Advances from related corporation give basis to S shareholder.

The Tax Court held that cash transfers from one corporation controlled by a shareholder to an S corporation controlled by the same shareholder gave him basis for purposes of deducting S losses. In Daniel J. Culnen, TC Memo 2000139, amounts lent from Culnen & Hamilton (C&H) to Wedgewood Associates were, in fact, loans from C&H to Culnen, followed by loans from him to Wedgewood. Under S rules, losses are limited to a shareholder's basis, which includes both stock and loans.

The issue was whether the debt ran "directly to" Culnen. The IRS argued that he was precluded as a matter of law from arguing this, because cash went from one corporation to the other. However, C&H's books (as well as Culnen's personal financial statement) reflected the payments as loans to him. Culnen and his accountants testified that he viewed C&H as an "incorporated pocketbook" There was no relationship between C&H and Wedgewood other than their common ownership. The funds from C&H were used in Wedgewood's business and to purchase shares from another Wedgewood shareholder.

By ruling that the C&H payments were made on Culnen's behalf, the court held that the payments gave him additional basis in Wedgewood. Although it was not part of the court's explicit reasoning, it appears that Culnen was helped by the fact that C&H had previously been an S corporation. Thus, Culnen's subjective belief that he had already paid personal tax on C&H's earnings bolstered the argument that the loans were made on his behalf.

Culnen is distinguishable from a situation in which a shareholder guarantees S debt (which does not confer additional basis). Similarly, merely establishing a liability from an S corporation to a shareholder without an actual transfer of cash will not increase basis. This is sometimes referred to as the "economic outlay doctrine"; in this area, courts are not flexible in finding in favor of S shareholders when they cannot show a direct investment.

In effect, the court accepted Culnen's substance-over-form argument. This was fortunate for him; courts usually hold that taxpayers that have selected the form of a transaction are barred from arguing that the substance was something different. The court could have found that the loans were between the corporations. Alternatively, the court could have found that the loan did run to Culnen, but that the absence of documentation meant that it was a taxable dividend to him by C&H, followed by a loan or capital contribution of the dividend by him to Wedgewood.

Although the case cited no precedents specifically supporting its taxpayer--friendly result, the Tax Court has held on other occasions that a loan in similar situations did not result in additional shareholder basis. For example, in Sanford P. Burnstein, TC Memo 198474 (a similar type arrangement as in Culnen), a taxpayer lost, even though both the corporations were S corporations.

This was clearly a close case that was decided on its facts and circumstances (including what the court obviously found to be credible testimony). Certainly, the case should not be read to mean that there is an attribution rule for related parties when it comes to determining who has made an economic outlay. A clue as to how the court weighed the factors in its decision can be found at the end of the opinion. The court criticized the IRS'S trial tactics of "offensive attacks" and "resort[ing] to name calling," which suggests that the Service may not have presented a strong case.

Given the factual nature of this type of transaction, S shareholders should maintain contemporaneous records to support the substance of a transaction. Thus, having the cash go from C&H to Culnen (appropriately documented by promissory notes), followed by his advance to Wedgewood, might have resulted in a favorable outcome without litigation.

FROM MICHAEL J. GOLDBERG, CPA, NEW YORK, NY