Case — S Corporation Basis

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TL Case Summ

THE QUESTION

Can a taxpayer who owns two related S corporations contribute distributions received from the profitable company to the other company in order to deduct a loss?

THE DISPUTE

Taxpayer Says: The contributions constituted an economic outlay and increased the basis in the nonprofitable company and the losses could be claimed.

Internal Revenue Service Says: There was no actual economic outlay between the related parties, and the losses of the nonprofitable company should not be deductible.

THE LAW

From Internal Revenue Code Section 1366(a), (d): A shareholder of an S corporation is liable for the tax on his pro rata share of the corporation’s gross income. A shareholder is also entitled to deduct his pro rata share of an S corporation’s losses. Losses deductible by a shareholder are limited to the shareholder’s basis in the corporation. As a result, losses cannot exceed the sum of the shareholder’s adjusted basis in his or her stock in the S corporation and the shareholder’s adjusted basis in any indebtedness of the S corporation to the shareholder.

From Internal Revenue Code Section 1012, 351(a), 358(a)(1): A shareholder’s basis in his stock is increased by his contributions of capital to the corporation.

From Underwood v. Commissioner, 63 T.C. 468, 477 (1975), aff’d, 535 F.2d 309 (5th Cir. 1976): In determining whether a particular transaction qualifies as a shareholder investment, a taxpayer must make an actual “economic outlay”.

From Putnam v. Commissioner, 352 U.S. 82, 85 (1956): A taxpayer makes an “economic outlay” when he incurs a cost or is left poorer in a material sense after the transaction.

From Ruckriegel v. Commissioner, T.C. Memo. 2006-78: The fact that funds lent to an S corporation originate with another entity owned or controlled by the shareholder of the S corporation does not preclude a finding that the loan to the S corporation constitutes an “actual economic outlay” by the shareholder.

From Bhatia v. Commissioner, T.C. Memo. 1996-429: “[T]he existence of * * * [a close relationship between the parties] is not necessarily fatal if other elements are present which clearly establish the bona fides of the transactions and their economic impact.”

THE CAUSE OF THE DISPUTE

When you’re a shareholder in a Subchapter S corporation, you can deduct the corporate losses on your personal income tax return to the extent of your basis in the stock you own, as well as the amount you have loaned the company.

Your basis consists of your initial investment, and is increased or decreased by items such as income, losses, deductions, distributions, and contributions and loans you make to the company.

In this case, the taxpayer owned part of two S corporations, an auto dealership and a finance company that purchased notes from the auto dealership for cars sold. The auto dealership had losses, which the taxpayer did not have enough basis to deduct. The finance company was profitable, and the taxpayer had substantial basis in it.

On the advice of outside tax professionals, the finance company distributed accounts receivable to the taxpayer, which he contributed to the auto dealership. The contributions to the auto dealership increased his basis, allowing him to deduct the losses on his personal tax return for the three years in question (2004-2006).

The IRS said the transactions were carried out via journal entry, and never actually took place. In addition, no economic outlay was made because the journal entries had no economic reality and did not alter the economic position of the taxpayer. The transfers did not increase the taxpayer’s basis and the losses should not be deductible.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 34KB)

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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.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
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For the taxpayer. Shareholders in two related S corporations are not prohibited from receiving a distribution of assets from one of their S corporations and then contributing those assets into another of their S corporations in order to increase their bases in the latter. The effect is to decrease the shareholders’ bases in the S corporation making the distribution and thereby reducing the shareholders’ ability to get future tax-free distributions from the distributing S corporation, while increasing the shareholders’ bases in the S corporation to which the contributions are made. The fact that the two S corporations have a synergistic business relationship and are owned by the same shareholders does not preclude accomplishing the taxpayer’s goal, so long as the underlying distributions and contributions actually occurred. We find that these transactions did actually occur.
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