The Tax Court held that the intercompany payables of an S corporation from transactions with affiliated passthrough entities that were recharacterized as loans from a shareholder to the S corporation were not bona fide indebtedness that gave rise to debt basis in the S corporation for the shareholder.
Homero Meruelo is a real estate developer in South Florida who has held interests in numerous passthrough entities, including an interest in Merco of the Palm Beaches Inc. (Merco), an S corporation he incorporated to purchase a condominium complex in a bankruptcy sale. In 2004, Meruelo transferred $4,985,035 of the proceeds from a personal loan he obtained to Merco Group at Akoya (Akoya), an S corporation in which he and his mother owned 50% interests, and Akoya afterward transferred $5 million to Merco to cover half of the required deposit to purchase the condo complex. Akoya had previously transferred Merco funds to cover the remaining $5 million needed for the deposit.
During 2004-2008 Merco entered into hundreds of transactions with various partnerships, S corporations, and LLCs in which Meruelo held an interest (the Merco affiliates), and the Merco affiliates regularly paid expenses on each other's and Merco's behalf. The payer in the transactions recorded the payments as accounts receivable, and the payee recorded them as accounts payable.During 2004-2008, the Merco affiliates made payments in excess of $15 million to or on behalf of Merco, but Merco repaid the affiliates less than $6 million of these advances. On its tax returns for each year in question, Merco reported its accounts payable to its affiliates in excess of its accounts receivable as a "shareholder loan" and allocated a percentage of this supposed indebtedness to Meruelo, on the basis of his ownership interests in the various affiliates that had extended credit to Merco.
To show indebtedness from Merco to Meruelo, Meruelo's accountant, who was also the accountant for Merco and the Merco affiliates, drafted a promissory note dated March 31, 2004, whereby Meruelo provided Merco a $10 million unsecured line of credit at a 6% interest rate. The accountant claimed he would make an annual charge to Merco's line of credit for an amount equal to Meruelo's share of Merco's net accounts payable to its affiliates for the preceding year. However, there was no documentary evidence that this was done or that Merco accrued interest on the debt. There was also no evidence that Merco made any payments of principal or interest on the line of credit or that Meruelo made any payments to the Merco affiliates for the money they transferred to or the expenses they paid for Merco.
In 2008, at which time Meruelo owned 49% of the shares of Merco, the corporation incurred a loss of over $26.5 million when banks foreclosed on the condominium complex it had purchased in 2004. Merco allocated 49% of the loss ($13 million) to Meruelo, and, after netting the loss against gains passed through from two other S corporations, Meruelo claimed an ordinary loss deduction of $11.8 million on his personal return. After taking into account his other income and deductions, Meruelo claimed a net operating loss (NOL) for a slightly smaller amount for 2008. Meruelo carried the loss back to 2005, and the IRS issued him a refund of $3.9 million.
The IRS examined Meruelo's 2005 and 2008 returns. It determined that his basis in Merco was only $4,985,035, the amount of the proceeds of the personal loan that Meruelo contributed to Merco through Akoya. As a result, it disallowed, for lack of a sufficient basis, $8 million of the $13 million loss passed through to him from Merco. Based on this loss disallowance, the IRS also disallowed a large portion of Meruelo's NOL carryback to 2005 and determined that he had a deficiency of $2.6 million for that year.
Meruelo challenged the IRS's determination in Tax Court. In Tax Court, Meruelo contended that Regs. Sec. 1.1366-2(a)(2)(i), issued by the IRS in 2014, applied to his case and that under this regulation he was not required to show an actual economic outlay to have debt basis for his loans to Merco. He also argued that he was entitled to debt basis for the payments made by the Merco affiliates either because they were in substance back-to-back loans, with his share of the payments from the affiliates being loans to him, followed by loans from him to Merco. In the alternative, he argued that he had used the Merco affiliates as an "incorporated pocketbook," loaning money to the affiliates that they then used to pay his expenses.
Governing statutory and regulatory framework
Under Sec. 1366(d)(2), the losses passed through from an S corporation that a shareholder may take are limited to the sum of the adjusted basis of the shareholder's stock in the S corporation and the adjusted basis of any indebtedness of the S corporation to the shareholder. The Code, however, does not specify how a shareholder may acquire debt basis. Traditionally, the Tax Court and other courts have held that to acquire debt basis, the shareholder must have made an actual economic outlay and the debt must run directly to the shareholder (see, e.g., Hitchins, 103 T.C. 711, 715 (1994)).
In July 2014, the IRS issued regulations under Sec. 1366 addressing S corporation debt basis. Regs. Sec. 1.1366-2(a)(2)(i) states:
The term basis of any indebtedness of the S corporation to the shareholder means the shareholder's adjusted basis . . . in any bona fide indebtedness of the S corporation that runs directly to the shareholder. Whether indebtedness is bona fide indebtedness to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.
Regs. Sec. 1.1366-5(b), however, provides that "S corporations and their shareholders may rely on § 1.1366-2(a)(2) with respect to indebtedness . . . result[ing] from any transaction that occurred in a year for which the period of limitations on the assessment of tax has not expired before July 23, 2014."
The Tax Court's decision
The Tax Court held that Meruelo did not have sufficient basis in Merco to take the entire loss that was passed through to him in 2008 and, consequently, the IRS had properly disallowed a portion of his claimed NOL carryback to 2005. The court found that whether Regs. Sec. 1.1366-2(a)(2)(i) applied to the transactions in question would not affect its determination and rejected Meruelo's claims for increased debt basis under both his back-to-back loan and incorporated pocketbook arguments.
Regs. Sec. 1.1366-2(a)(2)(i): Meruelo argued that Regs. Sec. 1.1366-2(a)(2)(i) applied because for the years at issue in the case, 2005 and 2008, the periods of limitation on assessment had not expired, and the IRS conceded that the regulations did apply to at least some of the transactions involved. However, the Tax Court noted that many of the transactions on which Meruelo relied to generate his basis occurred during 2004, 2006, and 2007, and that the periods of limitation on assessment for those years appeared to have expired long before July 23, 2014. Thus, the court stated "[i]t is not clear how the new regulation would apply in these circumstances."
The Tax Court further found, however, that it made no difference whether and to what extent the regulation applied because the same test applied in deciding whether a shareholder was entitled to increase his basis in an S corporation for debt under the regulation and the case law prior to it. Under both, the test was whether the claimed debt was "bona fide indebtedness of the S corporation that runs directly to the shareholder." Moreover, the court observed that the new regulation provides that the existence of bona fide indebtedness is determined "under general Federal tax principles" and stated that the actual economic outlay doctrine "is a general tax principle that may be employed under the new regulation, as it was applied under prior case law, to determine whether this test has been met."
Back-to-back loan argument: The Tax Court noted that Regs. Sec. 1.1366-2(a)(2)(iii), Example (2), provides that back-to-back loans, if representing bona fide indebtedness from the S corporation to the shareholder, can give rise to increased basis. However, as the court explained, it had previously held in Ruckriegel, T.C. Memo. 2006-78, that transactions between related parties are subject to special scrutiny and, in cases of such transactions, taxpayers "bear a heavy burden of demonstrating that the substance of the transactions differs from their form." In addition, in Hitchins, the Tax Court had held that to increase basis, debt of the S corporation must run directly to the shareholder and that debt running to a passthrough entity that is closely related to the taxpayer does not meet this requirement.
The court determined Meruelo failed to meet either of these requirements, so the intercompany transactions did not give rise to bona fide indebtedness from Meruelo to Merco under a back-to-back loan theory. It found he had not shown that the intercompany transactions were in substance debt because none of the transactions were contemporaneously documented as loans and that there was "simply no evidence" that Merco and its affiliates intended to create loans to or from Meruelo at the time the transactions took place. In addition, even if they were loans, they ran to the Merco affiliates and not directly to Meruelo, with the funds moving from one company to another without affecting Meruelo's economic position in any way. Unlike the funds Meruelo originally borrowed and contributed to Merco, he made no actual economic outlay toward any of the advances that Merco's affiliates made to Merco.
Incorporated pocketbook argument: In Yates, T.C. Memo. 2001-280, and Culnen, T.C. Memo. 2000-139, the Tax Court held that where a taxpayer used a related entity as an incorporated pocketbook, payments from that entity to the taxpayer's S corporation may constitute payments on the taxpayer's behalf and thus give rise to increased basis. However, for an incorporated pocketbook to exist, the court also held that the taxpayer must establish that he or she habitually had the related corporation pay money to third parties on his or her behalf.
The court found that Meruelo's case was not analogous to Yates and Culnen, and Meruelo had not used the Merco affiliates as an incorporated pocketbook, pointing to four key ways in which the facts in Meruelo's case differed from those of the taxpayers in the earlier cases. First, in Yates and Culnen, the taxpayer was the sole shareholder of a single corporation that disbursed the funds, and the corporation only disbursed funds, while Meruelo was seeking to treat 11 separate Merco affiliates, many of which had co-owners, as the incorporated pocketbook, and the entities were disbursing and receiving funds.
Second, the court found that unlike the taxpayers in Yates and Culnen, Meruelo had failed to establish that the Merco affiliates habitually paid his expenses. In addition, the court found that while in the earlier cases the incorporated pocketbook entities were disbursing the taxpayers' own funds, Meruelo did not do so, and, instead, all the funds were disbursed by Merco affiliates to or for Merco and that Meruelo made no actual economic outlay, with Meruelo being at best a third-party beneficiary of the transactions. Finally, in the earlier cases, the transactions alleged to create basis were initially booked as loans, whereas in Meruelo's case, they were contemporaneously booked as capital contributions, payroll expenses, or intercompany payables or receivables, and only recharacterized as loans after the close of each year.
Although the IRS stated in the preamble to T.D. 9682 that actual economic outlay is no longer the applicable standard used to determine whether a shareholder received basis for indebtedness, the Tax Court here simply brings the standard back in by finding that it is a "general tax principle" that may be employed in determining whether a debt is bona fide indebtedness. Thus, if, as the preamble to the regulations suggests, it was the IRS's intent to eliminate the actual economic outlay requirement through the regulations, its efforts may end up being thwarted by the courts.