A real estate developer could not deduct a portion of his S corporation’s losses because there was no debt between the S Corp and the developer as shareholder. Transfers between the S corporation and various business entities he partly owned did not establish a “bona fide indebtedness” that “runs directly” to the taxpayer. The 11th Circuit affirmed a Tax Court decision.
Debt Between Taxpayer-Owned Entities
The S corporation suffered a nearly $27 million loss after banks foreclosed on its condominium complex. The taxpayer asserted that he had sufficient basis in the corporation’s debt for him to deduct $13 million as his share of the loss. The taxpayer claimed basis from:
- a $5 million capital contribution; and
- more than $9 million from transfers through other business entities in which he held an interest.
The IRS determined that the taxpayer could claim only the $5 million basis and not the $9 million because any debt ran from the S corporation to the other entities.
No Economic Outlay Made by the Taxpayer
The Tax Court agreed with the IRS, ruling that:
- the taxpayer had failed to establish a bona fide debt of $9 million running directly to him; and
- he failed to establish that he made an “actual economic outlay” toward the debt.
The appeal concerned whether the debt ran “directly to the shareholder.”
Under case law, an S corporation’s debt does not run directly to the shareholder if it instead flows through “an entity with passthrough characteristics which advanced the funds and is closely related to the taxpayer.”
Back-to Back Loans
However, under Reg. § 1.1366-2(a)(2)(iii), if a shareholder engages in genuine “back-to-back” loans—in which an affiliated entity loans the shareholder funds that the shareholder then loans directly to the S corporation—those loans can establish bona fide debt running directly to the shareholder.
The taxpayer argued the loans were back-to-back loans based on:
- substance over form; and
- his accountant’s end-of-year reclassification of the intercompany transfers, as reflected on tax returns and line-of-credit annual adjustments.
Substance-over-Form Doctrine Does Not Apply
The 11th Circuit dismissed the taxpayer’s substance over form argument, stating, “Only an ‘unusual set of facts’ can warrant judging a transaction based on its substance.” The Court further dismissed the taxpayer’s argument concerning his accountant’s year-end reclassification because:
- the transactions were contemporaneously classified as transactions between the affiliates and the S corporation; and
- the designation the corporation’s accountant gave them at the end of the year does not govern.
The Incorporated-Pocketbook Theory Does Not Apply
Finally, the Court rejected the taxpayer’s incorporated-pocketbook theory. This theory holds when the taxpayer has a “habitual practice of having his wholly owned corporation pay money to third parties on his behalf.” Court decisions based on this theory involved a single, wholly owned entity paying third parties on the shareholder’s behalf.
In this case, the taxpayer sought to treat 11 affiliates, many of which he partially owned, as his incorporated pocketbook.
The Court found that many of the affiliates acted more like ordinary business entities than as incorporated-pocketbook companies. The affiliates both disbursed and received funds for business expenses from the S corporation.
H.F. Meruelo, CA-11, No. 18-11909, 05/06/2019. Aff’g, 115 TCM 1060, Dec. 61,120(M), TC Memo. 2018-16.