August 2000


By Scott A. Cheslowitz, CPA, Rothenberg & Peters, PLLC

When hearing about yet another Tax Court case concerning indirect shareholder loans involving an S corporation, most CPAs can be forgiven for replying: “Why read the case or memos? The answer is obvious—basis is denied.” However, the court recently turned heads with its decision in Culnen (TC Memo 2000-139). In Culnen, the Tax Court held that a shareholder did have basis by virtue of a direct transfer of funds from one controlled corporation to another controlled corporation.


The players in this case, all residents of New Jersey, are Wedgewood Associates, Inc., a restaurant business, an insurance brokerage firm, and Daniel Culnen. Culnen was a 40% owner of Wedgewood Associates, Inc., and later increased his ownership interest to 73%. The insurance brokerage firm Culnen & Hamilton, of which Daniel Culnen was the sole shareholder, made numerous payments to and on behalf of Wedgewood. The insurance brokerage firm even paid $570,000 to buy out one of the Wedgewood shareholders on behalf of Culnen. All of the payments were recorded on the insurance firm’s books as loans receivable from Culnen, and on Wedgewood’s books as loans due to Culnen. Wedgewood also recorded interest on those loans amounting to more than $600,000.

The loan basis allowed Culnen to deduct losses of $388,000, $651,000, and $214,000, for the tax years 1987, 1989, and 1990. (Wedgewood declared bankruptcy in 1990 and conveyed its assets to an assignee for the benefit of its creditors in an amount equal to $1, resulting in a flow-through loss on the sale of business property claimed by Culnen.)

The Decision

The IRS disallowed the losses and stated that under IRC section 1366(d), a shareholder’s losses are limited to the sum of her basis in S corporation stock and any debt directly owed to her by the S corporation. The IRS cited Hitchins, F. Howard [(1994) 103 TC 711], where it was found that because the debt did not run directly through to the shareholder, basis was disallowed. However, the Tax Court said that this does not mean that borrowed funds that originate with a closely related entity can never result in the individual shareholder having debt basis. The Tax Court said it would scrutinize the relationships surrounding the transfer of funds to ensure that they conform to the statutory requirement that debt run to the shareholder.

Based on the testimony of key parties (including the accountant) and the clean and consistent bookkeeping, the Tax Court found that it was reasonable in this case to consider the indirect payments as direct loans for the purposes of calculating debt basis. The court noted that the insurance firm was often used as an “incorporated pocketbook with payments often made on Culnen’s behalf and recorded as loans.”

Again, the court’s emphasis on clean books and consistent recordings led it to this decision. The lesson to CPAs is to read all the cases and court memos. The findings may be surprising and perhaps to our liking.

Edwin B. Morris, CPA

Rosenberg, Neuwirth & Kuchner


Contributing Editor:
Ira Inemer, CPA

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