A shareholder creates stock basis by contributing capital, and debt basis by lending money to the S corporation, both of which are considered “actual economic outlays” by the shareholder. As described in a recent court case (Meruelo v. Comm., 123 AFTR 2d. 2019), to claim a loss from the activity the shareholder must have been “left poorer in a material sense after the transaction."
In Meruelo, the S corporation suffered a nearly $27 million loss after banks foreclosed on its condominium complex. The taxpayer claimed he had sufficient basis to claim his $13 million share of the loss. His basis comprised of $5 million of capital contributions and more than $9 million of debt basis for transfers from other businesses in which he was an owner. The IRS ruled, and the Tax and Appellate Courts confirmed, that the taxpayer was entitled to claim a $5 million loss, but denied the deduction for any loss claimed on the debt as it was not directly from the shareholder.
The Problem with Debt Basis
It’s clear that a loan from a shareholder to their S corporation creates debt basis. Debt basis is also established when the shareholder borrows funds that it then loans directly to the S corporation, commonly referred to as a “back-to-back loan.” However, the IRS and courts have consistently ruled that anything outside a direct loan from the shareholder to the S corporation does not create debt basis.
In Meruelo, the taxpayer’s CPA was aware of this rule and drafted a promissory note from the S corporation to the taxpayer for a $10 million unsecured line of credit with a 6 percent interest rate. The CPA also reported the taxpayer’s share of related entity debt as shareholder loans on the S corporation’s tax return. The Court rejected the taxpayer’s argument that the arrangement was in effect a back-to-back loan, because there was no evidence that the funds had been lent to the taxpayer and then back to the S corporation. It explained that a shareholder could create debt basis by borrowing from an affiliated company and then lending the funds to an S corporation. But it also held that taxpayers are bound by the form of the transaction they initially choose; the funds advanced as intercompany loans cannot later be reclassified as shareholder loans to create basis.
What Should Shareholders Do?
The fact pattern in Meruelo is one we often encounter, a taxpayer with ownership in multiple entities using earnings from one or more to fund the losses of another. The case highlights the potential tax pitfalls of using this arrangement without proper planning. Shareholders should avoid using intercompany transfers to fund operations where basis limitations could become an issue. Instead, they should consider taking distributions or loans from their related businesses and either contributing or loaning the funds to the entity in need of cash. Done properly, this will create basis.