ordering rule for s corporation losses and distributions

It is said that repetition is the mother of all learning. It is also said that insanity is repeating the same mistake and expecting a different result. It is my hope that the result of the former will overwhelm the source of the latter before it is too late.

However, based upon the seemingly continuous flow of decisions from the Tax Court rejecting taxpayers’ characterization of their outlays of funds as indebtedness, it may be a forlorn hope.

What follows is a summary of one especially ill-advised or misguided taxpayer.

Debts and Distributions

Taxpayer was the sole shareholder of S-Corp.[i] The corporation operated a mortgage broker business. It acted as an intermediary between borrowers and lenders; it did not hold any loans itself. https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11650

Bad Debts?

In Tax Year, S-Corp. to make a series of advances to Borrower. The advances were made by checks, credit card payments, and wire transfers. Each advance was recorded on S-Corp.’s general ledger as a loan receivable from Borrower.

Borrower did not execute any notes for the advances received during Tax Year. The advances were unsecured, and neither S-Corp. nor Taxpayer made a public filing to record a debt in connection with the advances. Taxpayer did not know the business activities that Borrower conducted.

An adjusting entry in S-Corp.’s general ledger for December 31 of Tax Year reflected that Taxpayer instructed that the loan receivable for the Tax Year advances be written off.

On its return for Tax Year, S-Corp. claimed a large deduction for bad debts; the debt deduction was attributable to a write off for advances made to Borrower.

S-Corp.’s trial balance for the following tax year reflected that it made another loan to Borrower in that year. Taxpayer claimed not to know the purpose for that advance.

“Bad” Distributions?

As S-Corp.’s president and sole shareholder, Taxpayer authorized distributions to himself during the two years in issue. In Tax Year, Taxpayer received total distributions in excess of $1.6 million. In the following year, he received distributions in excess of $2 million.

For the years in issue, S-Corp. reported ordinary business losses, based in part on the bad debt deduction claimed for the advances made to Borrower. Taxpayer claimed S-Corp.’s losses on the Schedules E, Supplemental Income and Loss, Part II, Income or Loss from Partnerships and S Corporations, attached to his Forms 1040, U.S. Individual Income Tax Return. He engaged the same CPA firm to prepare S-Corp.’s returns and his individual returns for the years in issue.

For the years in issue, S-Corp. reported on its returns the distributions to Taxpayer. It issued Schedules K-1, Shareholder’s Share of Income, Deductions, etc., for Taxpayer that reflected the distributions and reported them as “[i]tems affecting shareholder basis”.

Taxpayer did not report any of the distributions that he received from S-Corp. for the years in issue on his individual returns.

The IRS Disagrees

The IRS examined Taxpayer’s income tax returns for the years in issue, and then issued a notice of deficiency in which it: (i) disallowed the full amount of S-Corp.’s claimed bad debt deduction for Tax Year – this adjustment flowed through to Taxpayer and was reflected as an increase to the income reported on his Schedule E; and (ii) determined that Taxpayer had unreported long-term capital gains for the years in issue.

Taxpayer petitioned the U.S. Tax Court.

Bad Debt Deduction

The Code allows a deduction for a taxable year for any debt that becomes wholly worthless within the taxable year. To deduct a business bad debt, the taxpayer must establish the existence of a valid debtor-creditor relationship, that the debt was created or acquired in connection with a trade or business, the amount of the debt, the worthlessness of the debt, and the year that the debt became worthless.

The IRS contended, and the Court agreed, that Taxpayer failed to establish any of these elements as they relate to the advances made by S-Corp. to Borrower during Tax Year.

A bad debt is deductible only for the year in which it becomes worthless. The Court explained that the subjective opinion of the taxpayer that the debt is uncollectible, without more, is not sufficient evidence that the debt is worthless.

The Court observed that Taxpayer failed to present any evidence that the alleged debt was objectively worthless in Tax Year. He testified only as to his subjective belief. Taxpayer did not identify any events during Tax Year which showed that the alleged debt was uncollectible. He testified that Borrower told him early in the following year that he could not repay the Tax Year advances, but he offered no reasoning as to why in that case the alleged debt should be treated as being worthless at the end of Tax Year.

Even accepting Taxpayer’s uncorroborated testimony, Borrower’s statement early in the following year was not enough to establish that the alleged debt to S-Corp. was objectively worthless at the end of Tax Year. Taxpayer did not describe any actions taken to try to collect the alleged debt, and he testified that he did not know whether Borrower was actually insolvent in the following year. Moreover, there was no reasonable explanation for advancing more funds to Borrower the next year if the prior advances were deemed totally unrecoverable.

Bona Fide Debt?

Taxpayer also failed to establish that the advances constituted a bona fide debt – “a valid and enforceable obligation to pay a fixed or determinable sum of money” – and that the parties intended to create a bona fide debtor-creditor relationship. Generally a debtor-creditor relationship exists if the debtor genuinely intends to repay the loan and the creditor genuinely intends to enforce repayment.

Factors indicative of a bona fide debt include: (1) whether the purported debt is evidenced by a note or other instrument; (2) whether any security was requested;

(3) whether interest was charged; (4) whether the parties established a fixed schedule for repayment; (5) whether there was a demand for repayment; (6) whether any repayments were actually made; and (7) whether the parties’ records and conduct reflected the transaction as a loan.

Borrower did not execute any notes, and Taxpayer did not request any collateral or other security for the advances. Taxpayer did not provide any documents reflecting the terms for the purported loan.

Apart from the way that the advances were recorded in S-Corp.’s general ledger, the parties’ conduct did not reflect that the advances were intended as a bona fide loan. S-Corp. made a series of unsecured advances to Borrower, and as the balance of the advances rapidly increased S-Corp. did not receive any offsetting payments or obtain any guaranties of repayment. Taxpayer did not claim that he and Borrower agreed to a schedule for repaying the advances or that he ever demanded repayment. Rather, he contended that he determined that the advances were uncollectible as of the end of Tax Year, only 10 days after the last advance had been made and without making any efforts to collect the amounts allegedly owed. He testified that by early the next year, he believed Borrower would not be able repay the advances, but he continued to direct S-Corp. to advance him more funds.

Taxpayer contended that he had a “good-faith expectation” that Borrower would repay him. He testified about his prior business dealings with Borrower, but the objective evidence and the preponderance of all evidence suggested that Taxpayer had no genuine intention of requiring Borrower to repay the advances. The real purpose of the advances remained unexplained.

The Court was not persuaded that a bona fide debt was created. It held that Taxpayer had failed to establish whether and when the advances became worthless or that the advances should even be considered a bona fide debt for tax purposes. Accordingly, the Court sustained the IRS’s determination to disallow the bad debt deduction in full.

Distributions from S-Corp.

The IRS contended that Taxpayer failed to report capital gains from the distributions that he received from S-Corp., during the years in issue. According to the IRS, the distributions were in excess of Taxpayer’s adjusted basis in S-Corp’s stock.

Under the Code, a shareholder of an S corporation takes into account their pro rata share of the corporation’s items of income, loss, deduction, or credit for the corporation’s taxable year ending with or in the shareholder’s taxable year. The Code also provides that a shareholder’s basis in their stock of the S corporation is increased by items of income passed through to the shareholder, and decreased by passed through items of loss and deduction. A shareholder’s stock basis is also decreased by distributions received from the S corporation that are not includible in the shareholder’s income. A distribution is not included in the gross income of a shareholder to the extent that it does not exceed the shareholder’s adjusted basis for the stock. The portion of a distribution that exceeds this adjusted basis is treated as gain from the sale or exchange of property.

Taxpayer contended that he did not take distributions in excess of basis. He claimed that he was personally liable to S-Corp. for the distributions that he received during the years in issue because he received them in violation of State law. Under State law, Taxpayer claimed, a shareholder who knowingly receives any distribution that exceeds the amount of the corporation’s retained earnings immediately prior to the distribution is liable to the corporation for the amount so received. For each of the years in issue, S-Corp.’s tax return reflected that it had negative retained earnings.

At this point, one might have expected Taxpayer to characterize the erstwhile “distributions” as loans from the corporation; after all, if his description of the result under State law was accurate, the funds had to be returned. However, Taxpayer instead contended that his liability to S-Corp. under State law “increased his debt basis in the corporation.” How this would have been relevant in determining the proper tax treatment of the distributions made to Taxpayer is anyone’s guess.

The Court stated that Taxpayer had misinterpreted the Code in arguing that his purported obligation to repay the distributions created debt basis. The Court then pointed out that even if Taxpayer established that he had basis in some bona fide indebtedness of S-Corp., it would not affect the taxability of the distributions that he received. The Court pointed out that the Code’s S-corporation-distribution provisions do not identify distributions that decrease a shareholder’s stock basis as an item to be applied to a shareholder’s debt basis after the stock basis has been reduced to zero.

The Court agreed with the IRS that the distributions had to be reported as income and treated as capital gain to the extent that they exceeded Taxpayer’s basis in S-Corp.’s stock. Taxpayer did not dispute the IRS’s calculations of his stock basis for the years in issue. Thus, the Court sustained the determination that Taxpayer had unreported capital gain for the years in issue.

Another One Bites the Dust

Taxpayer did not fare well, but he received his “just deserts.” He totally failed to establish that the advances to Borrower were real debts. The disallowance of the bad debt deduction claimed by Taxpayer resulted in an increase of his “flow-through” S corporation income and, thereby, an increase in his basis for his S-Corp. stock.

The interplay of the disallowed bad debt deduction for Tax Year, and the tax treatment of the distribution made to Taxpayer that year, affords us an opportunity to consider the order in which stock basis is increased or decreased under the Code, and the importance thereof.

The taxability of a distribution and the deductibility of a loss are both dependent on stock basis; for this reason, there is an ordering rule in computing stock basis. Under this rule – which favors tax-free distributions over currently deductible losses – stock basis is adjusted annually, as of the last day of the S corporation’s tax year, in the following order:

  1. Increased for income items;
  2. Decreased for distributions;
  3. Decreased for non-deductible, non-capital expenses; and
  4. Decreased for items of loss and deduction.

When determining the taxability of a distribution, the shareholder looks solely to their stock basis; debt basis is not considered, as Taxpayer learned.

Thus, there was a “silver lining” in the denial of Taxpayer’s loss deduction in that his stock basis was increased, thereby sheltering some of the distribution from S-Corp. – small comfort, though, because he recognized more ordinary income in exchange for less capital gain. Oh well.

 

[i] The corporation was always treated as an S corporation for tax purposes, and had no earnings and profits accumulated from the operations of any C corporation tax years.