A post earlier this year considered the basis-limitation that restricts the ability of S corporation shareholders to deduct their pro rata share of the corporation’s losses. It was observed that, over the years, shareholders have employed many different approaches and arguments to increase the basis for their shares of stock or for the corporation’s indebtedness, in order to support their ability to claim their share of S corporation losses.
Many of these arguments have been made in situations in which the shareholder did not make an economic outlay, either as a capital contribution or as a loan to the S corporation.
In a recent decision, however, the Tax Court considered a shareholder who did, in fact, make a significant economic outlay, but who also utilized a form of transaction – albeit for a bona fide business purpose – that the IRS found troublesome. In defending its right to claim a loss deduction, the shareholder proffered a number of interesting arguments.
Taxpayer owned Parent, which was taxed as an S corporation.
Parent acquired 100% of the issued and outstanding stock of Target from Seller through a reverse triangular merger: Parent formed a new subsidiary corporation (“Merger-Sub”), which was then merged with and into Target, with Target surviving. As a result of the merger, Target became a wholly-owned subsidiary of Parent, and the Seller received cash plus a Merger-Sub promissory note; Target became the obligor on the note after the merger.
Immediately after the merger, Target made an election to be treated as a qualified subchapter S subsidiary (“QSub”).
The cash portion of the merger consideration was funded in part by a loan (the “Loan”) from Lender, which was senior to the promissory note held by Seller.
After the merger, Taxpayer decided to acquire the Loan from Lender. However, Taxpayer believed that (i) if he loaned funds directly to QSub to acquire the Loan, or (ii) if he contributed funds to Parent, intending that they be loaned to QSub to repay the Loan in full, his loan would not be senior to the QSub note held by Seller without obtaining Seller’s consent.
In order to make QSub’s repayment of the Loan to Newco senior to QSub’s repayment of the note to Seller, Taxpayer organized another S corporation, Newco, to acquire the Loan from Lender. Taxpayer transferred funds to Newco, which Newco used to purchase the Loan, following which Newco became the holder of the Loan.
Thus, the indebtedness of QSub was held, not directly by Taxpayer, but indirectly through Newco.
During the Tax Year, Parent had ordinary business losses that were passed through to Taxpayer.
The Tax Return
In preparing his return for Tax Year, Taxpayer used his adjusted basis in the Parent stock, and also claimed adjusted basis in what he believed was QSub’s indebtedness to Taxpayer, to claim deductions for the losses passed through to Taxpayer from Parent for the Tax Year.
The IRS reduced the losses Taxpayer could take into account for the Tax Year, thereby increasing Taxpayer’s taxable income by that amount. Taxpayer petitioned the Tax Court.
Taxpayer argued that Newco should be disregarded for tax purposes, and that the Loan should be deemed an indebtedness of Parent (through its disregarded QSub) to Taxpayer. This would allow Taxpayer to count Newco’s adjusted basis in the Loan in calculating the amount of Parent’s flow-through losses that he could deduct for the Tax Year.
The IRS urged the Court to respect Newco’s separate corporate existence, and not to treat the Loan as indebtedness of Parent to Taxpayer.
S Corp. Losses
The Code generally provides that an S corporation’s shareholder takes into account, for his taxable year in which the corporation’s taxable year ends, his pro rata share of the corporation’s items of income, loss, deduction, or credit.
However, the aggregate amount of losses and deductions taken into account by the shareholder is limited: It may not exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation plus the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder (the “loss-limitation rule”).
The Code does not define the term “indebtedness of the S corporation to the shareholder” as used in the loss-limitation rule.
A QSub is a domestic corporation which is wholly-owned by an S corporation, and that elects to be treated as a QSub. In general, a QSub is not treated as a separate corporation, and all of its assets, liabilities, and items of income, deduction, and credit are treated those of the S corporation. Thus, for purposes of the loss-limitation rule, a QSub’s indebtedness to its parent S corporation’s shareholder is treated as the parent’s indebtedness for purposes of determining the amount of loss that may flow through to the parent’s shareholder.
Acquisition of Basis in Indebtedness of Parent
The IRS argued that a shareholder can acquire basis in an S corporation either by contributing capital, or by directly lending funds, to the corporation. The loan must be direct, the IRS maintained; no basis is created where funds are loaned by a separate entity that is related to the shareholder.
The IRS emphasized that the Loan ran to QSub from Newco, not from Taxpayer; thus, the Loan could not be considered in computing the basis of any indebtedness of Parent to Taxpayer.
Taxpayer conceded that the courts have interpreted the loss-limitation rule generally to require that the indebtedness of an S corporation be owed directly to its shareholder. However, the Taxpayer asserted, “form is but one-half of the inquiry, and the transaction’s substance also needs to be considered.”
The IRS asserted that Taxpayer ought to be bound by the form of the transaction chosen, and should not, “in hindsight, recast the transaction as one that they might have made in order to obtain tax advantages.”
Moreover, the IRS pointed out, where the entities involved in transactions are wholly-owned by a taxpayer, the taxpayer bears “a heavy burden of demonstrating that the substance of the transactions differs from their form.”
Taxpayer posited that an intermediary, such as Newco, could be disregarded for tax purposes where it (1) acted as a taxpayer’s incorporated pocketbook, (2) was a mere conduit or agent of the taxpayer, or (3) failed to make an actual economic outlay to the loss S corporation that made the intermediary poorer in a material sense as a result of the loan.
Taxpayer urged the Court to find that Newco acted as the Taxpayer’s incorporated pocketbook in purchasing the Loan from the Lender and holding it thereafter.
Taxpayer emphasized that Newco had no business activities other than holding the Loan and acting as a conduit for payments made by QSub.
The Court observed that the term “incorporated pocketbook” refers to a taxpayer’s habitual practice of having his wholly-owned corporation pay money to third parties on his behalf.
The Court, however, stated that the “incorporated pocketbook” rationale was limited to cases where taxpayers sought to regularly direct funds from one of their entities through themselves, and then on to an S corporation. Here, the Court found, Taxpayer did not use Newco to habitually to pay QSub’s, or his own personal, expenses. “Frequent and habitual payments,” the Court stated, are “key to a finding that a corporation served as an incorporated pocketbook.” Newco did not make frequent and habitual payments on behalf of Taxpayer.
Conduit or Agent
Taxpayer also argued that Newco served as Taxpayer’s agent in purchasing the Loan from Lender and, as such, could be ignored for tax purposes.
Taxpayer pointed out that the Court had previously suggested that, in a true conduit situation, a loan running through a corporate intermediary could instead be considered to run directly from the shareholder for purposes of the loss-limitation rule.
Taxpayer emphasized that Newco had no business activity besides the Loan acquisition, and no assets besides the Loan; all the funds necessary to purchase the Loan came from Taxpayer; thus, Newco served effectively as a conduit for payments from Parent and QSub.
The IRS reminded the Court that, in other cases, it had been reluctant to apply the agency exception to the rule that indebtedness must run directly from the S corporation to its shareholder.
Moreover, the IRS argued, Parent, QSub, Newco and Taxpayer were sophisticated parties who consulted with their advisers before purchasing the Loan from Lender. They consciously chose the form of the transaction to maintain the Loan’s seniority with respect to QSub’s obligations under the notes.
The IRS also asserted that the record was devoid of any indication of an agency relationship.
The Court agreed with the IRS that Newco did not act as Taxpayer’s agent. It set forth several factors that are considered when evaluating whether a corporation is another’s agent, including:
- whether it operates in the name, and for the account, of the principal,
- whether its receipt of income is attributable to the services of the principal or to assets belonging to the principal,
- whether its relations with the principal depend upon the principal’s ownership of it,
- whether there was an agreement setting forth that the corporation was acting as agent for its shareholder with respect to a particular asset,
- whether it functioned as agent, and not principal, with respect to the asset for all purposes, and
- whether it was held out as agent, and not principal, in all dealings with third parties relating to the asset.
The Court reviewed each of these indicia, and concluded that no agency relationship existed between Newco and Taxpayer.
Actual Economic Outlay
Taxpayer argued that: (i) Newco made no economic outlay to purchase the Loan, (ii) it was he who provided the funds used by Newco to purchase the Loan, (iii) he owned and controlled Newco, (iv) Newco was a shell corporation with no business or other activity besides holding the Loan, and (v) Newco’s net worth both before and after the Loan’s acquisition was the amount of Taxpayer’s capital contribution.
The IRS noted that the amounts contributed by Taxpayer to Newco were first classified by Newco’s bookkeeper as shareholder loans and then as paid-in capital, which increased Taxpayer’s basis in the Newco stock; accordingly, Taxpayer’s capital contributions to Newco, which increased his stock basis in that corporation, could not be used to increase his debt basis in Parent.
The IRS also disputed Taxpayer’s characterization of Newco as a shell corporation, arguing that Taxpayer had a significant business purpose in structuring the transaction as he did: the maintenance of the Loan’s seniority to Seller’s promissory note.
The Court agreed that Taxpayer did make actual economic outlays, and that these outlays were to Newco, a corporation with its own separate existence. It was not simply a shell corporation, but a distinct entity with at least one substantial asset, the Loan, and a significant business purpose. Taxpayer’s capital contributions, combined with Newco’s other indicia of actual corporate existence, were compelling evidence of economic outlay.
The Court also noted that taxpayers generally are bound to the form of the transaction they have chosen. Taxpayer failed to establish that he should not be held to the form of the transaction he deliberately chose. Therefore, any economic outlays by Taxpayer were fairly considered to have been made to Newco, a distinct corporate entity, which in turn made its own economic outlay.
Step Transaction Doctrine (?)
Finally, Taxpayer argued that the Court should apply the step transaction doctrine (really “substance over form”) to hold that Taxpayer, and not Newco, became the holders of the Loan after its purchase from Lender.
The IRS disputed Taxpayer’s application of the step transaction doctrine, arguing that Taxpayer intentionally chose the form of the transaction and should not be able to argue against his own form to achieve a more favorable tax result. The IRS added that because Newco was not an agent of or a mere conduit for Taxpayer, the form and the substance of the Loan acquisition were the same, and the step transaction doctrine should not apply.
Again, the Court agreed with the IRS, stating that Taxpayer’s “step transaction” argument was just another permutation of his other theories, which were also rejected by the Court.
Taxpayers, the Court continued, are bound by the form of their transaction and may not argue that the substance triggers different tax consequences. It explained that they have “the benefit of forethought and strategic planning in structuring their transactions, whereas the Government can only retrospectively enforce its revenue laws.”
Accordingly, the Court found that Taxpayer did not become the holder of the Loan after its acquisition from Lender.
Thus, the Court held that Taxpayer did not carried his burden of establishing that his basis in Parent’s (i.e., QSub’s) indebtedness to Taxpayer was other than as determined by the IRS.
Was it Equitable?
I suspect that some of you may believe that the Court’s reasoning was too formulaic. I disagree.
Both taxpayers and the IRS need some certainty in the application of the Code, so as to assure taxpayers of the consequences of transactions, to avoid abuses of discretion, and to facilitate administration of the tax system, among other reasons.
Of course equitable principles play an important role in the application and interpretation of the Code, but as to the Taxpayer, well, he was fully aware of the applicable loss-limitation rule, chose to secure a business advantage instead (a senior loan position) by not complying with the rule, which in turn caused him to resort to some very creative justifications for his “entitlement” to the losses claimed.
So, was the Court’s decision equitable? Yep.