TAX MATTERS

TAX CASE

ADVANCES TO S CORPORATIONS
Shareholders who lend money to an S corporation can deduct losses in excess of the stock basis. Recently the Tax Court considered how to compute the amount of deductible loss and the effect of a debt repayment.

Fleming S. Brooks owned 51% and Fleming G. Brooks owned 49% of the stock of Brooks AG Company Inc., an S corporation. After the shareholders deducted their losses, their stock basis was zero. Between 1997 and 2000 each of them advanced the corporation $500,000 (1997), $800,000 (December 31, 1999), and $1.1 million (December 29, 2000). On January 5, 1999, they each received $500,000 from the corporation; on January 3, 2000, each received $800,000. The corporation generated losses both years. The taxpayers argued that debt basis is determined at the end of each year; thus, they could deduct the losses and treat the repayments as nontaxable. The IRS disagreed.

Result. For the taxpayers. There are two tax rules that could apply. Under section 1367, S corporation shareholders can deduct losses up to the amount of their stock basis (with a corresponding reduction in basis). When the stock basis is reduced to zero, shareholders can deduct losses equaling their loans to the corporation with a corresponding basis reduction. Future profits fully restore the debt basis and then increase the stock basis.

Normally the repayment of a loan is tax-free. However, under section 1001, if the repayment exceeds the creditor’s basis in the loan, the taxpayer must report income. Thus, a shareholder has income if a loan to an S corporation is repaid before basis is restored. The court had to determine whether the basis determination occurred at repayment or at the end of the year. The IRS argued it was at repayment; the taxpayers argued it was at the end of the year.

The IRS relied on Cornelius v. Commissioner, which held that advances to an S corporation which were separate, closed transactions must be accounted for separately. The taxpayers argued that all the advances were a single, open account measured at yearend. Although relying on Cornelius, the IRS did not argue the advances were separate transactions. The Tax Court agreed with the taxpayers.

The case does not explain why the IRS did not argue separate advances or what is necessary to prove one open account. Taxpayers in similar circumstances will need to be prepared: It would be helpful if the accounting records and all documentation referred to such transactions as being part of a single, open account.

Even if a taxpayer succeeds in making an argument for a single, open account, he or she needs to pay attention to timing. If the advances occur at the end of the year and the repayment occurs shortly after the start of the next year, the IRS may argue the advance is a sham to generate a tax loss and disregard the entire transaction.

Fleming G. Brooks v. Commissioner, TC Memo 2005-204.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

TAX CASE

LOANS TO EMPLOYEE SHAREHOLDERS
Unlike loan proceeds, dividends are taxable income. The IRS closely examines loans a corporation makes to an employee-shareholder—and scrutinizes the transaction even more carefully when the employee-shareholder owns a controlling interest in the corporation. For a loan to be genuine, both the lender and the borrower must intend that the debt be repaid.

The court examines the entire transaction to determine whether it is a loan; no one factor is conclusive. To determine whether both parties meant to treat the transaction as a loan, the court examines the borrower’s ability to repay the loan, the amount of interest, whether there is a note outlining the repayment schedule and collateral for the loan and whether the borrower made repayments.

Nariman Teymourian, CEO and president of the board of directors of Capsian Corporation, owned 60% of the software-development company’s stock. Although he did not execute a formal loan agreement, he used approximately $643,000 of the corporation’s money to purchase a home in 1999 and received an additional $927,000 in 2000. The corporation listed both amounts as notes receivable on its balance sheet. During 2000 Teymourian repaid $448,000 of his debt to the corporation, and Capsian reported $48,000 of this amount as interest income. During the tax years 1999 and 2000 the corporation neither paid nor declared any dividends. The IRS reclassified the monies received as a dividend and assessed Teymourian a deficiency for 1999 and 2000. He petitioned the Tax Court for relief.

Result. For the taxpayer. The court examined the factors that distinguish a true loan from a disguised dividend. Three factors indicated the transfer in this case was a dividend: the lack of a formal loan agreement, a specific repayment schedule and collateral for the loan. However, during the period of time the loan was outstanding, both parties acted as if the transfer was a loan. Teymourian paid interest to the corporation ($48,000) and repaid a substantial portion ($400,000) of principal, and there was a reasonable prospect he would repay the entire loan.

The absence of a written loan agreement does not automatically mean money transferred from a closely held corporation to a majority shareholder is treated as a dividend. In this case the court examined the parties’ actions after the transfer. However, to reduce the chance of having a transfer recharacterized as a dividend, taxpayers should formalize an agreement with a note and treat the transaction as a loan.

Nariman Teymourian v. Commissioner, TC Memo 2005-232.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

TAX CASE

DEDUCTING S CORPORATION LOSSES
When an S corporation incurs losses, its shareholders can directly deduct their share of them in accordance with the flowthrough rules of subchapter S. A shareholder’s aggregated amount of losses and deductions for any taxable year can’t exceed the sum of his or her adjusted basis of stock in the S corporation and any indebtedness of the corporation to the shareholder (IRC section 1366(d)). Unless they make an actual “economic outlay” under the arrangement, taxpayers generally may not increase their basis in S corporation stock as a result of a loan guarantee, pledge of stock as collateral or loss of control of the corporation.

In William H. Maloof, TC Memo 2005-75, the court considered whether an S corporation shareholder’s personal guarantee, pledge of stock or loss of control resulted in an economic outlay entitling him to increase his basis.

Maloof was the sole shareholder of Level Propane, Petroleum & Gases Co., which provided propane gas and services to customers in 14 states. The company generated approximately $18 million in annual revenues and had about 600 employees. To sustain its growth it borrowed $4 million from Provident Bank in July 1993. The money had three principal components: $750,000 secured by equipment; a $2.5 million revolving-term loan secured by tanks and supply contracts; and a $750,000 demand loan secured by inventory and accounts receivable. As additional collateral, Maloof pledged all his shares of Level Propane and a $1 million life insurance policy.

From 1990 through 2000 Level Propane had substantial losses. Maloof increased his basis in the company by the amount of the $4 million loan to claim Level Propane’s net operating losses as pass-through deductions. The company was forced into involuntary bankruptcy when it defaulted on the loan. At no time, however, did the bank demand payment or begin collection action against Maloof.

The IRS determined that Maloof had insufficient basis against which to deduct S corporation losses and, therefore, assessed the deficiencies in tax for the years 1990 through 2000.

Maloof claimed he was entitled to increase his basis in the stock of Level Propane by $4 million because he personally had guaranteed the loan, pledged stock to secure it and incurred a cost when he lost “control” of Level Propane. Citing an Eleventh Circuit Court of Appeals precedent, United States v. Selfe, Maloof argued his pledge of stock constituted an economic outlay. Finally, he suggested the transaction be recharacterized as a personal loan he made to Level Propane.

Result. For the IRS. The court found that Maloof’s personal loan guarantee, his pledge of stock and the bank’s control of Level Propane did not constitute an economic outlay to create basis. A taxpayer makes an economic outlay when he or she incurs a “cost” on a third-party loan or is left poorer in a material sense after the transaction. Guaranteeing a bank loan does not constitute an economic outlay because the shareholder is only secondarily liable. Because Maloof did not need to perform under the loan or make any payment, the court held that his personal guarantee did not increase his basis in Level Propane.

Taxpayers are bound by the “form” of their transactions and may not argue that the “substance” of their transaction triggers different tax consequences. Therefore, Maloof had to accept the tax consequences of his choice.

The Tax Court has held that pledging personal assets is not an economic outlay sufficient to increase basis (see Luiz v. Commissioner, TC Memo 2004-21). The court found the facts in Selfe were distinguishable and thus noncontrolling. Because the bank did not require Maloof to make payment on the loan, he did not make an economic outlay and could not increase his basis.

Maloof owned the Level Propane S corporation shares at all times. He did not substantiate any loss of control or provide the court with a means to value the cost associated with such loss.

William H. Maloof v. Commissioner, TC Memo 2005-75.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.