Do loans between related businesses result in basis that allows the deduction of losses?
Taxpayer Says: Money borrowed from a wholly owned partnership and subsequently loaned to a wholly owned S corporation created basis and allowed the deduction of losses from the S corporation.
Internal Revenue Service Says: The loans had no economic substance and did not create basis. The losses are not currently deductible.
From Internal Revenue Code Section 1366(a): In determining tax liability for the year in which an S corporation’s taxable year ends, shareholders must to take into account their pro rata shares of: (1) The corporation’s income, losses, deductions, and credits whose separate treatment could affect the tax liability of any shareholder and (2) its non-separately computed income or loss.
From Internal Revenue Code Section 1366(d)(1): The aggregate amount of losses and deductions for any taxable year cannot exceed the sum of the shareholder’s adjusted bases in the corporation’s stock and any indebtedness of the S corporation to the shareholder.
From Underwood v. Commissioner, 63 T.C. 468 (1975): In order to acquire basis in indebtedness of an S corporation, case law has required that: (1) The indebtedness run directly from the S corporation to the shareholder and (2) the shareholder make an actual economic outlay that renders him poorer in a material sense.
THE CAUSE OF THE DISPUTE
Subchapter S corporations are “pass-through” entities. When you own a Subchapter S corporation, you deduct losses generated by the business on your personal income tax return, as long as you have basis in the corporation’s stock and loans. (Note: There may be other restrictions on the deductibility of losses, including at-risk and passive loss rules.) Without basis, losses are suspended, which means they are carried forward until you have basis to take them.
You acquire basis initially by purchasing the stock of your S corporation. Income you report on your tax return and capital contributions you make to the corporation increase basis. Losses you claim and distributions reduce basis.
Loans you make to the corporation can also increase your basis, provided the loans have economic substance, meaning they create an economic effect aside from merely allowing a tax deduction.
In this case, the taxpayer personally borrowed money from a partnership in which he was a partner and loaned that money to an S corporation in which he was a shareholder. The S corporation used the taxpayer-shareholder’s loan to pay rent to the partnership. The taxpayer believes the loans to the S corporation create the basis necessary to claim losses.
The IRS says the loans were circular transactions, with the money ending up where it began, in the partnership. Because the only reason for making the loans was to establish basis, the loans had no economic substance and did not create basis.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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