Monday, September 23, 2019
Receiving income tax basis for a contribution of debt to an S corporation is an important issue. Tax basis allows a shareholder to determine the tax effect of transactions with the corporation. It’s a measure of the shareholder’s investment in the corporation and is adjusted upward by the shareholder’s share of corporate income and downward by the portion of the corporation’s losses (and nondeductible expenses) allocated to the shareholder. Similarly, any expenses that the shareholder transfers to the corporation will increase basis and expenses the shareholder receives from the corporation will decrease basis.
But, what if the shareholder loans money to the corporation? Will that increase the shareholder’s stock basis? The answer is that “it depends.”
Shareholder loans and stock basis – it’s the topic of today’s blog post.
Debt Basis Rules
A fundamental principle is that debt basis has no impact on the determination of gain or loss on the sale of stock. It also doesn’t impact the taxability of an S corporation’s distributions. Two fundamental principles apply: 1) debt basis has only one purpose – to “soak up” losses that are allocated to a shareholder; and 2) a shareholder in an S corporation gets basis only for those debts made directly from the shareholder to the S corporation. That means for a shareholder to get debt basis, the shareholder must make the loan directly to the S corporation rather than through a related party (entity) that the shareholder owns. There must be an “economic outlay” that (as the courts have stated) makes the shareholder “poorer in a material sense.” See, e.g., I.R.C. §1366(d)(1)(B).
Regulations and Cases
In 2014, the Treasury adopted regulations on the matter. The regulations, known as the “bona fide debt” provisions appeared to replace the “actual economic outlay” test set forth by the judicial decisions on the matter. Under the regulations, the debt must satisfy two requirements: 1) the debt must run directly from the shareholder to the S corporation; and 2) the debt must be bona fide as determined under general federal tax principles based on the facts and circumstances. Treas. Reg. §1.1366-2(a)(2).
In Oren v. Comr., 357 F.3d 854 (8th Cir. 2004), a case decided by the U.S. Court of Appeals for the Eighth Circuit in 2004 (a decade before the 2014 regulations) the court held that a taxpayer lacked enough stock basis to deduct losses passed through to him from his S corporations. He had created loans between himself and his commonly owned S corporations. The transactions were designed to create stock basis so that he could deduct corporate losses. The taxpayer’s S corporation loaned $4 million to the taxpayer. He then loaned the funds to another S corporation in which he was also an owner. The second S corporation then loaned the funds back to the first S corporation. All of the transactions were executed on the same day with notes specifying that the interest was due 375 days after demand. Annual interest was set at 7 percent. The taxpayer claimed that he could use the debt basis created in the second S corporation to deduct the passthrough losses on his individual return. The IRS disagreed and the court agreed with the IRS – he wasn’t poorer in any material sense after the loans were made and he had no economic outlay. The only thing that happened was that there were offsetting bookkeeping entries. There were also other problems with the way the entire transaction was handled.
In Meruelo v. Comr., No. 18-11909, 2019 U.S. App. LEXIS 13305 (11th Cir. May 6, 2019), a case involving a tax year after the 2014 regulations became effective, the taxpayer was a shareholder in an S corporation that bought a condominium complex in a bankruptcy sale. To fund its operations, the S corporation accepted funds from numerous related entities. Ultimately, lenders foreclosed on the complex, triggering a large loss which flowed through to the taxpayer. The taxpayer deducted the loss, claiming that the amounts that the related entities advanced created stock basis (debt basis) allowing the deduction. The IRS disallowed the deduction and the Tax Court agreed.
The appellate court affirmed on the grounds that the advances were not back-to-back loans, either in form or in substance. In addition, the related entities were not “incorporated pocketbooks” of the taxpayer. There was no economic outlay by the taxpayer that would constitute basis. There was no contemporaneous documentation supporting the notion that the loans between the taxpayer and the related entities were back-to-back loans (e.g., amounts loaned to a shareholder who then loans the funds to the taxpayer), and an accountant’s year-end reclassification of the transfers was not persuasive. While the taxpayer owned many of the related entities, they acted as business entities that both disbursed and distributed funds for the S corporation’s business expenses. The appellate court noted the lack of caselaw supporting the notion that a group of non-wholly owned entities that both receive and disburse funds can be an incorporated pocketbook. To generate basis, the appellate court noted, a loan must run directly between an S corporation and the shareholder.
Some had thought that the 2014 regulations had materially changed the way that debt basis transactions would be looked at in the S corporation context. Indeed, the preamble to the regulations did lead to the conclusion that the IRS was moving away from the “economic outlay” test to a “bona fide indebtedness” test (except in the context of shareholder guarantees). See also Treas. Reg. §1.1366-2(a)(2). That lead some to believe that debt basis could be created without an economic outlay. Meruelo establishes that such a belief may not be true.
The lesson of Meruelo (and prior cases) is clear. Debt basis won’t result with a loan from a related party, and it won’t result from simply a paper transaction entered into near the end of the tax year. Don’t cut corners. Pay the money yourself or borrow it from a third party (such as a bank) and then loan the funds directly to the S corporation. Also, make sure that the transaction is booked as a loan. Interest should be charged, and a maturity date established. Make a duck look like a duck.