We have a taxpayer with a C corporation (stock owned 50/50 by husband and wife) that loaned $350K to an S corporation (all stock owned by the husband), due to cash flow issues in the S corporation. Both corporation use accrual-basis accounting. The C corporation is an oil company, the S corporation is a tire store. There was no note, and no payments have been made, principal or interest. They now want to get this "loan" off the books for both companies. It appears to me that 1) there is no recourse debt, so the S-corp would not have cancellation of debt income; 2) there was no business purpose for an oil company to loan money to a tire store, and the loan was somewhat informal anyway, so the C corporation can't take a bad-debt deduction; 3) it appears to me that for the S-corp, the note payable amount on the balance sheet would be removed and replaced with the same amount in Additional Paid-in Capital (by a non-shareholder).

4) My most vexing questions have to do with how to remove the note receivable from the C-corp balance sheet, and the tax consequences. Would I enter it as a non-deductible expense, which would then cause a corresponding reduction in retained earnings? Would it have to be treated as a divided to the shareholders because of the common ownership of the 2 corporations? And if so, since the loans were made before 2011, would these adjustments to the balance sheet be made for 2011, or for the year(s) the "loans" were made (if the latter, it would require amended returns for those years, right?). Because of the common ownership, would these transactions in effect be treated as a dividend distribution to the shareholders of the C corporation coupled with a contribution of paid-in capital from a shareholder to the S-corporation?

I think you've zeroed in on the most likely answer, with your concluding question.

Because of the relationship of the parties, on top of the "no promissory note, no payments, no interest", they'd have a tough time arguing that a valid loan did indeed exist.

Instead, the fact-pattern suggests that the true nature of the deal was (1) a dividend distribution from C Corp to Husband and Wife; followed by (2) Husband giving his share of the cash to Wife; and then (3) Wife making an equity contribution to S Corp as additional paid-in capital.

You don't want to structure it as an equity investment by C into S, as this would immediately torpedo the "S" election (as an S Corp can't have a C Corp as a shareholder).

As to the timing issue, you could avoid having to knock out amended prior-year returns if you could legitimately argue that it was indeed originally intended as a loan to S Corp, but that sometime during 2011 the parties' intentions changed. As a result of their revised intentions, (1) the C corp distributed the receivable to H & W as a dividend; (2) H gave his share of the receivable to W; (3) W cancelled the receivable in exchange for additional capital investment in S Corp. Whether the parties' actions make this a valid assertion is a matter of the specific facts and circumstances.

Best of luck with it!