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Restructuring Debt Basis in Light of the "Economic Outlay" Doctrine An S corporation shareholder seeks to have as high a basis as possible to be able to use passthrough losses. This has led shareholders to creative methods of restructuring S debt in an attempt to boost basis, but the courts have required an actual shareholder economic outlay. This article examines cases addressing this issue and offers planning strategies.
Gregory
A. Porcaro, MST, CPA/ABV For more information about this article, contact Mr. Porcaro at (401) 739-9250 or gporcaro@brindamour.com. Editor's note: Mr. Porcaro is a member of the AICPA Tax Division's S Corporation Taxation Technical Resource Panel.
Executive Summary
S corporations have been a part of the practitioner's repertoire of available entity structures for over 40 years. Although they have evolved significantly over that time, one area of subchapter S continues to require careful monitoring and planning—stockholder basis. An S stockholder's basis may be comprised of both stock and debt; it changes constantly due to corporate profits, losses, distributions, loans and loan payments. This article focuses on the effect of basis in stockholder debt on the use of an S corporation's losses by its stockholders. Sec. 1366(d)(1) limits deductibility of S losses to a stockholder's basis in stock and debt. If the corporation's current-year's loss exceeds such basis, Sec. 1366(d)(2) provides that it may be carried forward indefinitely (a suspended loss). Generally, this statutory structure provides some relief from a temporary lack of basis, but planning opportunities and pitfalls exist, particularly when one or more individuals own stock in multiple S corporations with varying degrees of profitability and basis. This is not uncommon; however, if not properly monitored, it can lead to taxation of profits from one S corporation and suspended losses from another (due to lack of basis). Can shareholder action avoid this result? The answer depends on the facts and circumstances; however, two criteria are not specifically defined by Sec. 1366, 1367 or the regulations—economic outlay and direct debt.
Economic Outlay The economic outlay doctrine was first developed in Perry,1 which involved an S shareholder's failed attempt to create basis through the issuance of notes between him and the corporation. The court interpreted the economic outlay doctrine to require an actual cash investment by the shareholder in the corporation. Rev. Rul. 81-1872 applied the concept to deny a basis increase for the exchange of a sole shareholder's note for stock. In Underwood,3 the Tax Court concluded (and the Fifth Circuit affirmed) that no basis is created when a shareholder exchanges demand notes with his wholly owned corporations. The court considered the lack of an actual advance of funds by the shareholder and questioned his intent to demand repayment.
In Underwood, one stockholder controlled both entities; perhaps the result would have been different had the stockholder not been in control.
A shareholder can create basis by substituting his note for the corporation's note to an unrelated third-party lender, if the corporation is thereby released from liability (a "back-to-back" loan).4
Three factors should be considered when using the debt-substitution method for creating basis: 1. The form of the transaction must be respected; the corporation should not continue to make payments to the third-party lender. 2. The corporation and shareholder should execute a note. 3. If corporate assets must be used as security for the substituted loan, the corporation should pledge its assets to the shareholder, who would then reassign the security interest to the third-party lender.
Direct Debt In limiting the amount of passthrough losses that can be deducted, Sec. 1366(d)(1)(B) refers in part to "the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder." This phrase has been applied to require direct debt between the corporation and shareholder; thus, basis is not attributed to a stockholder when the S corporation owes on loans from other controlled entities. A number of unfavorable cases and rulings have addressed indirect debt between related parties and Sec. 1366(d); stockholders of multiple S corporations could not restructure their combined debt and increase basis to increase the current deductibility of S losses. However, as is discussed below, a recent case, Culnen,6 represents the first taxpayer victory on this issue. To assist clients in this area, tax advisers need to be familiar with the facts of the relevant cases.
S Corporation's Assumption of Note As indicated earlier, Underwood was the first case to decide that no basis increase stems from a shareholder exchanging demand notes with his wholly owned corporations. A number of other decisions have been based on Underwood. In Hitchins,7 an S corporation's assumption of a note due a shareholder, from a C corporation controlled by him, did not create S debt basis for the shareholder.
The Hitchins court found that the taxpayer had made an "economic outlay," but concluded that there was no direct debt between the taxpayer and the S corporation. Two factors weighed against the taxpayer in Hitchins. First, the C corporation was not released from liability; second, the taxpayer and the S corporation never executed a note.
Shareholder's Assumption of S Corporation's Note In Bhatia,8 a shareholder's assumption of a loan from one controlled S corporation to another did not create debt basis.
This resembles the back-to-back loan situation discussed previously, except that in Bhatia, there was no third-party lender. The taxpayers in Bhatia contended that their case was distinguishable from Underwood, because basis reductions resulted in suspended losses in subsequent years; however, the court did not address this issue, because it was not satisfied that any debt existed, due to a lack of records. The court's decision may have been influenced by the lack of documentation and the fact that the transaction was represented only by journal entries in the companies' books and records. The Sec. 6661(a) substantial-understatement penalty applied, because of the amount of the underpayment and the lack of substantial authority and adequate disclosure. The taxpayers unsuccessfully attempted to rely on Rev. Rul. 75-144,9 which applies only when the debt restructuring involves an unrelated lender.
Shareholder's Loan to S Corporation In Bergman,10 the taxpayer seems to have attempted to restructure intercompany debt to avoid the results in Hitchins and Bhatia. The taxpayer restructured debt between himself and three wholly owned S corporations, so that the S corporation with operating losses was indebted to him. The restructuring was accomplished by simultaneous payments from the loss corporation to a related corporation, to the stockholder and back to the loss corporation.
In Bergman, the Eighth Circuit relied primarily on the rationale employed in Underwood to conclude that the restructuring did not result in an increase in basis, for the following reasons: 1. The taxpayer did not make an economic outlay. 2. The transaction did not make the taxpayer poorer in a material sense.11 3. It was not clear that the loans were bona fide (i.e., no intent to repay the loans when made). The third item was complicated in Bergman, because the taxpayer moved for summary judgment, for-cing the court to consider the facts and inferences therefrom in favor of the nonmoving party (i.e., the IRS). The court concluded that the facts failed to indicate the existence of a bona fide debt, even though the debt was repaid in full, with interest, within two years. The court also found no intent to repay the debt at the time it originated, apparently due to the taxpayer's statements regarding the existence of collateral and his intent not to foreclose. It would appear that, based on Hitchins, Bhatia and Bergman, only direct loans from a shareholder to an S corporation create basis; restructuring related-party loans to create basis is generally ineffective. In 2000, Culnen delivered the first taxpayer-friendly decision on the issue of indirectly created basis. The Culnen facts are quite common when one or more individuals control multiple entities. The taxpayer was the sole stockholder of a former S corporation (H); he directed that various payments be made on his behalf to support his controlling interest in an S corporation (W) generating operating losses. The payments, which totaled over $6 million, were recorded as a stockholder loan receivable on H's books and a stockholder loan payable on W's books. For 1987–1990, the taxpayer used the advances from H as debt basis to deduct W losses (see Exhibit 4). The key issue was whether the payments H made directly to W and a former minority stockholder on the taxpayer's behalf created a direct investment in W for Sec. 1366 purposes. The IRS position was that, as a matter of law, the taxpayer was barred from a basis increase due to the indirect investment.
The Tax Court, referring to Hitchins, stated that, "in explaining the statutory requirement that the indebtedness of the S corporation must run directly to the shareholder, we made it clear that an indebtedness to an entity with passthrough characteristics that has advanced the funds to the S corporation and is closely related to the taxpayer does not satisfy the statutory requirement...We did not say, however, that the fact that the borrowed funds originate with the closely related entity precludes the indebtedness of the S corporation from running directly to the shareholder." The court relied heavily on the testimony of the taxpayer's witnesses (primarily his bookkeeper and accountant), because no original records were available. There was no mention of the existence of an actual note or any substantial loan repayments. In conclusion, the Tax Court found that the taxpayer had basis in his debt to W; thus, he could deduct its losses.
Planning Opportunities An analysis of the preceding cases identifies one key factor, substance versus form. This is not a new concept, but it is a critical factor when attempting to restructure a client's capital structure to create S basis. According to Hitchins, "in the area of indebtedness for the purposes of applying 1366(d), form coupled with adequate substance or reality is not to be disregarded." Although this statement may provide some guidance, its application to the cases discussed appears to be inconsistent. In Hitchins itself, the result hinged on the fact that the original debtor corporation was not released from its obligation after the stockholder's note was assumed. In fact, the court stated that had the taxpayer chosen an alternative form (e.g., executing a release or loaning money directly to the loss corporation to repay its debt to the related S corporation), he might have successfully established basis for Sec. 1366(d) purposes. In Bhatia, the fact that the debt was documented only by bookkeeping entries and no note was executed was detrimental to the taxpayer's position. The taxpayer was also unsuccessful in establishing basis in Bergman, despite the fact that notes were executed and ultimately paid, and cash was actually transferred in an offsetting transaction. The court concluded, based on the taxpayer's statements, that there was no collateral for the note, nor intent to repay it when executed. The Culnen facts were not dramatically different from the other cases—funds were advanced from one corporation directly to another, it was not clear whether notes were executed and bookkeeping entries documented the transfers—but the taxpayer was successful in establishing basis.
Other Options QSub Use One alternative that did not exist when most of the above cases were litigated is use of a qualified subchapter S subsidiary (QSub). The Small Business Job Protection Act of 1996 created the opportunity for one S corporation to own 100% of a QSub, a disregarded entity for Federal income tax purposes. Only one S return is filed for the parent and each subsidiary for which a QSub election has been made. One potential benefit of this structure is that a shareholder's basis in stock and debt can be determined on an aggregate basis. However, two potential issues limit QSub use. First, the parent S corporation must own 100% of each QSub; thus, to restructure a group of S corporations, each one must be proportionately owned by the same group of shareholders (which may require a shift in ownership interest). This option would have been helpful in Bhatia and Bergman, because all of the entities were owned by the same shareholder(s). The second issue involves the application of the QSub final regulations (Regs. Sec. 1.1362-8), which provide that the step-transaction doctrine applies in certain situations. In general, the restructuring of multiple S corporations can be classified as a tax-free reorganization under Sec. 368(a)(1)(D), which can result in gain recognition under Sec. 357(c), if the subsidiary's liabilities exceed the basis of its assets. To avoid this result, the loss corporation should be the group's parent.
Additional Stock/Paid-in Capital Another option involves the issuance of additional stock or paid-in capital instead of a note. For example, the result might have differed in Bergman had the taxpayer taken back additional stock instead of a note. Arguably, the receipt of stock carries with it greater risk than the receipt of debt, which should constitute an economic outlay. Ultimately, the taxpayer may still recover his investment, regardless of whether the corporation becomes profitable and makes distributions or sustains additional losses and liquidates. A shareholder can recover basis tax-free under Sec. 1368(b). The shareholder of an S corporation with accumulated earnings and profits may be exposed to ordinary income if distributions exceed the accumulated adjustments account, under Sec. 1368(c).
Conclusion Monitoring a shareholder's basis in an S corporation can be quite complicated. The economic outlay doctrine is broadly applied and does not really consider the underlying risks associated with a capital re-structuring. It would seem that when a shareholder of a profitable S corporation defers distributions to fund the operations (directly or indirectly) of an unprofitable S corporation or guarantees a note from a third party for the same purpose, the increase in risk and the reduction in the ability to raise additional capital should constitute an economic outlay for Sec. 1366(d) purposes. Perhaps Culnen is the first step by the courts in accepting this economic reality. |
