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S Corporation Shareholder Denied $8,000,000 Loss Deduction Due to Poor Structure of Loan

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S Corporation Shareholder Denied $8,000,000 Loss Deduction Due to Poor Structure of Loan

An S corporation does not pay federal income taxes.  Instead, its income or losses pass through to its shareholders, and they report the income or loss on their federal individual income tax returns.  A shareholder can deduct losses, but only up to the adjusted basis of the shareholder’s stock and the basis in any debt that the S corporation owns the shareholder.

An S corporation’s shareholder’s stock basis generally reflects the amount of money that she paid into the corporation to purchase the stock or the amount of money she paid to a third-party to acquire the stock.  The basis is adjusted each year.  It is increased by S corporation profits and decreased by S corporation losses.

A shareholder’s basis in debt is created by lending the S corporation money.  The basis is reduced as the loan is repaid and by S corporation losses in excess of stock basis that pass through to the shareholder.

As an example, if a shareholder has a $2,000,000 basis in her stock and a $3,000,000 basis in the S corporation debt, then she has $5,000,000 of basis available to offset any losses that would pass through to her.  First the stock basis is used up and then the loan basis.

In Maruelo v. Commissioner of Internal Revenue, Maruelo owned shares of Merco of the Palm Beaches, Inc. (“Merco”).  He owned 49% of the stock.  Maruelo had paid $5,000,000 into the corporation as a capital contribution and his basis at that point was $5,000,000 for loss pass-through purposes, but his share of losses was $13,000,000.

Maruelo owned interests in numerous other partnerships, S corporations and LLCs (collectively, “Merco affiliates”).

If a shareholder of an S corporation lends her own funds to the corporation, it creates basis in the debt.  Alternatively, the shareholder can borrow money from another entity such as a bank or a related entity and lend that money to the S corporation (back-to-back loans) and this also creates basis.  The problem comes about when a shareholder has one of her other businesses lend money directly to the S corporation.

In this case, Maruelo claimed that he had a debt basis of $9,000,000.  However, the $9,000,000 was lent from a Merco affiliate to Merco as opposed to the Merco affiliates lending to Maruelo and then Maruelo in turn lending it to Merco.

Maruelo’s CPA prepared a Promissory Note from Merco to Maruelo for a $10,000,000 secured line of credit.  In addition, the CPA created loans from Merco affiliates to Merco as a loan from Maruelo on the S corporation’s tax return.  Maruelo argued this was in substance a back-to-back loan.  However, he could produce no documentation showing the funds were loaned to him by the Merco affiliates and that he then lent the funds to Merco.  The Tax Court held that while a taxpayer can borrow money from a related entity and lend it to another entity and create basis, direct inter-company loans cannot create shareholder basis.

It is very important that S corporation owners realize that an inter-company loan does not create a basis for the shareholders of the borrowing S corporation.  The proper way to create basis is to borrow money from a related business or a third party and then contribute it to the entity experiencing losses.

The Tax Court held that a taxpayer is bound by the form she chooses and the fact that she could have easily structured it differently is not relevant.  The result of the taxpayer not “dotting his I’s and crossing his T’s” resulted in a deficiency over $2,000,000.

The case is a good reminder that taxpayers have to be very careful when attempting to create basis in shareholder loans to utilize his share of an S corporation’s losses.

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