S Corporations: New Regulations, Back-to-Back
Loans and Adjusted Basis of S Corporation Debt
J. LEIGH GRIFFITH , J.D., LL.M., CPA, is a Partner at Waller Lansden Dortch & Davis, LLP, in Nashville, Tennessee.
For federal income tax purposes, an S corporation is a form of pass-through entity and generally does not pay federal income tax on its income and gain. 1 Income is passed through to the shareholders in accordance with
stock ownership. Losses are similarly passed through to each of the S corpora-tion’s shareholders to the extent of the shareholder’s adjusted basis in stock and debt of the S corporation to such shareholder. With respect to S corporation debt to shareholders that can support losses, the language of Code Sec. 1366 only requires that the debt be between the S corporation and the shareholder. Losses in excess of the adjusted basis of such debt and the adjusted basis of a shareholder’s stock are suspended. To the extent losses are passed through to a shareholder, subject to various limitations such as the “at risk” rules and passive activity loss limitations, they may be used to reduce the shareholder’s other taxable income and gain. S corporation losses fl owing to a shareholder fi rst reduces the shareholder’s adjusted basis in his or her S corporation stock and then the adjusted basis in any indebtedness of the S corporation directly to the shareholder. 2 S corporation income fi rst increases the adjusted basis of
a shareholder’s S corporation debt and then the adjusted basis of such share-holder’s stock. 3
Unlike a partnership in which the entity level debt is shared by its partners and increases each such partner’s basis, 4 S corporation debt to others does not increase
the basis of the S stock in the hands of its shareholders. All too frequently, an S corporation shareholder is looking at S corporation losses that are suspended and cannot currently be used by such shareholder because the shareholder does not have suffi cient adjusted basis in the shareholder’s S stock or S debt.
Th e situation of inadequate basis has generated a great deal of confusion and controversy for both the taxpayers and the courts. Code Sec. 1366 provides the aggregate amount of losses and deductions taken into account by a shareholder cannot exceed the adjusted basis of the shareholder’s stock and “the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder ...” 5
It is particularly frustrating to shareholders who have guaranteed S corporation third party debt, have the economic risk of loss, but cannot utilize S corporation losses because of the lack of basis. Th e guarantee itself does not generate basis. In contrast, a partner obtains basis as a result of the partner’s share of partnership debt whether or not such debt is guaranteed. 6
By J. Leigh Griffi thpassiv other first r ar a ax duc o tivity ble es th y loss l ncome e shar mitat an ho ions, gain. er’s a limitat y ma orpora ted basi on e on s in sed to losses his or reduce the owing to er S cor shareh a share ration older ho st t a sh
Shareholders have tried a variety of methods to at-tempt to increase their debt-adjusted basis in order to take advantage of current S corporation losses. Often S corporations are smaller businesses with less sophisticated tax advisors who become confused by the diff erent tax rules applicable to partnerships and S corporations. In addition the courts also have gotten confused and have created and misapplied a judicial doctrine of “actual economic outlay” with respect to back-to-back loans whereby a shareholder (1) borrows funds from a related party and reloans the funds to the S corporation or (2) restructures a related-party debt to the S corporation into a related-party debt to the shareholder followed by a loan from the shareholder to the corporation. Th ese methods include (1) guarantees; (2) loans from entities owned by the shareholders to the S corporation; (3) contribution of shareholder notes (including demand notes); (4) attempted restructuring of related-party debt to cause such debt to be an obligation of the S corpora-tion to the shareholder with the shareholder owing the related party an amount equal to such debt; and (5) a circular fl ow of funds whereby (a) a second entity owned by a shareholder loans dollars to the shareholder, (b) the shareholder contemporaneously loans similar amounts to the S corporation, and (c) the S corporation repays loans or other obligations to the second entity in a similar amount.
Reg. §1.1366-2 concerning Code Sec. 1366(d)(1)(B) was amended in July 2014 7 to address or clarify debt
basis issues in three situations: (1) basis increases related
to guarantees or similar arrangements involving a loan to an S corporation; (2) basis increases involving a loan directly to an S corporation from an entity related to the S corporation shareholder under the so called “incorporated pocketbook” theory; and (3) basis increases associated with traditional back-to-back loans. Th ese fi nal regulations (“Final Regs.”) do not address basis increases of stock and the Treasury is continuing to study those issues. Th e Final Regs. leave it up to existing law to defi ne what constitutes
a bona fi de debtor-creditor relationship between the S
corporation and a shareholder. 8 While the determination
is fact and circumstance specifi c, the circular fl ow of funds structures present diffi cult analytical issues and are likely to lead to many future disputes between the taxpayer and the IRS, subsequent litigation and inconsistent court results.
Shareholder Guarantees of Loans
Th e Final Regs. clearly provide that the guarantee of an S corporation debt, serving as a surety for an S corporation’s debt, serving as an accommodation party, or in any similar capacity relating to a loan does not create or increase the basis of indebtedness to a shareholder until there has been an actual economic outlay by the shareholder. 9 For this
purpose, a payment by an entity disregarded for federal income tax purposes in which a shareholder is the sole owner is considered a payment by the shareholder. 10 Th e
actual economic outlay standard as developed by the courts requires that the shareholder be made “poorer in a material sense” to increase his basis in S corporation indebtedness. In this context, courts have concluded that an S corporation shareholder was not poorer in a material sense if the shareholder borrowed funds form a related entity and then lent those funds to his S corporation. Rather baffl ing to the author is the preamble’s state-ment: “With respect to guarantees, however, the Final Regs. retain the economic outlay standard by adopting the rule in the proposed regulations that S corporation shareholders may increase their basis of indebtedness only to the extent they actually perform under a guarantee.” 11
Th e text of the Final Regs. retains the requirement that for the shareholder to have basis, the shareholder must perform under the guarantee. Performance or payment, however, may be diff erent than complying with “eco-nomic outlay.” Presumably the shareholder’s payment on the guarantee creates a right of subrogation and therefore the basis will be with respect to debt from the S corpora-tion to the shareholder. Th e author does not believe the statement in the preamble regarding the application of the economic outlay standard is technically accurate if the courts’ engrafting of “poorer in a material sense” is included in such a meaning. If the shareholder receives funds via a bona fi de loan from a related entity (or wholly owned entity that is not disregarded) or a distribution from such entity and uses those funds to pay a guaran-tee, the shareholder should have basis. If the shareholder has subrogation rights, the basis should be that of debt under Code Sec. 1366(d)(1)(B) . If the shareholder does not have subrogation rights, the shareholder should have basis under Code Sec. 1366(d)(1)(A) .
The situation of inadequate basis has
generated a great deal of confusion
and controversy for both the
taxpayers and the courts.
sg Code c 13 6(d (1)(B) the sh to rule i hold he ext he econ e pr may in they act om se ea ual regula their y perfo tions that S asis of ind m under S corpo btedne guara ratio s o te s or il her r oth 66-2 d g. §1.136 d
alg §1 amou
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In these transactions, the transfer from a related entity directly to the S corporation is found to be made on the shareholder’s behalf and is, in substance, a loan from the related entity to the shareholder, followed by a loan from the shareholder to the S corporation. It is fairly rare that this will be found to be the case. 12 Th e Final Regs.
did not eliminate this possibility, but a loan by an entity owned by the taxpayer does not constitute a loan of the shareholder unless the facts and circumstances establish a bona fi de creditor-debtor relationship directly between the shareholder and the borrowing S corporation. 13 On
September 21, 2012, as reported by Tax Analysts, Caro-line Hay, branch 3 attorney-advisor, IRS Offi ce of Chief Counsel (Passthroughs and Special Industries) and the principal author of the Final Regs., commented on the then-proposed regulations and indicated that under the appropriate facts and circumstances the “incorporated pocketbook” situations could be classifi ed as a bona fi de
debt to the shareholder 14 and therefore provide basis under
Code Sec. 1366(d)(1)(B) .
According to the preamble of the proposed regulations 15
the regulations were proposed to clarify the require-ments for increasing basis of indebtedness and to assist S corporations shareholders in determining with greater certainty whether their particular arrangement creates basis of indebtedness. Th e preamble to the Final Regs. states an S corporation shareholder need not otherwise satisfy the “actual economic outlay” doctrine for pur-poses of Code Sec. 1366(d)(1)(B) . 16 Th e preamble to
the Final Regs. also states “... the proposed regulations provided that shareholders receive basis of indebtedness if it is a bona fi de indebtedness of the S corporation to the shareholder.” 17 Th e driver for the regulation was to
reduce the frequency of disputes between S corporation shareholders and the IRS and reduce the uncertainty on the part of both the shareholder and the government. When the shareholder has related entities and loans between and among the shareholder and/or the related entities, economic substance and tax consequences get rather confusing. Th e Code (and the new Final Regs.) require the “indebtedness of the S corporation to the shareholder.” Th e courts had moved away from legal rights into the area of an “actual economic outlay” standard when analyzing back-to-back loans or other arrangements involving related entities, the shareholder, and a loan or purported loan from the shareholder to
with the Code, the Final Regs. merely provide if there is a bona fi de indebtedness 18 between the S corporation and
the shareholder, the shareholder will have basis. How to determine what constitutes a bona fi de indebtedness is left to the federal tax common law—much of which has been developed outside of Code Sec. 1366 . 19 Th e fact
the shareholder obtained the funds by borrowing from a third party, a related party, or even an entity wholly owned by the shareholder, is irrelevant. Th e question is not the source of funds, but whether the S corporation has a bona fi de debt to the shareholder. In order to clarify this point, the Final Regs. contain two examples.
Th e fi rst example on back-to-back loans is Example 2 of the Final Regs. 20 Th is is an extreme version of the classic
back-to-back loan transaction whereby the sole sharehold-er of S corporation 1 borrows funds from S corporation 1 and then loans such funds to S corporation 2 of which the shareholder is also the sole shareholder. Under prior case law, many courts would not honor such a back-to-back loan, as the shareholder is not “poorer in a material sense.” Th e Final Regs. provide that so long as under the facts and circumstances the loan from the shareholder to the borrowing S corporation is a bona fi de indebtedness, the shareholder’s basis of indebtedness will support losses from the S corporation. 21
Example 3 of the Final Regs. is the second example concerning back-to-back loans and involves restructuring a loan between to wholly owned S corporations into a loan between one S corporation and the sole shareholder. 22
Un-der the facts of this example, the note held by S corporation 1 evidencing the loan to S corporation 2 was distributed to the sole shareholder. In the example, under state law, S corporation 2 would no longer be entitled to payment but only the shareholder would be entitled to payment. Th is was found to provide basis to the shareholder so long as the debt was a bona fi de debt of the corporation to the shareholder. Th e example states that under local law, the debtor S corporation was relieved of its liability to the original lender corporation and was directly liable to the shareholder. Under prior case law, 23 such a loan would not
be honored to give the shareholder basis in the debt of the debtor S corporation because the shareholder as the owner of both corporations was not poorer in a material sense. If under local law the debtor S corporation continued to owe either the shareholder or S corporation 1, the tax result is unclear. 24 Th is situation was apparently raised with the
IRS but was not clarifi ed in the Final Regs.
Comments by the ABA Section of Taxation with respect to the proposed regulations requested that, due to the confusion
sis of indebted ers in determ articular a preamb mining w rangem o the d it en ina o grea cr Re ter tes s con a b cernin n bet ween of the ack-t n to wh S corpor Fi ac ll atio loans owned n and t nd involves corporat sole sh restru ons into holde turin a 22 ording too th l i ebted is of f inde S w asin er d asin har ert si he men men S co regu nts fo nts fo orpor tainty is of ulati for in for in ratio y wh f inde ons ncrea ncrea ons sh hethe ebted the ess.ss ic ou d)(1) utlay” (B) . doc Th e
on the part of the courts with respect to “the economic outlay standard,” the text of the regulations should clearly state that doctrine does not apply to back-to- back shareholder loans so long as the debt to the shareholder is a bona fi de obligation. Th e Final Regs. did not incorporate this comment but the preamble states: “... the Treasury Department and the IRS believe that the proposed regulations clearly articulate the standard for determining the basis of indebtedness of an S corporation to its shareholder, and future discussion of the actual economic outlay test in the regulations is unnecessary. Accordingly, the Final Regs. adopt the rule in the proposed regulations without change.” 25
Th e ABA Section of Taxation comments on the pro-posed regulations also propro-posed an example of a circular fl ow of funds to accomplish loan restructurings to wind up with a shareholder loan to the S corporation. Th e IRS declined to include this or any other example involving circular fl ow of funds. Th e preamble of the Final Regs. state: “Th e Treasury Department and the IRS are aware, however, of cases involving circular fl ow of funds that do not result in bona fi de indebtedness. See for example,
Oren v. Commissioner ... Kerzner v. Commissioner ...
whether a restructuring represents in bona fi de indebt-edness depends on the facts and circumstances.” 26 Th e
failure to have an example in the Final Regs. of a circular fl ow of funds and the citation to these particular cases greatly concern the author and raise the concern that a sibling concept to “economic outlay,” that of “at risk,” is lurking and may continue to apply. If this is the case, restructuring existing situations to comply with the Final Regs. may be more diffi cult than a reading of the Final Regs. might indicate.
In Oren , the taxpayer owned two S corporations and with his family owned a third. Th e S corporations were involved in the trucking industry. Dart (the family-owned company) was a motor carrier that provided “truckload” service through the lower 48 states using independent driv-ers who leased or owned their tractors. HL leased traildriv-ers to Dart. HS “leased to purchase” tractors to independent contractor drivers. Due to depreciation on equipment, HS and HL generated tax losses for which Oren needed basis for the losses to pass-through. Over three years, Dart loaned Oren approximately $15 million who in turn loaned the same amount to HS and HL, both of which then contemporaneously loaned the amounts back to Dart. Actual funds changed hands, contemporaneous notes (payment on demand plus 375 days) were executed, interest was paid, and the loans were recorded on the books of the various corporations. Th e IRS disallowed the increase in basis under Code Sec. 1366(d) because Oren had not made the “actual economic outlay.” As an
alternative, if the loans properly increased Oren’s basis, the IRS disallowed the deductions because the funds were not “at risk” within the meaning of Code Sec. 465 . Th e Eighth Circuit stated: “We agree with the tax court that Oren’s loans to HL and HS had no economic substance and, thus, were not real economic outlays.” It is clear the Court of Appeals was applying the “economic outlay stan-dard” with its requirement that the shareholder be made “poorer in a material sense” in order to increase his basis. Th e Court of Appeals concluded: “Oren’s loans were not actual economic outlays. He was in the same position after the transactions as before; he was not materially poorer afterwards. Th e transactions much more closely resemble off setting book entries or loan guarantees than substan-tive investments in HL and HS.” 27 In reviewing the Code
Sec. 465 alternative argument, the Court of Appeals also determined that the taxpayer was not “at risk” under Code Sec. 465 . Th e Court of Appeals stated: “Th e at risk analysis is very similar to the actual economic outlay analysis ...” 28
In Kerzner , 29 Mr. and Mrs. Kerzner had a partnership,
which made cash loans to the Kerzners who deposited such amounts in their personal bank accounts. Th e Kerzners then contemporaneously loaned such funds to their wholly owned S corporation. Th e S corporation paid equivalent amounts of rent back to the partnership. Judge Nims framed the case: “Th e issue for decision is whether peti-tioners made an economic outlay on yearly loans to their S corporation, giving them a suffi cient basis in indebted-ness under section 1366(d)(1) to claim the S corporation’s losses ...” 30 Th e partnership reported the interest income
from the Kerzners on the Kerzners’ K-1s and they reported such income on their returns. Th e Kerzners reported the interest expense as investment interest on their tax returns. Th e S corporation, however, apparently did not report interest expense nor did the Kerzners report interest in-come with respect to the loans to the S corporation. Th is scenario apparently occurred each year from 1986 through 2001. Th e case involved the 2001 tax year and a loss car-ryback to 1996 and 1997. Th e Tax Court found there was no question that an indebtedness ran directly from the S corporation to the shareholders. In the Tax Court’s mind “Th e issue is thus whether petitioners made an economic outlay on the yearly loans to HCI [the S corporation].” Th e Tax Court cited Oren for the proposition that a brief circular fl ow of funds designed solely to generate bases in an S corporation has no economic substance. Disturbingly the Tax Court stated: “In the case before us, there is no back-to-back loan situation. Instead, there is a circular fl ow of funds.” 31
Th e refusal of the Treasury and the IRS to include a cir-cular fl ow of funds example and the citation to these cases
nomic outlay,” nue to apply tions to co t than a If this mply wi ading f “ s h f th r he ca e F e Fin se, nal al ness lo fr unde s ...” m the , giving tion The part ners on th 66 er he d)(1) to ip rep Kerzne claim the S ted the in K 1s an corpo terest i hey re ation c po of l ds an fund e mo i gs. mmay b i h th to stin o to ay estr g ea ibli ibli s lu atly c ing c ing c urkin ructu gs m conc conc conc ng an uring may b ern t ept t ept t nd m g exis e mo ng s e diffi g d ned rd. Th two Th e S S corp corp
in an initial application. Th e preamble indicates that there are appropriate circumstances when it will be honored, but only cites cases where the court determined it was not ap-propriate. However, as discussed above, the basis in these cases for the inappropriateness was the “economic outlay” doctrine, which the regulations are supposed to be reject-ing. With respect to a circular fl ow of funds the regulations may not have eliminated the rationale of economic outlay if the preamble comment is read literally.
Based on presentations by AICPA members on the subject of basis in S corporation stock and debt at the IRS Nationwide Tax Forums during the summer of 2012, the AICPA comments to the proposed regulations recommended an example of a bona fi de debt of the corporation to the shareholder which has no adjusted basis and therefore do not support losses. 32 Th e example
used was accrued payroll and bonus payments to the S corporation shareholder by a cash method S corporation. Th e shareholder would not yet have recognized income and therefore the basis would be zero. Th e IRS declined to elaborate on this suggestion or provide the example in the Final Regs. believing that the cross-reference to Reg. §1.1011-1 and Code Sec. 1367(b)(2) is suffi cient.
Suspended Loss Carry-Forward
Th e Final Regs. were not amended to alter the historic rules concerning the carry-forward of the amount of losses and deductions for a tax year that are suspended as a result of insuffi cient basis in stock and debt and the character of such losses and deductions is retained and treated as incurred in the next subsequent year until used by the taxpayer S corporation shareholder. 33
Contribution of Shareholder Note
Th e Final Regs. were not amended to modify or clarify how to treat the contribution of a shareholder note to the S corporation that can be enforced by the S corporation. Th e Final Regs. strictly dealt with basis in the context of debt and the preamble said the Treasury Department and IRS were continuing to study issues relating to stock basis and may address these issues in future guidance. Th erefore, the Final Regs. leave unchanged the holding of Rev. Rul. 81-187 34 that a shareholder does not increase his basis in S
corporation stock for purposes of Code Sec. 1366(d)(1)(A) by contributing the shareholder’s own unsecured demand promissory note to the corporation. Such a note has no adjusted basis.
Taxpayers May Elect to Apply
to the Past
Under Code Sec. 7805(b) the Treasury cannot apply regulations retroactively to any statutory provision en-acted after July 30, 1996. However, under Code Sec. 7805(b)(7) , the Treasury is permitted to allow taxpay-ers retroactive application of a fi nal regulation through election. Th e amended provisions of the Final Regs. are eff ective for indebtedness between an S corporation and its shareholders resulting from any transaction occurring
on or after July 23, 2014. However, S corporations and their shareholders may rely on the Reg. §1.1366-2 with respect to S corporation indebtedness to a shareholder that resulted from any transaction that occurred in a year for which the period of limitations for assessment of tax has not expired before July 23, 2014.
Th e new Final Regs. are benefi cial in establishing that the “economic outlay” doctrine should not apply to de-termine if a shareholder loan to an S corporation creates basis in indebtedness to meet the requirements of Code Sec. 1366(d)(1)(B) . What constitutes a bona fi de creditor-debtor relationship between a shareholder and a borrowing S corporation is determined by general tax principles and taxpayers and practitioners are cautioned that such a determination is based on all the facts and circumstances. Th e failure to clarify (either taxpayer favorable or unfa-vorable) the circular fl ow of funds scenario will result in more litigation and probably more misapplication of the law by the courts and represents a missed opportunity by the IRS to avoid many future disputes.
The new Final Regs. are benefi cial
in establishing that the “economic
outlay” doctrine should not apply
to determine if a shareholder loan
to an S corporation creates basis in
indebtedness to meet the requirements
of Code Sec. 1366(d)(1)(B).
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1 See Code Sec. 1361 et seq. However see Code
Sec. 1374 for the built-in gain tax provision.
2 Code Sec. 1367(a) and (b).
3 Code Sec. 1367(b) .
4 Code Secs. 705 and 752 .
5 Code Sec. 1366(d)(1)(B) .
6 Code Sec. 752 .
7 T.D. 9682 , July 23, 2014.
8 See R. Broz , CA-6, 2013-2 USTC ¶50,488, 727 F3d
621 (for an example of back-to-back loan agree-ment that did not constitute a bona fi de debt between the S corporation and the shareholder. See J. Leigh Grifﬁ th and Brian S. Masterson, Broz v. Commissioner: How Not to Structure Back-to-Back Loans to an S Corporation , TAXES , Apr. 2014, at 29 (for a discussion of Broz ).
9 Reg. §1.1366(a)(2)(ii) Ex. 3.
10 Reg. §1.1366(a)(2)(iii) Ex. 1.
11 T.D. 9682 , July 23, 2014.
12 See C.E. Yates , 82 TCM 805, Dec. 54,523(M) , TC
Memo. 2001-280 and D.J. Culnen , 79 TCM 1933, Dec. 53,856(M) , TC Memo. 2000-139.
13 Cf. Reg. §1.1366(a)(1)(ii) .
14 136 TAX NOTES 1558 (Sept. 24, 2012).
15 Notice of Proposed Rulemaking, Reg.
§134042-07, 2012-27 IRB 5.
16 T.D. 9682 , July 23, 2014. 17 Id.
18 Bona fi de indebtedness is not deﬁ ned in the
regulations. The preamble of the Proposed Reg. §134042-07 states that general federal tax prin-ciples—many of which have developed outside of Code Sec. 1366 determine whether indebt-edness is bona fi de . See K.F. Knetsch , SCt, 60-2 USTC ¶9785, 364 US 361, 81 SCt 132 (disallowing interest deductions for lack of actual indebted-ness); J.B. Geftan , CA-3, 98-2 USTC ¶50,630, 154 F3d 61 (based on the objective attributes and the economic realities of the transaction, holding that the transaction at issue was not a bona fi de debt); T. Mixon, Est., CA-FC, 72-2 USTC ¶9537 (discussion of factors indicative that debt is bona fi de ); Litton Business Systems, Inc. , 61 TC 367, Dec. 32,263 (1973).
19 Caroline Hay, branch 3 attorney-advisor, IRS
Office of Chief Counsel (Passthroughs and Special Industries) and the principal author of the ‘Final Regs.’ responding to a question concerning bona fide debts and whether a written note was required stated that “A writ-ten instrument isn’t the be-all and end-all, but that is one of the factors.” 136 TAX NOTES
1558 (Sept. 24, 2012).
20 Reg. §1.1366(a)(2)(ii) , Ex. 2. 21 Id.
22 Reg. §1.1366(a)(2)(ii) , Ex. 3.
23 See D.G. Oren , CA-FC, 2004-1 USTC ¶50,165 and
M.S. Kerzner , 97 TCM 1375, Dec. 57,783(M), TC Memo. 2009-76.
24 Presumably, if the S corporation remained liable
to the original corporate lender, the debt may not run to the shareholder. At a minimum, this would be a “bad” fact and circumstance.
25 T.D. 9682 , July 23, 2014. Due to the confusion
of revenue agents and the courts in the past, the author anticipates that counsel will need to refer to the preamble from time to time in the future.
26 T.D. 9682 , July 23, 2014, at 42676.
27 The court also engaged in an “at risk” analysis
and determined that Oren was not “at risk” under Code Sec. 465 .
28 See Oren , supra note 23.
29 See Kerzner , supra note 23. 30 Id. , at 1.
31 Id. , at 5.
32 222 TAX NOTES 44 (Nov. 13, 2012). 33 Reg. §1.1366-2(a)(3) .
34 Rev. Rul. 81-187 , 1981-2 CB 167.
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