Back-to-back loans may not create basis.
The facts presented are fairly typical of transactions made between shareholders and their wholly owned or controlled corporations. A corporation wholly owned or controlled by the taxpayer will make a loan to an S corporation also wholly owned or controlled by the taxpayer. The S corporation will incur a loss during the year. At the end of the year, the shareholders will restructure the loans between the corporations so that the debt runs from the S corporation to the shareholders.
In the TAM, the taxpayer owned 100% of the stock of an S corporation (S3) and was a majority stockholder in two other S corporations (S1 and S2). In May 1990, S2 borrowed directly from a bank. S2 then loaned those funds to S3, along with additional advances during the tax year. There were no promissory notes issued between S2 and S3.
Following what appeared to be prudent advice, the taxpayer had S3 repay all of its debt owed to S2. The funds were deposited in S2's bank account. S2 then transferred the funds into the taxpayer's bank account. The taxpayer, in turn, transferred the funds into S3's bank account. Promissory notes were issued for the transactions between S2 and the taxpayer and between the taxpayer and S3. At the end of the restructuring, the loans ran from S3 (a wholly owned corporation) to the taxpayer and from the taxpayer to S2 (a controlled corporation).
The IRS concluded that the taxpayer's loan made to his wholly owned corporation did not create debt under Sec. 1366(d). In order for the loan to qualify as debt, an actual economic outlay by the shareholder was required, one that found the shareholder poorer in a material sense after the transaction than when the transaction began (Underwood, 63 TC 468 (1975), aff'd, 535 F2d 309 (5th Cir. 1976)).
In Underwood, the taxpayer owned all the stock of corporations L and A. Over the years, L had advanced substantial funds to A. When it appeared that the taxpayer would not have sufficient basis in A to deduct A's losses, the taxpayer restructured the loans. The taxpayer gave a note to L, L canceled A's debt, and A gave its note to the taxpayer. Although notes were exchanged, no funds were transferred between the parties.
In this case, the taxpayer merely exchanged notes between himself and his wholly owned corporations. The taxpayer did not advance funds to either corporation. Under these circumstances, it was not clear whether the taxpayer would ever make demand on himself, through L, for payment of the note. Consequently, the court felt that since there was no requirement for repayment, the taxpayer was merely acting as a guarantor of the S corporation's indebtedness. In addition, the court noted that when a shareholder merely guarantees a debt of his S corporation, there is no increase in his adjusted basis in the corporation's indebtedness to him. Therefore, the court decided that the taxpayer did not make an additional investment in A that would increase his adjusted basis in the indebtedness of A to him.
In contrast to Underwood, the court came to a different conclusion in Gilday, TC Memo 1982-242. In Gilday, the taxpayer's S corporation borrowed from an unrelated bank. The corporation's shareholders guaranteed repayment of the notes. At the end of the year, the shareholders gave the bank their personal note, and the bank canceled the corporation's note. The following year the corporation issued a note to the taxpayers.
The Service argued that the taxpayers were merely guarantors of the corporation's debt and acquired no basis in that debt. As guarantors, the shareholders do not increase their investment in the corporation, since they may never have to make an actual payment. The court disagreed, and found the taxpayers had moved from positions as guarantors to positions as primary obligors. The court's decision was consistent with Rev. Rul. 75-144, in which the IRS ruled that the substitution of a taxpayer's personal note to a bank for a corporation's note created debt to the shareholder.
However, in TAM 9403003, the Service distinguished Gilday on the grounds that the obligee on the shareholder's note was a bank (an unrelated third party) rather than a corporation under the taxpayer's control. Following the Underwood decision, the IRS concluded that as a result of the debt restructuring, the taxpayers had put themselves in between their controlled S corporations, and it was not clear that the taxpayers would ever make demand on themselves for payment.
The conclusion reached in this ruling may seem somewhat questionable. First, the original loan was to an unrelated bank. With an outside lender involved in the transaction, a demand for repayment of the notes would occur through S2. This would seem to bring the transaction under the guidelines established by Gilday, while in Underwood, the loans were created among the taxpayer's wholly owned corporations, with no outside party ready to enforce the repayment of the notes.
Second, in the TAM, the Service stated that it was unclear whether the taxpayer would ever make demand on himself for payment. This position seems to ignore the fact that the taxpayer's funds were obtained from S2, a corporation with minority shareholders who would have a legal right to enforce the loan made to the taxpayer, in contrast to Underwood, in which the loans were obtained from the taxpayer's wholly owned corporation.
Third, the IRS's position seems to ignore the form of the transaction. In this case, the taxpayer's investment in S3 was evidenced by the transfer of funds into separate bank accounts, the issuance of separate checks and the execution of promissory notes. Unlike Underwood, the facts support the intention of the parties to create debt between S3 and the taxpayer.
Although the Service's position concerning back-to-back loans may be subject to challenge, taxpayers may wish to avoid falling under TAM 9403003 by restructuring their loans. Taxpayers may be well-advised to borrow from a bank rather than a related entity, and lend the proceeds of the loan to the loss S corporation to create basis. As an alternative, the S corporation can borrow directly from the bank and the shareholder can then substitute his own note for the corporation's, provided that the bank allows the shareholder to assume the corporation's debt. Each of these scenarios may avoid the unfavorable treatment under TAM 9403003.
From Gary Grush, CPA, Los Angeles, Cal.
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|Publication:||The Tax Adviser|
|Date:||Feb 1, 1995|
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