United States

Court reiterates requirements to get basis in S corporation debt

Shareholder could not recast related party advances

TAX ALERT  | 

In a recent case, see Meruelo v. Commissioner T.C. Memo. 2018-16 (2018), the Tax Court rejected an S corporation shareholder’s argument that his tax basis should include amounts advanced from related companies. The Court also rejected the taxpayer’s claim that a set of 2014 final regulations (see T.D. 9682) eliminated the requirement for S corporation shareholders to demonstrate an actual economic outlay to receive tax basis for amounts loaned directly to an S corporation. Instead, the court explained that the determination of whether a bona fide debt exists is to be made under general Federal tax principles, and the actual economic outlay doctrine is a general tax principle that the Court has applied when making this determination.  

Generally, S corporation shareholders receive tax basis in one of two ways, either via capital contributions – such as the purchase of stock – or through loans.  In order to receive basis for the latter – so-called ‘debt basis’ – the loan must be bona fide debt and it must run directly between the S corporation and the shareholder.

In Meruelo, the taxpayer held an interest in an S corporation incorporated for the purpose of purchasing a condo complex in a bankruptcy sale. In order to fund the purchase and operations, the S corporation accepted funds from a number of related entities. In 2008, the complex was foreclosed on resulting in a large loss, which the shareholder recognized using amounts advanced by the related companies as loan basis.

To support its position, the taxpayer first argued that the final regulations issued in 2014 eliminated the requirement for S corporation shareholders to demonstrate an “actual economic outlay” to receive basis for amounts loaned directly to an S corporation. For support, the taxpayer cited the preamble to the regulations, which states, “Instead of applying the actual economic outlay standard…shareholders receive basis of indebtedness if it is bona fide indebtedness of the S corporation to the shareholder.” The court, however, disagreed with the taxpayer’s interpretation of this rule.

The court found that the final regulations did not change existing law, noting that the regulations actually reiterate the economic outlay standard developed by the courts. Moreover, the court stated that the regulations require that the existence of a bona fide debt be determined “under the principle of Federal taxation,” which includes the actual economic outlay doctrine.

The court went on to disagree with the taxpayer’s remaining arguments to support his claim that he had sufficient tax basis to sustain the losses. The court first disagreed that the loans between the S corporation and its affiliates should be recast as back-to-back loans – amounts advanced to the shareholder who in turn advanced the funds to the S corporation. The court found no contemporaneous documentation supporting such treatment. 

Finally, the court rejected the argument that the taxpayer was using the affiliates as incorporated pocketbooks. Here, the taxpayer claimed that 11 distinct entities – many of which he owned with other individuals – were incorporated pocketbooks. The court noted, however, that the taxpayer never advanced funds to these entities – a key characteristic in cases where the Court had accepted this claim. Moreover, not only did the purported incorporated pocketbooks distribute funds, they also routinely received funds. The Court noted this would be unusual for an entity that was in fact being used as an incorporated pocketbook. 

While this case generally reiterates the well-known principle that a loan must run directly between an S corporation and the shareholder in order to generate basis, it does highlight courts’ skepticism regarding substance over form arguments in this area. Accordingly, taxpayers wanting tax basis for loans to an S corporation should make sure that the requirements of the regulations, as well as those requirements set forth in case law, are strictly adhered to in order to ensure that any potential losses claimed against a shareholder’s debt basis are indeed deductible.

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