IRS Finds Shareholder Loans Did Not Create S. Corporation Basis
Scott E. Vincent
Vincent & Fontg LLC
Kansas City
A recent Taxpayer Advice Memorandum (“TAM”) from the IRS, TAM 200619021, finds that shareholders cannot easily obtain additional basis in an S corporation by arranging “circular” loans involving controlled entities. A common trap with S corporation planning arises when other entities controlled by the S corporation’s shareholder advance funds directly to the S corporation. These advances often provide cash to fund expenses and generate S corporation losses, but when the loans are not directly from the S corporation shareholder, the shareholder does not increase his or her basis in the S corporation. Without additional basis, the shareholder typically cannot utilize flow through of the losses generated by advances from the shareholder’s controlled entities. A common approach used in an effort to avoid this problem involves having the controlled entity first loan funds to the shareholder, and then having the shareholder loan funds to the S corporation to increase basis for flow through losses.
In this recent TAM, the IRS National Office ruled that the circular route of the transfers did not change the parties economic positions, and thus failed to provide the shareholders basis in an S corporation. The national office also ruled that basis in other shareholder loans to the S corporation had to be reduced by losses the taxpayers improperly had deducted in closed years on the strength of the loans later found not to have provided basis.
Factual Background
The IRS TAM outlines the following factual background. The taxpayers, husband and wife, were equal partners in a partnership (PRS) and equal shareholders in an S corporation. For three years PRS loaned money to the taxpayers, who loaned money to the S corporation. The S corporation paid rent to PRS. The loans were made within a short time of each other, and notes were drafted near the end of the calendar year. Each note included the cumulative outstanding loan balance (prior year-end balance, plus current year advances) and thus revised and superseded the notes issued in the prior year. Each note required no payments of principal until the end of the following year. Most but not all of the notes provided a stated interest rate. Except for one partial repayment of principal by the S corporation to the taxpayers, no repayments of either principal or interest had been made with respect to any of the notes.
PRS had borrowed money on a non-recourse basis from a third party lender to acquire and construct real property. Under the terms of this third party loan, no portion of the loan proceeds could be used (and no portion in fact was used) to fund the loans among taxpayers, PRS, and the S corporation. PRS could loan money to taxpayers only if three conditions were satisfied:
(1) the third party lender had to approve the loan;
(2) the proceeds of the loan had to be made from the net profits of PRS (after servicing debt to the third party lender); and
(3) the loan proceeds had to be used to fund the activity of PRS. In other words, under this third condition, S corporation had to use the loan proceeds to pay rent to PRS.
Analysis and Holding
The taxpayers claimed basis in indebtedness for the loans they made to S corporation under § 1366 of the code. On the strength of these loans, the taxpayers claimed losses from the S corporation. With respect to some of the years in which losses were claimed, the statute of limitations for assessing and collecting tax deficiencies had closed. After arranging the back-to-back loans at issue, taxpayers made additional loans to the S corporation that concededly provided basis in indebtedness.
The IRS first analyzed whether the taxpayer loans to S corporation had provided them basis to support deducting flow through losses from S corporation. Under § 1366(d)(1), a shareholder may deduct losses from an S corporation only to the extent of the sum of (A) the adjusted basis of the shareholder’s stock in the corporation, and (B) the adjusted basis of any indebtedness of the corporation to the shareholder. The national office characterized the case law on the issue as consistently holding, based on legislative history, that § 1366(d)(1)(B) requires an actual economic outlay leaving a shareholder poorer in a material sense after the transaction than when the transaction began.
The national office found the facts in TAM 200619021 to be very similar to those in Oren v. Comr., T.C. Memo 2002-172. In Oren, a controlled S corporation loaned money to the controlling shareholder, who loaned the money to another controlled S corporation, which loaned the money back to the first S corporation. The court characterized these disbursements as the equivalent of offsetting bookkeeping entries especially because the loan proceeds originated and ended with the original S corporation. According to the court, the circular route of the transfers indicated that the parties’ economic positions had not changed and that no actual economic outlay had occurred. The court also determined that the terms of the debt instruments rendered the notes economically insignificant. Finally, the fact that no repayments were made also proved to the court that the notes lacked substance. Reciting these same reasons, the national office found the transfers in TAM 200619021 substantially equivalent to the offsetting bookkeeping entries disapproved of in Oren.
The taxpayers argued that, because their notes to PRS could be subject to collection if PRS defaulted to the third party lender, their loans to S corporation truly were at risk and represented an actual economic outlay. Taxpayers based this argument on Gilday v. Comr., T.C. Memo 1982-242. In Gilday, an S corporation had executed a note in favor of a bank. Shareholders then substituted their own personal note for the S corporation’s note. Because the taxpayers had become primary obligors on the loan, the court allowed the taxpayers to increase their basis in indebtedness of the corporation. The court reasoned that, because the bank could require the shareholders to repay the loan, their money truly had been placed at risk.
The national office refused to reach a parallel conclusion with respect to the loans in TAM 200619021. Taxpayers never became primary obligors on the third party loan to PRS. The IRS found it “extremely unlikely” that the lender would permit such loans to jeopardize its own right to repayment. Furthermore, any loans from PRS to its owners had to be made from the profits of PRS, net of debt service to the third party lender. The national office also observed that PRS could anticipate using the rents received from S corporation to pay off the third party loan, which had been made on a non-recourse basis.
Because the circular loans did not provide basis, taxpayers had deducted losses exceeding their basis in their stock and indebtedness of S corporation. By the time technical advice was sought, the statute of limitations on assessing and collecting tax had closed with respect to some of the years in which excess losses were deducted. After making the circular loans, taxpayers made other loans to S corporation which the national office did not dispute provided basis.
With respect to these “closed years,” the national office stated that the basis of the stock and indebtedness of an S corporation in an open year must be computed by taking into account previously deducted losses that exceeded basis in stock and indebtedness in years now closed. The taxpayers had to comply with this requirement by placing in a suspense account under § 1366(d)(2) the claimed losses exceeding basis. Basis in the additional loans representing actual economic outlays first had to be reduced by the suspense account before providing additional basis from which subsequent years’ losses could be claimed. The end result was substantial disallowance of flow through losses from the S corporation.
TAM 200619021 takes a strong position that, in order to obtain basis for loaning money to an S corporation, a shareholder must make an actual economic outlay of funds. This analysis and holding calls into question the common practice of making circular transfers of funds among controlled entities to establish basis for S corporation flow through losses. The TAM also clearly indicates that IRS agents performing examinations of S corporation basis will trace flows of funds to determine whether shareholders truly have parted with them and placed them at economic risk.