Structuring Debt Basis in an S Corporation

Recent Tax Court rulings have dramatically changed the landscape for determining whether shareholders in commonly held S corporations have sufficient debt basis to deduct S losses. While previous decisions focused on the "economic outlay" principle and whether the indebtedness ran "directly" from the S corporation to the shareholders, recent taxpayer victories indicated that the transaction's original form (i.e., how the corporation treated it for book purposes) is ultimately the deciding factor.

Case Law

While the courts consistently decided against taxpayers who tried to restructure debt to increase tax basis, the reasons for their findings varied considerably. For example, in Burnstein, TC Memo 1984-74, debt transferred from one S corporation to another did not create basis for shareholders with identical ownership interests in both corporations. When the funds were first transferred, they were recorded on the books as loans between the two corporations. At year-end, the return preparer made adjusting entries to reclassify the loans as running to and from the shareholders. The court sided with the IRS. Because the amounts were transferred directly from one corporation to the other, any debt was not a debt directly from the S corporation to the shareholders.

Ten years later in Hitchins, 103 TC 711 (1994), the court determined that the shareholder's basis in his S stock did not include debt owed to him by a C corporation that was assumed by the S corporation in partial payment of its own debt to the C corporation. Even though the shareholder had made an economic outlay, it was significant that the C corporation was not relieved of its obligation and that the shareholder therefore had recourse against the C corporation in the event of default. As a result, the court held that there was no investment by the shareholder in the S corporation. The shareholder might have succeeded in establishing basis if he had adopted a different form of the transaction. The court suggested that the shareholder could have loaned money to the S corporation to repay its debt to the C corporation, and the C corporation could have in turn repaid its debt to the shareholder.

Several years later in Bergman, 8th Cir., 4/19/99, a shareholder executed a restructuring similar to the one suggested by the court in Hitchins. In Bergman, one S corporation issued checks to pay off a debt owed to another S corporation. The second S corporation loaned the same amount to the shareholder, who in turn loaned it back to the first S corporation. In this case, the district court granted summary judgment in the shareholder's favor. On appeal, the Eighth Circuit reversed, questioning the genuineness of the loan restructuring. Even though the shareholder repaid the loans, it was not clear that he intended to do so at the time they were made. In addition, the court found that the only economic outlay was the original loans between the corporations, as "the subsequent transactions could be viewed as merely a series of offsetting entries among bank accounts."

Recent Decisions

The first taxpayer victory came in Culnen, TC Memo 2000-139, in which the court held that the shareholder's adjusted basis included various loan checks that he wrote from his C to his S corporation and recorded on the books as shareholder loans. To prove his investment, the shareholder had to establish that a true debt existed between him and the S corporation. The fact that the payments ran directly from the C to the S corporation did not (as a matter of law) establish the C corporation's status as an investor in the S corporation. In finding for the shareholder, the court relied on the testimony of the shareholder's accountant that the corporation was the taxpayer's "incorporated pocketbook" and had no association with the S corporation other than to make loans to it on the taxpayer's behalf. The opinion is unclear about whether the taxpayer presented any actual loan agreements as evidence or whether they even existed.

Perhaps an even more important victory came in Yates, TC Memo 2001-280. In Yates, the shareholder argued that loans made from one wholly owned corporation to another were, in substance, transfers from the shareholder to the other corporation. Favorably citing Culnen, the court decided that although the shareholder skipped the steps of having one corporation transfer funds to him, depositing them in his account and transferring the funds to the S corporation, such transfers did in fact give rise to an increase in the shareholder's basis. As in Culnen, the shareholder in Yates had his accountant record the transactions in the corporate books as either shareholder loans or distributions, and the court accepted such characterization.

A Transaction's Form

In all of the cases, the facts are relatively similar. One crucial difference is the transaction's original form. In both Culnen and Yates, even though the corporation wrote the checks directly from one to the other, for book purposes, the shareholders treated the transactions from the onset as loans or distributions. That is the form that the shareholders chose, and that the courts apparently respected.

In Bergman, the court cited the age-old rule that a transaction's tax effect is in accordance with what actually occurred, not with what may have occurred. This fact appears to be of utmost importance in structuring debt basis in multiple, commonly owned S corporations. While the courts have found a number of different grounds for disallowing debt basis to shareholders transferring funds between commonly held entities, the recent decisions seem to rely on the transaction's form. Taxpayers must consider this when the loans first originate, not at a later date when they are trying to create shareholder basis to deduct S losses. The courts would frown on such restructuring, and the taxpayer would likely be unsuccessful if the Service challenged these transactions.

From Allyson Hayes, New York, NY