As shareholders of the S corp do, the S corp ALSO can take a bad debt loss since the loan of $89K becomes uncollectible from the deceased shareholder.If the Sc rop/ debt/loan is non-recourse NOT guaranteed by the deceased shareholder, then, the S corp needs to report the total debts becoming worthless in whole during the tax year, but only to the extent such debts relate to a trade or business activity. Aslongas the S corp uses the cash method of accounting, the corp cannot claim a bad debt deduction unless the amount was previously included in income.

If any assets of the S-Corp are sold they can be used to pay down this debt. Then possibly, at some time in the future this Shareholder Loan may be deemed uncollectable to the S-Corp. and at that point be written off as uncollectable?===>AS mentioned above; then when any assets of the S-Corp are sold .

In your opinion, this non-recourse loan that was never paid by the deceased Shareholder is now considered worthless to the SCorp and should be written off as a bad debt, but only to the extent such debts relate to a trade or business activity. And, if the amount was previously included in income. That is what I was sort-of thinking but wanted other opinions. I can't find any clear IRS ruling on this matter.

One of my concerns are should this uncollected Shareholder loan be reported on the Final K-1. Since it was monies received and not paid back would it be a distribution to the Shareholder. However, that would be considered a Disproportionate Distribution subject to S-Corp disqualification.

Could it be considered Other Income (Line 10) on the Final K-1???

Trying to keep my SCorp client out of trouble with the IRS and trying to do my due diligence for the IRS.

Thanks again - I appreciate any thoughts on this matter.

In your opinion, this non-recourse loan that was never paid by the deceased Shareholder is now considered worthless to the SCorp and should be written off as a bad debt, but only to the extent such debts relate to a trade or business activity. ===>Correct;simply speaking,( I mean I am NOT assuming the deceased S Corp shareholder may increase this adjusted basis because of “indebtedness” of the S corp to him aslongas the indebtedness, shareholder loan, is bona fide or other scenarios or etc.)

UNLIKE my misunderstanding, the loan is not shareholder loan given to the S corp by the deceased shareholder, but it is a loan from the S corp extended to the deceased shareholder before his death I guess.In general, This sort of financing is quite common while funding young S corps/ companies with positive cash flows from the S corp’s own AAA acct. because such firms are still not able to raise debt from banks but need debt anyway to create a tax shield.If this assumption is correct, then, when the loan extended to the deceased shareholder is NOT paid back, then it is bad debt for the corp; the loan from the S corp to the deceased shareholder is the corp’s assets. The loan needs to be recovered so that creditor, the S corp/ other creditor if the loan is NOT from the corp’s AAA as said previously, can be paid.If not, the corp will forgive the loan as its bad debt. Since S corps typically pass corporate profits and losses through to shareholders, who then report on their personal tax returns, the shareholder will have to report the loan as ordinary income on his SCh K1 of 1120S. If the loan is recharacterized as a distribution and the shareholder(or his beneficiaries /heirs) do't have sufficient tax basis in his stock, then a taxable gain will result. Then, the Sc orp also needs to write off the unclollected loan from its book as bad debt. Writing off the debt of N/R means the S corp is taking the asset off its balance sheet as said previously. N/R is in gnenral long-term asset. Consequently, writing off assets causes the corp to incur losses. A typical write-off policy covers tools and methodologies the corp follows to identify borrowers in financial distress, monitor the borrower’s economic situation over time or offer rebates on outstanding balances or etc. When all these efforts are fruitless, the corp may write off the loan of N/R. UNLESS the S corp writes off the loan of N/R , the corp overastae its assets in its B/S. Consequently, writing off assets causes the corp to incur losses. I guess you can contact an enrolled agent or a CPA doing taxes in your local area for more discussion in detail.

And, if the amount was previously included in income. That is what I was sort-of thinking but wanted other opinions. I can't find any clear IRS ruling on this matter.

One of my concerns are should this uncollected Shareholder loan be reported on the Final K-1. Since it was monies received and not paid back would it be a distribution to the Shareholder. However, that would be considered a Disproportionate Distribution subject to S-Corp disqualification. ======.Agreed as mentioned above.

Could it be considered Other Income (Line 10) on the Final K-1???====>As mentioned aboe as ordinary income in box #1 of SCh K1 of 1120S.