Subject to other Code limitations, a stockholder of a Subchapter S corporation can deduct his or her pro rata share of losses of the corporation to the extent of basis in his or her shares or in any indebtedness of the S corporation to the shareholder. This allowance of losses for shareholder loans often gives rise to taxpayer planning and structuring. However, planners need to note that not all such loans give rise to usable basis.
In a recent Tax Court case, the taxpayers’ controlled partnership loaned them money each year. This money was then relent by them to their controlled S corporation, creating basis for deduction of S corporation losses. The S corporation in turn leased property from the partnership, so the funds that went in to the S corporation were then paid to the partnership as rental payments.
The Tax Court held that the taxpayers did not make a sufficient enough economic outlay to gain basis for the loans to the S corporation, due to the complete circle that was made of the cash payments each year. The Court concluded that the transactions had no economic substance since the money wound up right where it started.
What about the loans that were accumulating from the corporation to the taxpayers, and from the taxpayers to the partnership? Wouldn’t those lend economic substance to the transaction? While cash was flowing in a circle, real world obligations were being created.
The Court did not believe in the substance of the loans, for several reasons. No interest amounts were deducted or included in income by the parties. Only one loan repayment had been made. The loans came from a related party.
Does this mean that if the bona fides of the loan were respected, the basis would have been allowed? The answer can only be maybe, since the opinion addresses other cases when back-to-back loans in this context were not respected – but those cases had their own problems as to viability of the loans and whether as a practical matter the shareholder suffered any actual liability exposure.
If you read the Internal Revenue Code and the Treasury Regulations, you will find no exception to Subchapter S corporation basis for circular loans. Nonetheless, this exception is alive and well as a court created exception, at least in some circumstances involving back-to-back or circular loans.
Marvin S. Kerzner, et ux., TC Memo 2009-76, 04/6/2009
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