Not your loan, not your basis. One of last week’s year-end tips discussed how S corporation shareholders can make loans to their corporations to enable them to deduct K-1 losses. As if on cue, the Tax Court issued a case showing how not to do that.
An Arkansas nursing home operator ran the day-to-day business of the facilities through S corporations. The real estate was owned by LLCs owned by the operator and his wife, and which were taxed as partnerships.
When entrepreneurs own multiple entities, intercompany financing can be pragmatic. If one entity has extra cash, it becomes the lender when another related company needs funds. That appears to be how things worked in this group. Judge Cohen explains (emphasis mine, citations omitted)
To meet operating expenses at times when the businesses suffered revenue shortfalls, petitioner’s operating companies relied on numerous loans from various sources. For the five operating companies [S corporations] whose losses are the subject of respondent’s notice of deficiency… these loans fell into three categories: (1) loans received from the nursing home LLCs in which [spouse] held an interest (and, in the case of one of the operating companies, loans received from an individual nursing home LLC member) (LLC loans), (2) loans received from petitioner’s other operating companies (intercompany loans), and (3) loans received from banks or institutions having no connection with petitioner or the LLCs (commercial loans).
For all of the LLC loans and intercompany loans, and for some of the commercial loans, petitioner signed the notes evidencing the loans in his individual capacity as a coborrower along with his operating companies. With respect to these loans petitioner signed on as a coborrower, proceeds were advanced directly by the lending entity to the coborrowing operating company. To the extent payments became due on such loans, they were made by the operating companies and not out of petitioner’s personal account.
The taxpayer took losses from the S corporations using these loans as basis. The IRS said that the loans weren’t made directly by the taxpayer, so the losses were no good.
Judge Cohen explains the rules:
In any event, it is well settled that for basis to be created for a shareholder under section 1366(d)(1)(B), the corporation’s indebtedness must run “directly to the shareholder.” No basis is created for a shareholder when funds are advanced to an S corporation by a separate entity, even one closely related to the shareholder. As is often said, “[n]o form of indirect borrowing, be it guaranty, surety, accommodation, comaking or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation. Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.”
The nursing home operator argued that the loans were his under Arkansas law. The Tax Court said that didn’t help:
Petitioners argue that under Arkansas State law a coborrower is “directly liable” for repayment and that his liability “is the same as if the loan were made to the borrower individually.” Petitioners believe that the assumption of coborrower’s liability, which they say put “[petitioner’s] own funds * * * at risk”, amounts to an economic outlay by petitioner that should be treated, in effect, as indebtedness of the operating companies to him. This is, however, the reasoning that has been rejected by this Court and others in prior cases. Those cases make clear that the bare potential for liability, without more, will not be considered a real economic outlay by a shareholder.
What would have caused him to get basis in the loans?
As coborrower, petitioner could theoretically have been required to make payments to the lenders when they became due, and in such a case it would be possible to say that petitioner’s payments subrogated him to the rights of the original lender; in that case, the operating company would be directly indebted to him. However, petitioner was never so required.
The court found that the operator was economically at most a guarantor of the loans, and therefore got no basis:
Because the form of the transactions shows the indebtedness existed directly between the operating companies and the lenders, and because petitioners have not shown that the substance of those transactions should be viewed differently from [*25] their form, we conclude that petitioner’s role as comaker or guarantor of the operating companies’ notes did not entitle him to claim basis in the indebtedness of the operating companies under section 1366(d)(1).
The IRS assessed over $3 million in deficiencies for 2009 and 2010, much of which apparently were for the S corporation disallowed losses.
The moral? When you want to loan money to your S corporation to get yourself basis to deduct losses, take no shortcuts. If you need to get the cash from another entity you own, make a distribution from that entity and then loan it yourself to the corporation. If the shareholder needs to borrow the funds to make the loan, they should borrow the funds directly from a party without an interest in the activity and then re-lend the proceeds to the the S corporation.
Cite: Hargis, T.C. Memo. 2016-232
This is part our series of 2016 year-end tax tips. Check for a new tip every day through December 31.
Bruce Campbell dies. The Iowa tax scene lost a giant last week with the death of Bruce Campbell, a whip-smart small-town Iowa boy with a Harvard law degree and the dryest sense of humor this side of the Sahara. His obituary is here.
Peter Reilly, Tax Court Sustains IRS Strict Interpretation Of Charitable Acknowledgement Rules:
One of the things that I am moderately fanatical about is getting good charitable contribution acknowledgements for my clients. Also when I have been involved with not-for-profits, I have endeavored to make sure that they have sent out good acknowledgements. It is not exactly rocket science. The Code requires that for contributions of $250 or more there must be a “contemporaneous written acknowledgement” that includes:
(i) The amount of cash and a description (but not value) of any property other than cash contributed.
(ii) Whether the donee organization provided any goods or services in consideration, in whole or in part, for any property described in clause (i) .
(iii) A description and good faith estimate of the value of any goods or services referred to in clause (ii) or, if such goods or services consist solely of intangible religious benefits, a statement to that effect.
“Contemporaneous” means that you have to have the written acknowledgement in your hot little hand at the earlier of the filing of your return or its due date including extensions.
Carelessness here blew a claimed deduction of $64 million. As Peter says, “Ouch!”
Lew Taishoff, EXECUTIVE NULLIFICATION. “What happens when Congress tells Treasury to make regulations, and Treasury doesn’t? What happens when Congress suggests Treasury make regulations, but Treasury doesn’t?”
Russ Fox, FINCEN Announces Due Dates for 2016 FBARs: “The FBAR will now be due on the same day as tax returns with an automatic extension for six months. There is no need to file a separate extension with FINCEN for the FBAR. Basically, this means the FBAR is now effectively due on October 15th.”
Roger McEowen, The Non-Corporate Lessor Rule – A Potential Trap In Expense Method Depreciation. “The rule makes it difficult for farm landlords to claim expense method depreciation with respect to many real estate improvements, particularly those that don’t require repairs and maintenance in that first 12-month period.”
Paul Neiffer, A New Simple Retirement Account Option for Farmers and Their Employees
Tony Nitti, When Are Professional Education Expenses Tax Deductible? “Youth may indeed be wasted on the young, but college is DEFINITELY wasted on those who haven’t first had their souls crushed by the real world.”
Robert Wood, For Trump Tax Cuts, Pay Legal & Other Bills In 2016. “But not every legal bill is tax deductible.”
Jason Dinesen, Glossary: C-Corporation. “A C-corporation is a tax term referring to one of two ways a corporation can be taxed.”
Annette Nellen, New Required Preparer Due Diligence for AOTC and Child Tax Credit. Once again preparers are required to preparer paperwork to pretend to fight refundable credit scammers. Honest taxpayers will pay, and the scammers will use Turbotax anyway.
Andrew Mitchel, Final Code §987 Regulations!! “Code §987 and the regulations thereunder deal with taxpayers that have one or more qualified business units (‘QBUs’) with a functional currency other than the dollar (or a functional currency other than the functional currency of the taxpayer).”
Kay Bell, Amazon to collect sales taxes in 2017 from Iowa, Nebraska and Utah online shoppers
Keith Fogg, Getting a Copy of the Fraudulent Return Filed in Your Name (Procedurally Taxing).
Jack Townsend, Q. How Many IRS Special Agents Brandishing Guns Does It Take to Execute a Tax Crimes Search Warrant? A. 73. That’s not funny.
Kristine Tidgren, Future of “Farmer Fair Practices Rules” Uncertain, Even as Unveiled (Ag Docket)
TaxGrrrl has kicked off her “12 Days of Charitable Giving 2016”, so far highlighting Alex’s Lemonade Stand, Chapel Haven, and Puppies Behind Bars.
Robert D. Flach comes through with a last-week-of-the year Buzz! Claiming dependents, year-end tax mistakes and lots of Trump in this final 2016 Buzz roundup.
Jim Maule, Music, Medicine, and Tax. “How many tax return preparers have music playing in the background while preparing returns, or interviewing clients?” As I right this I’m playing Eric Clapton’s rendition of “Early in the Morning.”
Morgan Scarboro, Will a New St. Louis Stadium Sales Tax Proposal be a Shutout? (Tax Policy Blog). “Even after St. Louis taxpayers were stuck with the bill in 2015 when the NFL’s Rams left for Los Angeles, city officials are now looking to finance a new $200 million stadium in the effort to attract a Major League Soccer team.” Brilliant.
Howard Gleckman, The 2016 Tax Vox Lump of Coal Award for the Year’s Worst Tax Ideas (TaxVox). Both major party 2016 presidential candidates find themselves carbon-enriched.
David Herzig, The Amazing Section 1202 (Surly Subgroup). “Let me start with the big lead: You can exclude from capital gains taxation the GREATER of $10,000,000 or 10 times the taxpayer’s aggregate adjusted basis. Yep, if your basis was $40,000,000, then your excludible amount is $400,000,000!”
Robert Goulder, Diagnosis: Trump Suffers From VAT Envy (Tax Analysts Blog). “VAT is neither a trade subsidy nor a trade barrier. In fact, VAT is economically neutral.”
Carl Davis, New Year’s Gas Tax Changes: Seven Up, Two Down (Tax Justice Blog).
TaxProf, The IRS Scandal, Day 1325, Day 1326, Day 1327, Day 1328
News from the Profession. PCAOB Inspectors Find IT Auditors on the Struggle Bus (Megan Lewczyk, Going Concern).
