As we’ve discussed previously, a shareholder in an S corporation may only utilize the loss allocated to them on Schedule K-1 to the extent of the shareholder’s basis in the stock and debt of the corporation.
While a shareholder’s stock basis is fairly straightforward, establishing debt basis is another matter entirely; with the vagaries in the Code having been manipulated enough times to foster reams of case law and new proposed regulations that would liberalize, to some extent, what types of transactions give a shareholder debt basis.
And while the IRS appears willing to make some concessions within the proposed regulations, one element of shareholder debt basis remains unchanged: the loan must be made directly from the shareholder to the S corporation, and perhaps just as importantly, the shareholder must be able to prove that this requirement has been met.
To illustrate the importance of attention to detail, the courts have blessed so-called “back to back loans,” whereby a shareholder borrows money and in turn loans it directly to the corporation, provided the shareholder can establish that they, and not the corporation, borrowed the money from the third party, and that they in turn loaned the borrowed amounts to the S corporation. To the contrary, should the same third party loan the amounts directly to the corporation without passing through the shareholder first, the faulty structuring dooms the shareholder’s claimed debt basis.
Late last week, the Tax Court drove this point home once again in Welch v. Commissioner, in which an S corporation shareholders claimed she had debt basis sufficient to allow her to absorb large flow-through losses from her S corporation. Her failure to establish that the purported advances were made directly from her to the corporation, however, convinced the Tax Court to deny the debt basis and the related losses.
In Welch, Ms. Welch owned 80% of the stock of Respira, an S corporation. During 2005 and 2006, Ms. Welch had no stock basis in the S corporation, but she asserted that she had substantial debt basis. Ms. Welch claimed that she had borrowed nearly $600,000 from a Dr. Levenson and lent all these funds to Respira.
These advances, however, were either paid directly by Dr. Levenson to Respira or else represented amounts that he charged to his credit card as payments of Respira’s expenses. Dr. Levenson wrote no checks to Ms. Welch, nor did he otherwise make any payments to her with regard to the alleged loans. Ms. Welch contributed no personal funds to Respira, nor did Respira execute a loan agreement or any notes evidencing any loans from Ms. Welch.
Respira’s trial balance as of December 31, 2005, listed a $60,848 shareholder loan from Ms. Welch. Respira’s balance sheet as of December 31, 2006, listed liabilities of $66,349 “Due to Majority Shareholder”.
When it came time to file the Forms 1120S for 2005 and 2006, Respira reported net operating losses of $50,294 for 2005 and $683,059 for 2006. On her separate individual Federal income tax returns for 2005 and 2006, Ms. Welch deducted her share of the losses — 80% — against her claimed debt basis.
Ms. Welch argued that she made loans to Respira by contributing funds she received as personal loans from Dr. Levenson. She claimed that as of December 31, 2005 and 2006, she had $521,061 and $480,826 of debt basis in Respira, respectively, for amounts personally borrowed from Dr. Levenson and reloaned to the S corporation.
The IRS denied the losses, arguing that the shareholders lacked sufficient basis in either the stock or debt of Respira. The Tax Court agreed, holding that Ms. Welch could not prove that she loaned any amounts directly to the S corporation.
Foremost among the damning evidence against Ms. Welch was that while she claimed to have made loans approximating half a million dollars to Respira, the books and records of the S corporation revealed loan payable balances of only $65,000 for the years at issue, rather than the $500,000 Ms. Welch claimed to have advanced. This, the court reasoned, was because the amounts used to fund the S corporation were not borrowed directly from Ms. Welch, but rather from Dr. Levenson, and thus were evidenced as normal liabilities on the balance sheet, rather than loans to shareholders.
Because the S corporation’s debt could not be proven to be owed directly to Ms. Welch, the Tax Court denied her claimed debt basis, and more importantly, the utilization of the underlying allocated losses.
The lesson? Even in the face of the proposed regulations, S corporation shareholders must take care in structuring any advances to the corporation. Any amounts borrowed from a third party must follow the proper channels — from the lender to the shareholder then to the corporation — and be properly recorded. In a back-to-back loan situation, each set of loans should be evidenced by formal written documents requiring interest and a stated maturity date.