S shareholders cannot increase bases using corporate debt.
Alton Bean and his son, Gary, operated a trucking company, Alton Bean Trucking Company (Company), and treated the business as a partnership. The Beans formed an S corporation, Alton Bean Trucking, Inc. (S Corporation), and continued running both businesses. On Dec. 31, 1992, Company sold all of its assets to S Corporation, which assumed all of Company's liabilities. S Corporation experienced net operating losses in 1990 and 1991. The shareholders claimed a pro-rata share of the losses on their individual tax returns. The IRS disallowed the losses because they exceeded the shareholders' respective bases in S Corporation and assessed tax deficiencies.
Following the sale of its assets to S Corporation, Company's only asset on its financial statement was a receivable from S Corporation for services and parts provided to S Corporation. The shareholders argued that they were entitled to increase their bases for the amount of the receivable, because they were never paid for the services and parts. The court disagreed. Any transaction that made up the balance of the receivable was between Company and S Corporation; thus, the balance in the receivable could not increase the shareholders' bases. The court also rejected the shareholders' argument that their pledging of personal property for a third-party loan to S Corporation created basis.
The disallowance of S shareholder basis for indirect debt and for third-party debt secured by personal property is well-established law. However, there are two interesting aspects of the Bean decision. First, the court cited Hitchens, 103 TC 711 (1994), in which the court disallowed basis for a loan from a partnership to an S corporation. The court stated:
The taxpayers cannot establish that the shareholders are entitled to an increase in basis unless the receivable was distributed by the partnership [Company] to the individual partners and then contributed to Inc. [S Corporation] or otherwise assumed by the individual partners.
Although the court cites Hitchens in dicta, it appears to be rejecting the Hitchens court's observation, also in dicta, that a properly restructured related-party loan that causes an S corporation to become directly indebted to its shareholders creates basis. Instead, it appears that this court would require an additional step consisting of either a contribution of the debt to the S corporation's capital or personal assumption of the debt by the shareholders (which would also likely be viewed as a contribution to capital).
Second, a number of cases have disallowed basis for S shareholder loss-use purposes when an entity that the shareholders owned loaned funds to the S corporation, restructuring the loan so that the S corporation became directly indebted to its shareholders; see, e.g., Underwood, 535 F2d 293 (5th Cir. 1976), and Wilson, TC Memo 1991-544. The dicta in the Bean decision indicated that the Eighth Circuit might take a different view if the loan distributed by the related entity was contributed to capital, instead of becoming debt from the S corporation to its shareholders. (For a discussion of this issue, see Porcaro, "Restructuring Debt Basis in Light of the `Economic Outlay' Doctrine," 32 The Tax Adviser 604 (September 2001).)
FROM LAURA MACDONOUGH, WASHINGTON, DC
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|Title Annotation:||S Corporations|
|Author:||Kautter, David J.|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 2002|
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