Consider the following common conundrum:
So what’s the issue? Under I.R.C. § 1366, A can only deduct the losses allocated to him from S Corporation 1 to the extent of A’s basis in the stock of the corporation. Since A has no stock basis, the losses are currently useless, though they may be carried forward indefinitely.
Section 1366 also allows A to deduct losses from S Corporation 1 to the extent of his basis in any debt of the S corporation. In order for a shareholder to generate basis in an S corporation’s debt, however, the amounts must be loaned directly from the shareholder to the corporation. As opposed to the partnership rules of I.R.C. § 752, an S corporation shareholder does not get debt basis for his share of all S corporation debt, but only for those amounts loaned from the shareholder to the corporation.
In the immediate case, A has fallen victim to a common example of poor planning. To fund the operations of S Corporation 1, A had a profitable related corporation, S Corporation 2, loan amounts to S Corporation 1. As scores of court cases have held[i], this loan from a related party — even though controlled by A — does not give A debt basis in S corporation 1.
Now it’s the end of the year, and S Corporation 1 is prepared to allocate additional losses to A, who would really like to use those losses to offset the income allocated to him from S Corporation 2. You’re A’s tax adviser. What do you do. What DO you DO???
Can you: Have S Corporation 2 surrender the receivable from S Corporation 1, mark them paid, and then have S Corporation 1 issue notes directly to A, with A turning around and giving a note to S Corporation 2, effectively reconfiguring the loan to be from A to S Corporation 1?
Nope.[ii] This looks too much like a guaranty by A of S Corporation 1’s debt to S Corporation 2, and thus under previous tax decisions, A does not get basis until he is actually called upon to pay the guarantee.
Can you: Have S Corporation 1 repay the loan to S Corporation 2, who in turn loans the money to A, who in turn loans the money back to S Corporation 1?
Nope.[iii] In this instance, the courts have held that A could not treat the amounts loaned to S Corporation 1 as indebtedness of the S corporation to him since A had not made an actual economic outlay in such a manner that he was poorer in a material sense after the transaction than he was before the transaction began. This underlined text has repeatedly been held to be a crucial requirement to establishing debt basis.
Lastly, can you: Have A assume the liability of S Corporation 1 to S Corporation 2 in return for a promissory note from A to S Corporation 2? You could make up journal entries on the books of S Corporation 1 debiting the note to S Corporation 2 and crediting a note payable to A. S Corporation 2 could then debit a receivable account due from A and credit the receivable from S Corporation 1. Would it work?
No again.[iv] Relying on the Underwood case cited above, the Tax Court has held that this transaction did not create indebtedness from S Corporation 1 to its shareholder because it did not reflect a current economic outlay from A to S Corporation 1. It was merely a function of creative journal entries; the relationship of the parties never changed.
So then how can A undo his mess and generate the basis in S Corporation 1 necessary to utilize the flow-through losses?
Until today, there really was no court approved method for unwinding the related party loans in a way that gave A basis in S Corporation 1. But in Maguire v. Commissioner, T.C. Memo 2012-160, the Tax Court blessed a transaction that would allow the intercompany notes to be eliminated while increasing A’s basis in S Corporation 1.
The fact pattern in Maguire was exactly as depicted in the diagram above. At the end of each year, S Corporation 1 owed substantial amounts to S Corporation 2. A had substantial basis in S Corporation 2; an amount that exceeded the losses being generated by S Corporation 1.
In order to increase A’s basis in S Corporation 1 prior to year end, A engaged a couple of savvy accountants. At first, they recommended the safest route: have S Corporation 2 distribute enough cash to A so he could contribute it to S Corporation 1 and increase his basis. As is often the case, however, there wasn’t enough cash available at S Corporation 2 to pay that large a distribution while also funding operations.
So the accountants looked to another alternative, recommending that A distribute the note receivable from S Corporation 2 out to A, who in turn would then contribute the note up to S Corporation 1, effectively offsetting the payable booked at S Corporation 1 to S Corporation 2 while increasing A’s basis in S Corporation 1 by the face value of the note, allowing A to deduct the losses generated during the year.
A couple of important facts:
- A had enough basis in S Corporation 2 to absorb the distribution of the note receivable in each year without generating gain under I.R.C. § 1366.
- The distribution and contribution of the notes receivable were carried out by the execution of separate written shareholder resolutions signed at the end of each year.
- Adjusting journal entries were made to the corporate books in the year following the tax year to which the distribution/contribution related, during the audit process.
The IRS disallowed A’s losses from S Corporation 1, arguing that the transaction described above did not increase A’s basis. In support of this contention, the IRS leaned on the long-held premise that a shareholder investment must contain an actual “economic outlay” that leaves him “poorer in an economic sense;” and in the immediate case, the resolutions and journal entries were devoid of any economic reality and did not alter the economic positions of the parties.
In a departure from previous holdings such as Underwood, the Tax Court disagreed, holding that the distribution and contribution of the debt created actual economic consequences to the parties because the note receivable had real value in that they were legitimate debts that S Corporation 1 owed to S Corporation 2, and thus were also legitimate assets of S Corporation 2. A’s contribution of the notes receivable left his “poorer in a material sense” in that the receivables were no longer collectible by him individually.
In addition, the distribution of the notes from S Corporation 2 to A had real tax consequences, as they decreased A’s basis under I.R.C. § 1368 and reduced the amount of future distributions A could withdraw tax-free.
The Tax Court also noted that by contributing a note receivable to S Corporation 1 and effectively wiping out its debt to S Corporation 2, S Corporation 1 was made solvent and thus exposed a greater amount of its assets to its general creditors.
Lastly and perhaps most importantly, the court placed little weight on the relationship between the parties, stating:
While it is appropriate to scrutinize the validity of transactions between related parties, we see no reason why shareholders in two related S corporations should be prohibited from taking distributions of assets from one of their S corporations and investing those assets into another of their S corporations, in order to increase their bases in the latter. The effect is to decrease the shareholders’ bases in the S corporation making the distribution, thereby reducing the shareholders’ potential future tax-free distributions from the distributing S corporation, while increasing the shareholders’ bases in the S corporation to which the contribution is made. The fact that the two S corporations have a synergistic business relationship and are owned by the same shareholders should make no difference so long as the underlying distributions and contributions actually occurred.
More on this soon, but it’s certainly a refreshing decision for S Corporation shareholders looking to unravel previous poor decisions.
[i] For example, see E.J. Frankel, 61 TC 343 (1973), aff’d without published opinion, 506 F2d 1051 (3d Cir. 1974) (loan by partnership to S corporation did not increase basis for shareholders, who owned partnership in exactly the same proportions).
[ii] Underwood v. Comm’r, 535 F2d 309, 76-2 USTC ¶ 9,557 (5th Cir. 1976), aff’g 63 TC 468 (1975
[iii] See TAM 9403003 (Jan. 21, 1994).
[iv] Shebster v. Comm’r, 53 TCM 824 (1987)