Loan to S Corporation May Not Generate Taxpayer Basis

In Oren, TC Memo 2002-172, the Tax Court held that a shareholder's loan to his S corporation, although evidenced by a promissory note, a cancelled check representing disbursement of the loan proceeds and subsequent interest payments, did not generate basis. As a result, the court sustained more than $5 million of assessed deficiencies for the three tax years at issue.

Background

Oren was the sole shareholder of Highway Sales (HS) and Highway Leasing (HL). He and his wife also owned approximately 61% of Dart Transit Company (Dart). The remaining Dart stock was owned by the Orens' children, either directly or through trusts. All of the companies were S corporations.

Although Dart was profitable for all years before the court, HL began to incur losses due to depreciation expenses. In December 1993, Dart lent $4 million to Oren, who lent $4 million to HL. HL then lent $4 million to Dart. The proceeds of each loan were distributed by check; each loan had a 7% annual interest rate, evidenced by a promissory note due 375 days after demand. The parties entered into similar transactions in 1994 and 1995, for $5 million and $4.4 million, respectively. Each paid the interest due on the loans in 1994, 1995 and 1996.

The Orens deducted $4 million, $4.6 million and $5.6 million in losses from HL on their 1993, 1994 and 1995 returns, respectively. The Service disallowed the losses, asserting that the loans from Oren to HL did not create debt under Sec. 1366(d) and so did not increase Oren's stock basis. A deficiency notice characterized the loans as going from Dart to HL through Oren, and did not respect the separate checks and promissory notes from Dart to Oren and from Oren to HL.

The Service argued that the transactions, in the aggregate, did not change the cash held or any of the taxpayers' net worth. Instead, each had loans receivable and loans payable in equal, offsetting amounts, with interest rates and repayment terms that mirrored one another.

The court examined Sec. 1366(d)'s legislative history, noting that losses are only deductible to the extent of a shareholder's “investment” in an S corporation. It then addressed the economic substance of all the loans. The court noted that all of the money started and ended with Dart. Unsecured loans of these amounts would not be available from third parties, and the Orens (as the sole corporate directors, principal officers and majority or sole shareholders of the corporations), controlled whether and when a repayment demand would be made. Thus, the loan transactions did not have a net economic effect and were the equivalent of bookkeeping entries.

The opinion does not discuss why the money was lent from HL to Dart after Oren made the loans to HL. During the three years involved, Dart generated more than $20 million of income. There is no indication that Dart needed cash as operating capital. If HL had not lent the money to Dart, Owen's loan to HL would have been an economic outlay, as it would have been subject to the risk of HL's ability to repay the funds. Instead, any demand by Oren for repayment would have triggered a demand from HL against Dart, followed by a demand from Dart against Oren, defeating any real economic recovery of funds.

Discussion

Taxpayers today have options not available when Dart was incorporated (1938). If the Oren entities were being formed today, each operating company could be created as a single-member limited liability company (SMLLC) owned by a common parent or partnership. Oren, his family members and the various trusts could own the parent. Although each SMLLC would insulate its assets against claims asserted against a brother/sister entity, it would be disregarded for income tax purposes. Because the parent would report a single ordinary income (loss) amount, the loss from one operating LLC would offset the profits from another without the need for intercompany loans. A taxpayer would determine his or her partnership basis rather than a separate basis in each LLC.

Exit tax on the liquidation of a corporation's deemed asset sale for fair market value often makes it prohibitively expensive to convert an existing corporation into an LLC to take advantage of the above structure. However, the introduction of qualified subchapter S subsidiaries (QSubs) in 1996 allows similar advantages in a corporate setting. Oren could have created a new S corporation (Newco), to which he and the other shareholders could have contributed all Dart, HL and HS stock. Newco could have then made elections to treat each of its three subsidiaries as QSubs.

The transfer of the stock to Newco would have been tax free under Sec. 351, as transfers to a controlled corporation. On making the QSub elections, the assets, liabilities, income and expenses of each subsidiary would have been treated as Newco items for tax purposes. However, for liability purposes, each corporation would continue to be respected as a separate legal entity. As in the case of the partnership holding the SMLLCs discussed above, Newco would report a single ordinary income (loss) amount, and the loss from one operating corporation would offset the profits from another without the need for loans. Each shareholder would determine his or her basis in Newco, rather than determining a separate basis in each subsidiary.

Taxpayers who want to restructure existing related entities into either a holding partnership or a QSub face additional issues when the existing entities do not have identical ownership. Each owner of the newly formed parent will have an ownership interest in all of the subsidiaries. The controlling owner might want to retain different entities, frustrating the ability to use this structure. If the controlling owner is willing to accept the shift in ownership that will result from adopting the holding company structure, he should obtain an appraisal of each company to determine each person's ownership of the new entity. Failure to do this increases the risk that the IRS will assert that a taxable gift has occurred. The putative gift would be the excess of the value contributed by an owner of an interest in one or more of the operating entities over the value of the interest he or she received in the parent.

Finally, if the taxpayer must adopt or maintain a separate entity structure and plans to rely on loans to provide basis (to permit the deduction of losses incurred by one or more entities), the loans must be bona fide debt that results in an economic outlay by the lender. (See Porcaro, “Restructuring Debt Basis in Light of the 'Economic Outlay' Doctrine,” TTA, September 2001, p. 604.)

From Barry Nagler, CPA, J.D., LL.M., Holtz Rubenstein & Co., LLP, Long Island, NY