Passing Through Losses
There is a problem that will sometimes plague the shareholders of an S corp that is going through challenging financial times. Whether because of a downturn in the general economy or in its industry, whether because of stiff competition or poor planning, the S corp is suffering operating losses. As if this wasn’t disturbing enough, the corporation may have borrowed funds from a bank or other lender, including its shareholders, in order to fund and continue its operations.
Because the S corp is a “pass-through entity” for tax purposes – meaning, that the S corp is not itself a taxable entity but, rather, its “tax attributes,” including its operating losses – flow through to its shareholders and may be used by them in determining their individual income tax liability.
Although this is generally the case, there are a number of limitations upon the ability of a shareholder of an S corp to utilize the corporation’s losses. Under the first of these limitations, the corporate losses which may be taken into account by a shareholder of the S corporation – i.e., his pro rata share of such losses – are limited to the sum of the shareholder’s adjusted basis in his stock plus his basis in any debt of the corporation that is owed to the shareholder. Any losses in excess of this amount are suspended and are generally carried forward until such time as the shareholder has sufficient basis in his stock and/or debt to absorb such excess.
Over the years, shareholders who are aware of this limitation have tried, in various ways – some more successful than others – to generate basis in an amount sufficient to allow the flow-through of a shareholder’s pro rata share of the S corp’s losses.
As for those shareholders who became aware of the limitation only after the fact, well, they have often put forth some creative theories to support their entitlement to a deduction based upon their share of the S corp’s losses. Today’s blog will consider such a situation, as well as the importance – the necessity – of maintaining accurate records and of memorializing transactions.
Taxpayer was a real estate developer who held interests in numerous S corps, partnerships, and LLCs. One of these entities was Corp-1, which had elected “S” status, and in which Taxpayer held a 49% interest.
In 2004, Corp-1 sought to purchase real property out of a third party’s bankruptcy. The court approved the sale to Corp-1, but required that Corp-1 make a significant non-refundable deposit. To raise funds for his share of the deposit, Taxpayer obtained a personal loan from Bank of approximately $5 million, which were transferred into Corp-1’s escrow account to cover half of the required deposit.
During the tax years at issue, Corp-1 had entered into hundreds of transactions with various partnerships, S corps, and LLCs in which Taxpayer held an interest (collectively, the “Affiliates”). The Affiliates regularly paid expenses (such as payroll costs) on each other’s or on Corp-1’s behalf to simplify accounting and enhance liquidity. The payor-company recorded these payments on behalf of its Affiliates as accounts receivable, and the payee-company recorded such items as accounts payable.
For a given taxable year, CPA – who prepared the tax returns filed by Taxpayer, Corp-1 and the Affiliates –would net Corp-1’s accounts payable to its Affiliates, as shown on Corp-1’s books as of the preceding December 31, against Corp-1’s accounts receivable from its Affiliates. If Corp-1had net accounts payable as of that date, CPA reported that amount as a “shareholder loan” on Corp-1’s tax return and allocated a percentage of this supposed Corp-1 indebtedness to Taxpayer, on the basis of Taxpayer’s ownership interests in the various Affiliates that had extended credit to Corp-1.
In an effort to show indebtedness from Corp-1 to Taxpayer, CPA drafted a promissory note whereby Taxpayer made available to Corp-1 an unsecured line of credit at a fixed interest rate. According to CPA, he would make an annual charge to Corp-1’s line of credit for an amount equal to Taxpayer’s calculated share of Corp-1’s net accounts payable to its Affiliates for the preceding year.
But there was no documentary evidence that such adjustments to principal were actually made, or that Corp-1 accrued interest annually on its books with respect to this alleged indebtedness. Moreover, there was no evidence that Corp-1 made any payments of principal or interest on its line of credit to Taxpayer. And there was no evidence that Taxpayer made any payments on the loans that Corp-1’s Affiliates extended to Corp-1 when they transferred money to it or paid its expenses.
The IRS Disagrees with the Loss Claimed
In 2008, Corp-1 incurred a loss of $26.6 million when banks foreclosed on the property it had purchased in 2004. Corp-1 reported this loss on Form 1120S, U.S. Income Tax Return for an S Corporation. It allocated 49% of the loss to Taxpayer on Schedule K-1.
Taxpayer filed his federal individual income tax returns for 2005 and 2008. On his 2005 return, he reported significant taxable income and tax owing. On his 2008 return, he claimed an ordinary loss deduction of almost $11.8 million. This deduction reflected a $13 million flow-through loss from Corp-1 ($26.6 million × 49%), netted against gains of $1.2 million from two other S corporations in which Taxpayer held interests.
After accounting for other income and deductions, Taxpayer reported on his 2008 return an NOL of almost $11.8 million. He claimed an NOL carryback of this amount from 2008 to 2005. After application of this NOL carryback, his original tax liability for 2005 was reduced and the IRS issued Taxpayer a refund.
After examining Taxpayer’s 2005 and 2008 returns, however, the IRS determined that his basis in Corp-1 was only $5 million; i.e., the proceeds of the Bank loan that Taxpayer contributed to Corp-1. Accordingly, the IRS disallowed, for lack of a sufficient basis, $8 million of the $13 million flow-through loss from Corp-1 that Taxpayer claimed for 2008.
After disallowing part of the NOL for 2008, the IRS determined that Taxpayer’s NOL carryback to 2005 was a lesser amount, and the refund granted was thereby excessive; consequently the Taxpayer owed tax for that year. The IRS sent Taxpayer a timely notice of deficiency setting forth these adjustments, and he petitioned the Tax Court for redetermination.
The IRS agreed that Taxpayer was entitled to basis of $5 million in Corp-1, corresponding to funds that Taxpayer personally borrowed from Bank and contributed to Corp-1.
Taxpayer contended that he had substantial additional basis in Corp-1 by virtue of the inter-company transfers between Corp-1 and its Affiliates.
The Code generally provides that the shareholders of an S corp are taxed currently on its items of income, losses, deductions, and credits, regardless of actual distributions.
However, it also provides that the amount of losses and deductions taken into account by the shareholder may not exceed the sum of: (1) the adjusted basis of the shareholder’s stock in the S corp, and (2) the adjusted basis of any indebtedness of the S corp to the shareholder.
Any disallowed loss or deduction is treated as incurred by the corporation in the succeeding taxable year with respect to the shareholder whose losses and deductions are limited. Once the shareholder increases his basis in the S corp, any losses or deductions previously suspended become available to the extent of the basis increase.
The Code does not specify how a shareholder may acquire basis in an S corp’s indebtedness to him, though the courts have generally required an “actual economic outlay” by the shareholder before determining whether the shareholder has made a bona fide loan that gives rise to an actual investment in the corporation. A taxpayer makes an economic outlay sufficient to acquire basis in an S corporation’s indebtedness when he “incurs a ‘cost’ on a loan or is left poorer in a material sense after the transaction.” The taxpayer bears the burden of establishing this basis.
It does not suffice, however, for the shareholder to have made an economic outlay. The term “basis of any indebtedness of the S corporation to the shareholder” means that there must be a bona fide indebtedness of the S corp that runs directly to the shareholder.
Whether indebtedness is “bona fide indebtedness” to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.
In short, the controlling test dictates that basis in an S corp’s debt requires proof of “bona fide indebtedness of the S corporation that runs directly to the shareholder.”
The Tax Court
Taxpayer argued that Corp-1’s Affiliates lent money to him and that he subsequently lent these funds to Corp-1.
Taxpayer contended that transactions among the Corp-1 Affiliates should be recast as loans to the shareholders (including himself) from the creditor companies, followed by loans from the shareholders (including himself) to Corp-1. The IRS’s regulations, Taxpayer argued, recognize that back-to-back loans, if they represent bona fide indebtedness from the S corp to the shareholder – i.e., they run directly to the shareholder – can give rise to increased basis.
The Court responded that the corollary of this rule is that indebtedness of an S corp running “to an entity with passthrough characteristics which advanced the funds and is closely related to the taxpayer does not satisfy the statutory requirements.” “[T]ransfers between related parties are examined with special scrutiny,” the Court noted, and taxpayers “bear a heavy burden of demonstrating that the substance of the transactions differs from their form.”
For example, the Court continued, courts have rejected the taxpayer contention that loans from one controlled S corp (S1) to another controlled S corp (S2) were, in substance, a series of dividends to the shareholder from S1, followed by loans from the shareholder to S2, holding that the taxpayer may not “easily disavow the form of [his] transaction”. Similarly, courts have upheld the transactional form originally selected by the taxpayer and have given no weight to an end-of-year reclassification of inter-company loans as shareholder loans.
The Court rejected Taxpayer’s “back-to-back loan” argument. No loan transactions were contemporaneously documented. The funds paid by a Corp-1 Affiliate as common paymaster were booked as the payment of Corp-1’s wage expenses. And the other net inter-company transfers reflected hundreds of accounts payable and accounts receivable, which went up and down depending on the various entities’ cash needs.
These inter-company accounts were recharacterized as loans to shareholders only after the end of each year, when CPA prepared the tax returns and adjusted Corp-1’s book entries to match the “shareholder loans” shown on those returns. None of these transactions was contemporaneously booked as a loan from shareholders, and Taxpayer failed to carry the “heavy burden of demonstrating that the substance of the transaction[s] [differed] from their form.”
Even if the transactions were treated as loans, the Court pointed out, Corp-1’s indebtedness ran to its Affiliates, not directly to Taxpayer. The monies moved from one controlled company to another, without affecting Taxpayer’s economic position in any way. The was true for the Corp-1 wage expenses that an Affiliate, in its capacity as common paymaster, paid on Corp-1’s behalf; and the same was true for the net inter-company payments, which Corp-1 uniformly booked as accounts payable to its Affiliates. The Affiliates advanced these funds to Corp-1, not to Taxpayer; and to the extent Corp-1 repaid its Affiliates’ advances, it made the payments to its Affiliates, not to Taxpayer.
The Court determined that there was simply no evidence that Corp-1 and its Affiliates, when booking these transactions, intended to create loans to or from Taxpayer. CPA’s adjustments to a notional line of credit, uniformly made after the close of each relevant tax year, did not suffice to create indebtedness to Taxpayer where none in fact existed.
A taxpayer, the Court observed, may not “easily disavow the form of [the] transaction” he has chosen. The transactions at issue took the form of transfers among various Corp-1 Affiliates, and the Court found that Taxpayer did not carry his burden of proving that the substance of the transactions differed from their form. Unlike the $5 million that Taxpayer initially borrowed from Bank and contributed to Corp-1, he made no “actual economic outlay” toward any of the advances that Corp-1’s Affiliates extended to it.
Accordingly, the Court found that none of the inter-company transactions mentioned above gave rise to bona fide indebtedness from Corp-1 to Taxpayer.
Thus, the Court concluded that the IRS properly reduced Taxpayer’s allowable NOL carryback to 2005, and the Taxpayer had to return a portion of the refund received for that year.
How many of you have examined an entry on a corporate or partnership tax return, and have wondered what it could possibly be? The entry usually appears in the line for “other expenses,” “other assets,” or “other liabilities.”
With luck, there is a notation beside the entry that directs the reader to “See Statement XYZ.” You flip to the back of the return, to Statement XYZ, only to see that the entry is described as an amount owed to an unidentified “affiliate,” or as an amount owed by an unidentified “affiliate.”
Then there are the times when, as in the case described above, there are several identified affiliated companies, and they have a number of “amounts owed” and “amounts owing” among them, including situations in which one affiliate is both a lender and a borrower with respect to another affiliated entity. As you try to make any sense of all the cash flows, you wish you had a chart.
And, in fact, I have heard “advisers” explain that the entries are intentionally vague so as to be “flexible,” and to make it more difficult for an agent to discern what actually happened.
At that point, I tell the taxpayer, “Find yourself another tax return preparer.”
As we have said countless times on this blog, always assume that the taxing authorities will examine the return. Always treat with related parties as if they were unrelated parties. A transaction should have economic substance, and it should be memorialized accordingly. If the taxpayer or his adviser would rather not have the necessary documents prepared, they should probably not engage in the transaction.
 Assuming the shareholder has sufficient basis to utilize his full share of the corporation’s losses, his ability to deduct those losses on his income tax return may still be limited by the passive activity loss rules of IRC Sec. 469 and by the at-risk rules of IRC Sec. 465. For taxable years beginning on or after January 1, 2018 and ending on or before December 31, 2025, there is an additional limitation, on “excess business losses,” which is applied after the at-risk and passive loss rules.
 The losses that pass through to the shareholder reduce his stock basis and then his debt basis; thus, a subsequent distribution in respect of the stock, or a sale of the stock, will generate additional gain; similarly, the repayment of the debt would also result in gain recognition for the shareholder-lender. IRC Sec. 1368, 1001, 1271.
 For example, by making new capital contributions or loans, or by accelerating the recognition of income.
 During the years at issue, Corp-1’s Affiliates made payments in excess of $15 million to or on behalf of Corp-1. Corp-1 repaid its Affiliates less than $6 million of these advances.
 On December 31 of each year, Corp-1’s books and records showed substantial net accounts payable to its Affiliates.
 On Form 4797, Sales of Business Property. IRC Sec. 1231(a)(2): net Sec. 1231 gains are capital; net Sec. 1231 losses are ordinary.
 Prior to the Tax Cuts and Jobs Act of 2017, Pub. L. 115-97, a taxpayer could ordinarily carry an NOL back only to the two taxable years preceding the loss year. However, prompted by the financial crisis and at the direction of Congress, the IRS, for taxable years 2008 and 2009, allowed “eligible small businesses” to elect a carryback period of three, four, or five years. Taxpayer made this election for 2008. After the 2017 legislation, the carryback was eliminated, and an NOL may be carried forward indefinitely, though the carryover deduction for a taxable year is limited to 80% of the taxpayer’s taxable income for the year. Query the impact of the Act’s elimination of a struggling company’s ability to carry back its losses to recover tax dollars and badly needed cash.
 Debt basis is restored before stock basis.
 Taxpayer also advanced a second theory to support his claim to basis beyond the amount the IRS allowed. Under this argument (which the Court rejected), he lent money to the Corp-1 Affiliates and they used these funds to pay Corp-1’s expenses. Taxpayer referred to this as the “incorporated pocketbook” theory.
 Never in the line for “other income.” Hmm.
 Indeed, the form itself directs the taxpayer to attach a statement explaining what is meant by “other.”
 Polonius would have a fit.
 Of course, more often than not, the return does not reflect any actual or imputed interest expense or interest income.