United States

Tax Court disallows debt basis claimed by S corp shareholders

Debt basis claimed by taxpayer did not run from shareholder to S corp

TAX ALERT  | 

In a recent case, see Messina, Dana D. et ux. et al. v. Commissioner, the Tax Court concluded that debt failing to run directly between an S corporation and its shareholders, instead running through a second, separate S corporation, did not constitute debt basis in the initial S corporation against which the shareholders could deduct losses.

Facts

In Messina, the taxpayers in question owned 80 percent of an S corporation (S-1) which, in turn, owned a qualified subchapter S subsidiary (QSub). QSub borrowed money from an unrelated third party to finance the acquisition of a business. The taxpayers subsequently organized another separate S corporation (S-2), of which they were the sole shareholders, and used it to purchase the indebtedness of the QSub. The issue in this case was whether the shareholders could use the QSub debt, which was now held by S-2, to increase their tax basis in S-1, thereby allowing them to deduct losses passing through from S-1.

Law

Generally, S corporation shareholders can generate tax basis through cash infusions into the company, either via capital contributions or through loans. However, in order for a shareholder to get basis for debt, the loan must generally run directly between the S corporation and the shareholder. This position was clearly enumerated in final regulations released in 2014. The events in Messina, however, preceded the final regulations.

Judicial guidance prior to 2014 was generally consistent with the provisions ultimately outlined in the final regulations. However, there were certain instances where courts had been more lenient, founding that an intermediary owning debt could be disregarded, such as when the intermediary was operating as an incorporated pocketbook or was acting as an agent or conduit of a taxpayer. This is exactly what the taxpayers argued in Messina.

The taxpayers contended, among other things, that S-2 was acting as the taxpayers’ incorporated pocket book, that S-2 was only a conduit or agent of the taxpayers and that there had been an actual economic outlay by the taxpayers with respect to the acquisition of the QSub debt that made them poorer in a material sense. Based on these factors, the taxpayers argued that S-2 should be disregarded and the debt held by S-2 should be considered to run directly between S-1 and its shareholders.

Decision

The Tax Court disagreed. Addressing these items in turn, the court found that there was no evidence supporting the fact that S-2 was operating as an incorporated pocket book of the taxpayers. S-2 had no purpose aside from the acquisition of the QSub debt, nor did the taxpayers use S-2 on a regular or habitual basis to pay expenses of the taxpayers or S-1. The court also found no evidence supporting the fact that S-2 was acting as a conduit or agent of the taxpayers. Specifically, the court found that S-2 was not operating in the name and for the account of the taxpayers, it could not bind the taxpayers by its actions, and its business purpose was not to carry on the normal duties of an agent. Finally, the court concluded that the taxpayers had not made an actual economic outlay to S-1 with regard to the acquisition of the QSub debt that left them poorer in a material sense. Instead, the court found that the actual economic outlay was to S-2. Accordingly, the court concluded that S-2 should not be disregarded, and that the debt held by S-2 could not be used by the taxpayers to increase their tax basis in S-1, as the debt did not run directly between S-1 and its shareholders.

Takeaways

While the 2014 regulations removed much of the ambiguity associated with when an S corporation shareholder can generate tax basis through company debt, this case does serve as a reminder that shareholders looking to generate tax basis for company debt are best served to structure their arrangements as closely to the regulations as possible in order to limit exposure. 

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