In a recent ruling (see Meruelo v. Commissioner, 11th Cir. 2019) the Eleventh Circuit has affirmed the Tax Court’s ruling (see Meruelo v. Commissioner T.C. Memo. 2018-16 (2018)) that an S corporation shareholder could not increase his tax basis for amounts advanced to the S corporation from related companies. The Circuit Court, affirming the Tax Court’s decision, agreed that advances made by related companies did not constitute back-to-back loans, either in form or in substance, and that those related companies were not ‘incorporated pocketbooks’ of the taxpayer.
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 running directly from the shareholder to the S corporation.
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 lenders foreclosed upon the complex, resulting in a large loss, which the shareholder deducted against debt basis attributable to amounts advanced by the related companies to the S corporation.
The taxpayer initially argued that his basis should include the amounts advanced from related companies, and claimed 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. The Tax Court disagreed with the taxpayer’s arguments, however, ruling instead that the amounts advanced by related companies did not constitute basis in the taxpayer’s S corporation, and that the final regulations did not eliminate the economic outlay requirement.
On appeal, the taxpayer advanced two arguments as to why the Tax Court had erred in its decision. First, he contended that the advances by the related companies constituted debt that either in substance or in form ran directly back to him. Alternatively, he argued under the incorporated pocketbook theory that the advances constituted debt that ran directly back to him. The Eleventh Circuit addressed these arguments in turn.
The court first disagreed with the taxpayer’s argument that the loans between the S corporation and its affiliates constituted back-to-back loans, amounts loaned to a shareholder who in turn loans the funds to the S corporation. The court found no contemporaneous documentation supporting such treatment, and it was not persuaded by the accountant’s end-of-year reclassification of the intercompany transfers. It was similarly unimpressed with the taxpayer’s argument that the economic substance of the advances was sufficient to support the argument that the advances were in substance back-to-back loans. In reaching their conclusion, the court noted the taxpayer’s “argument for substance over form [was] a nonstarter.” The court distinguished the taxpayer’s facts from those in a prior 11th Circuit case (Selfe v. United States, 11th Cir. 1985) where the court had accepted the substance over form argument. In doing so, it emphasized that only an “exceptional circumstance could warrant looking to the substance of a transaction instead of its form as having a different tax consequence.”
The court also rejected the argument that the debt ran directly back to the taxpayer under the incorporated pocketbook theory. Here, the taxpayer claimed that 11 distinct entities, many of which he owned with other individuals, were incorporated pocketbooks. Emphasizing facts similar to those highlighted by the Tax Court, the Circuit Court noted that the affiliates acted more like business entities than as incorporated pocketbooks, because they both disbursed and distribute funds for the S corporation’s business expenses. The Circuit Court, citing the Tax Court’s explanation, stated that, “…no court has ever ruled that a group of non-wholly owned entities that both receive and disburse funds in this fashion can constitute an incorporated pocketbook.”
Although the general principal this case addresses, that a loan must run directly between an S corporation and the shareholder in order to generate basis, is well known, it nevertheless serves as a reminder of the extreme skepticism that courts have toward substance over form arguments in this area. Accordingly, taxpayers seeking to claim tax basis for loans made to S corporations should follow the regulatory guidance in this area in order to ensure that any potential losses claimed against a shareholder’s debt basis are indeed deductible.