Deductibility of losses in leveraged S corporations.by Knight, Lee G.
THE TAXPAYER'S POSITION
Substance Over Form
The issue of guaranteed debt providing basis has been litigated often. Generally, the taxpayer does not deny that the actual debt instrument runs between the S corporation and a third party. Instead, he or she argues that despite the form of the transaction the substance is that the lender is looking primarily to the guarantor for repayment of the obligation. Although the taxpayer uses this substance-over-form argument in a variety of situations, the only successful approach focuses on a debt-equity recharacterization theory. Using this approach, the taxpayer attempts to recharacterize the guarantee as an equity investment by interpreting the flow of the debt proc4eds as a "deemed" triangular transaction. The theory is based on the supposition that if a lender requires a shareholder guarantee before making a loan and looks primarily to the shareholder for repayment, then the transaction should be looked upon as a loan to the shareholder followed by a loan or equity investment to the corporations.
The Thin Capitalization or
An early consideration of this theory is a 1972 Tax Court case, Blum v. Commissioner, in which the court applied a debt-equity analysis to the facts, but determined that the evidence did not support a recharacterization of the transaction. In Blum the sole shareholder of an S corporation guaranteed corporate loans made when the corporation had liabilities in excess of assets. The taxpayer argued that the loans were in substance made to him because the corporation was thinly capitalized and insolvent; no lender would loan funds to such an entity. With the loan in substance to the taxpayer, it must be considered that he simultaneously contributed the proceeds to the corporation, thereby increasing his stock basis. Applying a debt-equity analysis, the court refused to recast the transaction because the taxpayer failed to prove that the lender looked to him, rather than to the corporation, for repayment. Facts showed that the corporation had not failed to perform on the debt. The court however, acknowledged the merit of the debt- equity theory "in principle, ... upon a proper factual showing by the taxpayer."
The Pledged-asset Factor
More than a decade passed before a taxpayer succeeded in defending an increase in basis through guaranteed debt. In a 1985 Eleventh Circuit Court of Appeals case, Selfe v. United States, the taxpayer, Mrs. Selfe, was sole shareholder of a thinly capitalized retail clothing business. She operated the business as a sole proprietorship before incorporating and electing S status. Before incorporation, she obtained a line of credit from a bank, securing it with shares of stock she owned in another family corporation. After incorporation, at the suggestion of the bank, she converted the debt to a corporate loan guaranteed by her. The bank retained the collateral of Mrs. Selfe's stock in the other corporation. The S corporation performed on the obligation, making all payments of interest and principal. The District Court granted summary judgment in favor of the government. However, upon appeal, the decision was reversed and remanded to the District Court to determine whether the facts supported recharacterization of the transaction under debt-equity principles. In delivering the Court of Appeals' decision, Judge Kravitch explained that the pledge of assets, unrelated to the S corporation itself, is strong evidence supporting the assertion "that the bank was primarily looking to the taxpayer and her pledged stock for repayment of the loan." Relying upon the merits of debt-equity principles acknowledged by Blum in the context of S corporations, and relying upon these same principles applied successfully in several cases outside the context of S corporations, the court held that Mrs. Selfe's guarantee could increase the basis in her S corporation stock even though she had not yet made any payment on the obligation.
Economic Outlay Requirement
and the Single-step Doctrine
The IRS adheres to a strict application of statutory language, requiring an actual economic outlay be made by the taxpayer, regardless of whether the flow of funds is characterized as debt or equity. Debt basis arises from obligations of the S corporation to the shareholder, rather than from third-party loans, unless the shareholder performs on the debt. Stock basis arises from actual investment; deemed multi-step transactions are not recognized.
In Perry v. Commissioner, the Tax Court summarized its debt-basis position:
"The statutory language plainly refers to a debt of the corporation which runs to the shareholder. There is nothing in the statutory wording, nor the regulations nor the committee reports which warrants an inference that a shareholder's contract of guarantee with corporate creditors is tantamount to an indebtedness of the corporation to him."
In Perry, the Tax Court held that, "only after the guarantee does the debtor's indebtedness to the creditor become an indebtedness to the guarantor."
The mere guarantee of the debt, with no actual economic outlay by the guarantor has been resoundingly rejected by the courts, even when the shareholder pledged property as security on the loan. This is also the published position of the IRS in various rulings. Thus, the government sets three requirements before considering any debt to constitute basis against which losses may be deducted:
* That the corporation be under an existing unconditional and legally enforceable obligation to pay the shareholder;
* That the debt run directly to the shareholder; and
* That the shareholder has made through the debt an "actual investment" or "actual economic outlay."
The Tax Court does not easily accept the recharacterization of the transaction as stock investment. Each instance in which the taxpayer prevails in substance-over-form considerations is eventually refuted. After Blum's suggestion that the debt-equity theory might be used to obtain a basis increase, the Tax Court flatly rejected the argument. In a 1981 decision, Brown v. Commissioner, the Tax Court did not accept the taxpayer's use of Blum or the ability to invoke a classic substance- over-form argument. In Brown, the taxpayers were shareholder-guarantors of an unrelated creditor's loan to their thinly capitalized S corporation. They argued strenously that the court give effect to a two-step transaction: the lender making a loan to them followed by an investment by them in the S corporation. The court, citing the Supreme Court's opinion of a single-step transaction being treated as a series of steps, stated:
"A transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred .... This court has observed repeatedly that, while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not ... and may not enjoy the benefit of some other route he might have chosen to follow but did not."
Thus, the court reaffirmed its position that shareholder loan guarantees, purporting to be investments in stock, simply do not meet the requisite form. If the taxpayer intends to borrow money and invest in stock, why is the loan not originally made to the individual, and why is the transaction not originally recorded as equity rather than debt? In addition, the shareholder, not having been required to make any payments, has made no economic outlay. The taxpayer appealed the Brown decision, but in 1983 the Sixth Circuit Court of Appeals upheld the trial court's finding.
CONFLICT IN TAX COURT
When Selfe was heard in 1985, the government primarily relied upon Brown, asserting that Mrs. Selfe had not made the requisite economic outlay because she had not paid on the bank loans. The Eleventh Circuit, however, distinguished the pledged stock as the equivalent of an economic outlay, not in contradiction with the reasoning in Brown. In Selfe, the Court reasoned that a guarantor who has pledged stock to secure a loan is experiencing an economic outlay to the extent that the pledged stock is not available as collateral for other investments. Economic outlay results from the lost time value or use of the collateral. Once the economic-outlay barrier was overcome, the court proceeded to recognize a multi-step transaction, as if the bank loaned funds to Mrs. Selfe and she then made a capital contribution. It based this determination on the fact that the bank looked primarily to Mrs. Selfe and the collateralized stock as repayment.
The Leavitt Decision
Precedent does not support Selfe's conclusion with respect to a broad interpretation of economic outlay. Cases specific to S corporations also do not support debt-equity recharacterization. Only three years passed before Selfe was rejected. In 1988, the Tax Court decided the case of Estate of Leavitt v. Commissionher, narrowing the definition of the economic outlay requirement and rejecting the debt-equity substance- over-form argument in regard to S corporations.
Daniel Leavitt was a shareholder in VAFLA, an S corporation that operated an amusement park near Tampa, Florida during the years in question. Leavitt and the other shareholders thinly capitalized the business. Not long after incorporation, VAFLA incurred large net operating losses and retained earnings deficits. With liabilities in excess of assets and almost all assets collateralized against the initial mortgage, VAFLA sought bank loans. Leavitt and the other shareholders signed guarantee agreements on the loans, and based solely on these guarantees, the bank lent VAFLA substantial funds. By virtue of additional loans and capital contributions made by shareholders other than Leavitt, VAFLA was able to make all payments on the bank loans. VAFLA originally recorded the bank loans as "loans from shareholders." Leavitt deducted corporate net operating losses to the extent of his initial investment plus his share of the bank loans to VAFLA. The IRS disallowed his deduction of any losses in excess of the initial cash outlay. Leavitt asked the court to apply debt-equity principles. After all, VAFLA was insolvent at the time of the bank loans; the bank would not have advanced funds without the guarantee. Relying upon Blum, Leavitt argued that his situation met the burden of proving that the bank looked primarily to the guarantors. He further relied upon Selfe because it is the only S corporation case in which the taxpayer succeeded. Nevertheless, the Tax Court rejected Leavitt's arguments, finding that no action can be treated as an equity investment absent an economic outlay by the shareholder. It based this decision on a strict interpretation of the term "basis," under the statutes:
"The term 'basis' for purposes of deducting S corporation losses is defined in Sec. 1012 ... which provides the general rule that the 'basis of property shall be the cost of such property.' Reg. Sec. 1.1012-1(a) defines 'cost' to mean the 'amount paid' for property 'in cash or other property.' Because petitioner's guarantee in this case does not constitute cash or other property, the guaranteed loan amount cannot be included in the basis of petitioner's stock in the corporation."
In addition, the Tax Court specifically rejected Selfe because Selfe relied upon debt equity analysis as it had been applied in regard to C corporations. The court in Leavitt found this extension of the theory to be erroneous because of the following:
"Congress has promulgated a set of rules specifically applicable to S corporations, designed to limit the amount of deductions allowable to a shareholder of a subchapter S corporation .... The limit designed is the amount the shareholder has actually invested in the corporation and the amounts of income from the corporation which are included in the shareholder's gross income."
Thus, the Leavitt decision is bold and clear cut, ending the taxpayer's reliance upon both Blum and Selfe regarding basis issues involving guaranteed debt. The Tax Court eventually reviewed Leavitt en banc, with all but two judges agreeing with the results. One dissenting judge did not disagree with the ultimate finding, but did disagree with a total rejection of Selfe rationale. He believed there to be a limited area where a broad interpretation of economic outlay and debt-equity principles should apply, as in some cases involving a sole shareholder. The other dissenting judge was very outspoken in his disagreement with the ultimate finding in Leavitt, stating:
"This Tax Court has dangled an elusive carrot before taxpayers' eyes for more than 15 years since Blum stating that on the proper showing, a shareholder-guaranteed corporate debt can be characterized as a capital contribution. Petitioners here have made the proper showing, to which the majority states 'we were only kidding.'"
The taxpayer appealed the trial court's decision, but did not prevail. He also petitioned the Supreme Court, because Leavitt created conflict between the Fourth Circuit and the Eleventh Circuit's Selfe decision. The petition was denied. Thus, the current position of the Tax Court, and district court outside of the Eleventh Circuit, supports the government.
THE INTENT OF CONGRESS
Why is this issue the subject of so much litigation? Taxpayers continually take this issue to court, despite the voluminous body of case findings against them. What is Congress' intent in limiting the deductibility of S corporation losses to the shareholder's basis in his stock and basis in his loans to the S corporation?
Congress enacted subchapter S provisions in 1958. The purpose was to alleviate double taxation for the small entrepreneur. The original 1958 laws focused on income rather than losses. Losses in excess of basis could be lost forever under the 1958 laws. In 1982, Congress mitigated the harsh denial of losses by making S corporation provisions more like partnership provisions. It added Sec. 1366(d)(2) to the IRC, allowing an indefinite carryover of losses in excess of basis. Thus, S corporation shareholders did eventually receive tax benefit from losses, if not in future periods of holding the S corporation interest, then in the final disposition of the interest. Any limitation on current loss deductions is basically a timing difference.
Basis in Loans at the Entity Level
Despite the 1982 revision, a distinction remains between a shareholder's basis in his or her S corporation interest and a partner's basis in his or her partnership interest, with respect to the treatment of debt. A partner generally gets basis for third-party debt at the entity level; a shareholder does not. This is due to the difference in the legal forms of business; a partner has unlimited liability while the corporate entity shields the shareholder from liability. Congressional intent is therefore not to recognize any debt to third parties at the S corporation level as creating increased basis for the shareholder.
Basis in Stock
The report of the Committee on Finance of the Senate underscores Congress' definition of basis in stock to mean the shareholder's "investment" in corporate stock. No further definition of "investment" is stated. This is why taxpayers, caught in the trap of guaranteed debt, try to recharacterize the debt as an equity investment. Congress leaves the term "investment" vulnerable to interpretation. If, as the Committee Reports state, Congress does not intend for sophisticated taxpayers, or those with sophisticated advisors, to reap unintended tax benefits from subchapter S rules, then Congress needs to amend Sec. 1366(d) with a more specific definition of "investment."
THE TAXPAYER DOES NOT
If deductions for flow-through losses are disallowed upon IRS examination, the minimum cost is additional tax and interest. However, the taxpayer may also be subject to penalty for substantially understanding his or her tax liability if he or she does not prevail. The penalty automatically applies if the additional tax due, because of the disallowed S corporation losses, exceeds a threshold limit. The limit equals either 10% of the corrected tax liability after the disallowed losses are considered, or $5,000, whichever is greater. The penalty is severe--for tax years after 1989, it equals 20% of the additional tax.
The amount subject to the penalty may be reduced if the taxpayer shows that the substabce-over-form position has substantial authority under the law, or was adequately disclosed when the return was filed. The list of authorities upon which taxpayers may rely includes proposed regulations, private letter rulings, technical advice memoranda, actions on decisions, general counsel memoranda, information or press releases, notices, and any other similar documents published by the IRS in the Internal Revenue Bulletin. In addition, the list of authorities is to include General Explanations of tax legislation prepared by the Joint Committee on Taxation (the "Blue Book"). However, the weight of case law favors the government. Adequate disclosure means that a statement describing the tax treatment of taking S corporation losses in reliance upon basis generated from guaranteed debt must be attached to the taxpayer's return when filed.
THE RISK OF WINNING
The risk of prevailing is that the taxpayer may be subject to income tax arising from the S corporation's repayment of the debt. If the courts determine that the guaranteed debt is primarily that of the individual rather than that of the S corporation, then repayments by the S corporation, then repayments by the S corporation are considered distributions to the shareholder. If these distribusions exceed the adjusted basis of the shareholder's interest, then the excess is income to the shareholder. This circumstance generally occurs when the corporate net operating losses are large in relation to the debt at issue. The character of the income depends upon whether the debt is evidenced by a note or by an open account. If evidenced by a note, the income is capital gain. If evidenced on open account, the income is ordinary income.
TAX PLANNING ASPECTS
Use of guaranteed debt for purposes of increasing basis is not recommended, either at the outset of incorporation, or in restructuring existing financing arrangements. Because the form of the transactions apparently controls the courts' reasoning, the best plan is to control the form.
At Outset of Incorporation--Use
If third-party borrowing is necessary, structure a true triangular debt. Two transactions take place: 1) the lender makes a loan to the shareholder, and 2) the shareholder then lends or contributes the proceeds to the corporation. The parties should adhere to formalities. Note than instruments should be prepared when the shareholder loans funds to the corporation. A definite repayment schedule should be stated and complied with, along with adequate interest. The corporation should pay the shareholder, and the shareholder should then pay the bank with a personal check. If the lender requires security in corporate assets, the corporation should assign a security interest to the shareholder, and the shareholder can reassign the security interest to the lender.
Straight Substitution. The taxpayer can substitute his or her death for the S corporation's debt. The taxpayer can obtain a personal loan, adequate to pay off the corporation's debt. By loaning the new proceeds to the corporation, he or she creates the requisite debt between the corporation and the taxpayer to increase basis. The corporation then uses the new proceeds to pay off its debt to the third-party lender. If security interests are required, the parties should make back-to-back assignments.
Substitution via Subrogation. Alternatively, the shareholder can substitute his or her personal note for the corporation's note so that he or she is subrogated to the lender's rights against the corporation. Subrogation means that if the corporation defaults on the loan, then the lender requires payment from the shareholder. If and when the shareholder becomes obligated to the original lender, he or she may exercise all the rights of collection on the debt from the corporation. Under subrogation, the shareholder "stands in the place" of the original lender once the corporation defaults. The shareholder's basis in the S corporation would increase as, and to the extent, he or she makes payments to the third-party. This doctrine of subrogation succeeds only if, under state law, the lender accepts the new debt in full satisfaction of the corporation's debt, and if related parties are not involved, i.e., an outsider ready to enforce the obligation.
Increase Basis by Year-end. If conversion of the debt from an indirect to a direct obligation is not possible, other planning techniques to increase basis by year-end may be suitable. A shareholder may increase basis through an additional investment of funds in the corporation, unrelated to any restructuring of existing financing. Shareholders may choose not to withdraw funds affecting basis, such as any repayments of shareholder loans. Also, at the entity level, some discretion may be available to defer deductions or to generate income so a net operating loss can be controlled until further restructuring can be implemented.
Arrange for a Deferred Obligation. A shareholder may also consider using a deferred obligation sale to increase debt of the S corporation to him or her. Although this approach results in recognized gain if appreciated property is sold, such disadvantage must be weighed against the advantages of increased shareholder basis, and increased basis in the asset sold at the entity level. The idea is for the shareholder to sell capital gain property to the S corporation, receiving a minimal initial cash payment and financing the remainder. The shareholder's basis in the deferred payment obligation depends upon whether the installment method is applicable. There is some control over application of the installment method in that the taxpayer may at times elect not to use the method. The following is an example of this method.
Example: "K," a shareholder in S corporation "W" sells vacant land to W in 1989. The price is $50,000, to be paid $5,000 in cash and $45,000 in a note. The note is payable $5,000 per year for nine years. The land has an adjusted basis to K of $20,000. If the installment method is applicable, of the total $30,000 realized gain, K will recognize $3,000 in 1989. She will also have an initial basis of $18,000 in the deferred payment obligation as of December 31, 1989. $45,000 less unrecognized gain of $27,000. If the installment method is not applicable, such as if K elects not to use it, she will recognize the entire $30,000 gain in 1989, as a capital gain. K will also have an initial basis of $45,000 in the deferred payment obligation as of December 31, 1989.
This provides an excellent method of creating capital gains for an individual who has large capital losses that may otherwise be limited. It is doubly beneficial if the same individual, by virtue of not being able to deduct passive losses of the S corporation due to the basis issue, has excess passive income. Shareholders should, however, be aware of potential problems arising our of related party sales.
REMOVE THE HEAD FROM
The majority of court cases support the government's economic outlay requirement for guaranteed debt to increase a shareholder's basis in an S corporation. The substance-over-form argument is not likely to prevail because the Leavitt decision rejected debt-equity analysis in the context of S corporations. Only perhaps in the Eleventh Circuit, where the Selfe decision is precedent, might the taxpayer succeed, and, even then, under a very narrow set of circumstances.
Because of changes made by TRA 86, many entities are choosing to elect S corporation status. On making the election, shareholders may not even realize the potential consequences of having guaranteed debt. Shareholders may need to consider restructuring existing arrangements. Form and formalities are the key factors, and planning for them is critical to avoid losing deductible losses.
Ray A. Knight, JD, CPA, and Lee G. Knight, PhD, are Professors at Middle Tennessee State University. The have previously published articles in professional publications, including
The CPA Journal.
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