Contributions Increase Shareholders’ S Corporation Basis

S Corporations

The Tax Court held that shareholders in two related S corporations could increase their basis in one of the corporations by contributing assets to it that they had received in a distribution from the other corporation.

Background

James and Joy Maguire and their son, Marc, and his wife, Pamela, (the Maguires) owned two S corporations whose businesses were related: one an auto dealership, the other a finance company that purchased customer notes from the auto dealership. During the years in issue, the finance company operated at a profit and the auto dealership operated at a loss. The Maguires did not have sufficient bases in the auto dealership to deduct its losses. However, they had substantial bases in the finance company.

At the end of each year, the finance company owned substantial accounts receivable due from the dealership. At the end of each year, the Maguires received distributions of the accounts receivable from the finance company and then contributed them to the related dealership to increase their bases in the dealership enough to allow for the deduction of its losses. On audit, the IRS disallowed the claimed loss deductions, asserting that the Maguires’ actions did not increase their bases in the dealership because the Maguires did not make an economic outlay in the transactions between them and their related S corporations. The Maguires challenged the IRS’s determination in Tax Court.

The Tax Court’s Decision

The Tax Court held that the Maguires could deduct the losses from the auto dealership because they made a basis-creating economic outlay when they contributed the accounts receivable from the finance company to the auto dealership. The court found that the distribution and contributions of the accounts receivable actually did take place and that they had real consequences that altered the positions of the Maguires individually and those of their businesses.

With regard to whether the distributions and contributions took place, the court found sufficient evidence that they had. At trial, James and Marc Maguire testified that their accountants had advised them to effectuate the accounts receivable transactions at the end of the years in question, and a partner from the accounting firm testified that he had given this advice. This testimony, along with corporate resolutions and adjusting journal entries on the corporate books, convinced the court that the distributions and contributions took place as the Maguires claimed.

The IRS argued that even if the transactions occurred, they were devoid of economic reality and did not alter the economic positions of the Maguires and the S corporations. The Tax Court disagreed with the IRS because the accounts receivable had real value in that they were legitimate debts that the auto dealership owed to the financing company and thus were legitimate assets of the financing company. According to the court, the distribution of the accounts receivable diminished the values of the Maguires’ investments in the financing company by the amounts of the distributions. When they contributed the accounts receivable to the auto dealership, the contributions increased their bases in the dealership and made them poorer individually because they no longer owned the receivables in their individual capacities.

The Tax Court further concluded that the close relationships between the shareholders and the two S corporations, while making closer scrutiny of the transactions appropriate, did not warrant disregarding them. The court stated, “The fact that the two S corporations have a synergistic business relationship and are owned by the same shareholders should make no difference so long as the underlying distributions and contributions actually occurred.” Having already determined that the distributions and contributions did occur, the court found that the fact that the Maguires were motivated by tax purposes was not fatal.

Reflections

Essentially, the Tax Court allowed the Maguires through the distributions and contributions of the accounts receivables to treat their two S corporations as a single S corporation for tax purposes. Given that this allowed them to reverse their decision to set up the businesses in separate S corporations to gain a considerable tax advantage, the IRS’s disapproval of their scheme is understandable. Nonetheless, as the Tax Court explained, from a technical standpoint, it is allowable.

Maguire, T.C. Memo. 2012-160