S shareholder loan basis.

The deductibility of S corporation losses hinges on whether a shareholder has basis under Sec. 1366 and whether he or she is "at risk" under Sec. 465. Under Sec. 1363(a), an S corporation is generally a passthrough entity, not taxable for Federal income tax purposes; thus, its shareholders are usually subject to only one level of tax on earnings. In general, under Sec. 1366(a)(1), all S items of income, loss, deduction and credit pass through the corporation and ale taxed directly to its shareholders in proportion to their ownership interests.

Background

For an S shareholder to deduct iris or her pro-rata share of S losses under Sec. 1366(a), he or she must have sufficient basis in S stock or debt under the Sec. 1366(d) basis limitation rules. According to Sec. 1366(d)(1), the total amount of losses and deductions that the S shareholder takes into account for any tax year cannot exceed the sum of:

1. The adjusted basis of the shareholder's S stock; and

2. The shareholder's adjusted basis of any debt of the S corporation to the shareholder.

Although, according to Sec. 1366(d)(1)(B), a shareholder can deduct his or her proportionate share of the S losses and deductions to the extent of the shareholder's adjusted basis in S debt, the section does not specifically define "indebtedness of the S corporation to the shareholder." The cases and rulings interpreting Sec. 1366(d)(1)(B) have established two requirements for an S shareholder to be entitled to increase his or her basis for the S corporation's debt:

1. The indebtedness must run directly from the S corporation to the shareholder; and

2. The shareholder must have made an "actual economic outlay."

Although the IRS and the courts generally have been consistent in applying the requirement that a loan run directly from a shareholder to the S corporation, they have been inconsistent in a requiring the S shareholder to make an actual economic outlay.

Cases

Oren: The Eighth Circuit recently ruled, in Donald G. Oren, (2/12/04), aff'g TC Memo 2002-172, that loans husband-and-wife taxpayers made to two of their S corporations from funds lent to them by their third S corporation, to which the two corporations, in turn, made loans of the same amount, were not actual economic outlays. Thus, these loans did not allow the taxpayers to increase their basis in the borrower corporations, so as to enable them to deduct those corporations' losses.

In addition, the Eighth Circuit ruled that the Tax Court was correct in assessing that the Orens could not take loss deductions, because the funds were not "at risk" within the meaning of Sec. 465, even if the loans had properly increased their basis in the related S corporations. As applied to this case, which involved equipment-leasing businesses, the taxpayers could deduct a loss from the activity "only to the extent of the aggregate amount with respect to which the taxpayer is at risk ... for such activity at the close of the taxable year." Here, the money the Orens lent to the corporations was not truly at risk, because the possibility that they would suffer a direct loss was remote, given the loan trans actions' circular nature.

Thomas: A similar result was reached in Jerry, L. Thomas, TC Memo 2002-108, in which the Tax Court held that the taxpayer's basis in each of two S corporations was not increased by loans made to them by C corporations that the taxpayer controlled. Tim loans were initially reflected on the controlled corporations' books, as loans payable and loans receivable directly between the companies. Subsequently, such amounts were reclassified as loans from the controlled corporations to the shareholder, and then as loans that the shareholder made to the S corporation.

Other decisions: The Oren and Thomas cases reached different results than those in Charles E. Yates, TC Memo 2001-280, and Daniel J. Culnen, TC Memo 2000-139. The earlier decisions were very taxpayer-favorable, indicating that the Tax Court had changed its attitude on back-to-back loan restructuring between related entities. However, Yates and Culnen may have given taxpayers a false sense of security that the courts would be willing to allow an S shareholder to increase basis when a transaction was structured as a direct transfer, as long as it was properly documented as a distribution or loan from the related entity to the shareholder, then reflected as a loan or capital contribution by the shareholder to the S corporation.

Oren represents a setback for taxpayers and the Tax Court's return to the economic-outlay test, which requires a taxpayer to be "poorer in a material sense" after a transaction than before. The Tax Court's application of the economic-outlay rule to determine whether a taxpayer is entitled to increase his or her S stock basis sends a mixed message and is somewhat inconsistent with previous guidance. (For Further discussion of the Tax Court decision in Oren, see Nagler, Tax Clinic, "Loan to S Corporation May Not Generate Taxpayer Basis," TTA, October 2002, p. 643.)

Conclusion

The Tax Court is essentially applying an attribution rule in the Sec. 1366(d)(1) context so that funds that a shareholder obtains from a related corporation and then lends or contributes to another S corporation will not increase Ins or her basis. Absent statutory clarification to the contrary, taxpayers outside of the Eighth Circuit may be able to argue that the economic-outlay rule should have no application to direct share holder loans. (For more discussion, see Porcaro, "Restructuring Debt Basis in Light of the 'Economic Outlay' Doctrine," TTA, September 2001, p. 604.)

RANDY SCHWARTZMAN

CPA 

MST, MELVILLE, NY