The Eighth Circuit affirmed a Tax Court ruling that held that a shareholder's guarantee of a loan to an S corporation was not an actual economic outlay and therefore did not increase the shareholder's debt basis in the S corporation (Hargis, No. 17-1694 (8th Cir. 6/22/18), aff'g T.C. Memo. 2016-232). This item discusses that case and how a back-to-back loan is a viable option for shareholders who want to increase their debt basis in an S corporation. However, care must be taken to ensure that a loan to an S corporation is treated as a back-to-back loan from the shareholder.
Deductibility of S corporation losses
An S corporation's profits and losses are passed through to its shareholders and reported on their returns. Though all profits are considered income to the shareholders, deductions and losses are attributable to the shareholders only insofar as they do not exceed the shareholders' adjusted basis in the stock of the S corporation and indebtedness of the S corporation to the shareholders. Adjusted basis is determined by starting with the shareholder's basis at the beginning of the year, adding increases in stock purchases and any new indebtedness of the S corporation to the shareholder, and subtracting any nondividend distributions for the year (Sec. 1367(a)).
Prior to the issuance of regulations (T.D. 9682) governing debt basis in 2014 (the debt basis regulations), courts applied the judicially created "actual economic outlay" test to determine whether a debt created debt basis in an S corporation for an S corporation shareholder. Courts generally held that under the actual economic outlay test, a shareholder's guarantee of a loan to an S corporation was not an economic outlay by the shareholder that created debt basis. However, in 1985, in Selfe, 778 F.2d 769 (11th Cir. 1985), the Eleventh Circuit took a more taxpayer-friendly position based on the substance-over-form doctrine. In Selfe, the court held that a shareholder who has guaranteed a loan to an S corporation may increase his or her basis where the facts demonstrate that, in substance, the shareholder has borrowed funds and subsequently advanced them to the S corporation.
In Hargis, Bobby Hargis held 100% ownership of several S corporations that operated nursing homes, the assets of which were owned by limited liability companies (LLCs) that were partially owned by his wife. These companies were financed by loans received from three sources: (1) Hargis's other S corporations; (2) the LLCs that owned the nursing homes; and (3) third-party financing institutions. For most of the loans, Hargis signed the notes as a co-borrower and guarantor. Even though Hargis was a co-borrower on many of the loans, the proceeds and payments were transmitted directly between the financing sources and the companies, completely bypassing his personal bank account.
In an effort to deduct the full amount of his S corporations' losses, Hargis claimed that the loans for which he was a co-borrower should increase his adjusted basis. He argued that his status as a co-borrower, which obligated him to pay back the loans if the S corporations were unable to do so, created a personal liability equivalent to that resulting from a loan made directly to him individually and should therefore qualify as an economic outlay that created debt basis.
The Eighth Circuit affirmed the Tax Court's determination that Hargis's guarantees of the notes did not create debt basis. The Tax Court had found that since the loans were made directly to the S corporations and the proceeds and payments never touched Hargis's personal account, he had the potential for liability but not an actual liability. In previous cases, the Tax Court and other courts had held that the bare potential for liability, without more, did not create an economic outlay by a shareholder. Therefore, the loans did not increase Hargis's adjusted basis in his S corporations.
Hargis also argued that his position was supported by the Eleventh Circuit's decision in the Selfe case. While Hargis never personally received any of the proceeds from the loans in question and did not pledge any personal assets as collateral for the loans, the taxpayer in Selfe took out a loan personally, using the funds she received to finance her business, and pledged personal assets as collateral. Furthermore, Hargis provided no evidence that creditors looked to him as the primary obligor on the loans. Thus, the Tax Court found that, unlike the taxpayer in Selfe, Hargis had not proved that he had in substance taken out loans and advanced the borrowed funds to the S corporation.
Effect of loan guarantee under debt basis regulations
Hargis and Selfe were decided based on the actual economic outlay test, which applied to transactions before the issuance of the debt basis regulations on July 23, 2014. However, new Regs. Sec. 1.1366-2(a)(2)(ii) affirms the prior position of the IRS and most courts regarding guarantees of S corporation debt, providing that merely guaranteeing an S corporation's debt will not give the taxpayer basis in the debt and that a taxpayer may only increase debt basis in an S corporation when he or she makes a payment on a bona fide debt that he or she has guaranteed.
Like Hargis, many taxpayers with fledgling S corporations can find themselves unable to deduct the full amount of their company's losses due to the adjusted basis limitation, and under the law prior to the issuance of the debt basis regulations and after, guaranteeing an S corporation's debt will generally not solve the problem. Tax professionals who advise clients with S corporations would be wise to consider other strategies that allow the taxpayer to increase his or her debt basis. One such strategy is the back-to-back loan.
Instead of being made directly to his S corporations with Hargis as the guarantor, the loans could have been made to Hargis, then subsequently loaned from Hargis to his S corporations. This two-step process creates a back-to-back loan. Prior to the issuance of the debt basis regulations in 2014, whether a taxpayer's purported back-to-back loan to an S corporation created debt basis was generally decided under the actual economic outlay test discussed above.
The debt basis regulations replaced the actual economic outlay test with the "bona fide indebtedness" test. This test is set out in Regs. Sec. 1.1366-2(a)(2)(i), which 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.
Under the bona fide indebtedness test, a back-to-back loan increases a taxpayer's basis in an S corporation if the loan between the taxpayer and the S corporation is bona fide indebtedness.
In the preamble to the debt basis regulations, the IRS stated that a taxpayer did not need to meet the actual economic outlay test for debt to be bona fide indebtedness. However, in Meruelo, T.C. Memo. 2018-16, the Tax Court found that the preamble to the regulations did not have precedential effect and that "[r]equiring that the shareholder have made an 'actual economic outlay' 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" (Meruelo at *12).
Potential pitfalls for back-to-back loans
Though back-to-back loans can be an effective way to increase a taxpayer's basis in his or her S corporation, sloppy planning and shortcuts can result in loans that the IRS and courts have determined do not qualify as actual economic outlays. The following three cases illustrate common errors in planning back-to-back loans.
In Ruckriegel, T.C. Memo. 2006-78, two 50% shareholders in an S corporation that incurred losses were also 50% partners in a partnership. To finance the S corporation, the partnership issued loans directly to the S corporation. When the S corporation started realizing losses that exceeded the shareholders' bases, the shareholders made year-end adjusting journal entries that changed the direct loans into shareholder loans. They also created promissory notes and meeting minutes to evidence that the direct loans constituted bona fide back-to-back loans. The court ruled that the loans were not back-to-back loans because the promissory notes, meeting minutes, and accounting were done after the partnership had made the direct payments to the S corporation.
A proper back-to-back loan will show all transactions as flowing through the individual in the middle of the loan. In Russell, T.C. Memo. 2008-246, the fact that an S corporation's shareholders did not report interest income from the S corporation and interest expense to the lender on their individual tax returns was a factor in the Tax Court's ruling that the shareholders made no economic outlay that left them poorer in a material sense. The loans, therefore, could not be used to increase the shareholders' basis in the company.
Shareholders may be tempted to take a proper back-to-back loan one step further by making a loan from the S corporation back to the initial lender. The Tax Court analyzed such a situation in Kerzner, T.C. Memo. 2009-76, in which a husband and wife would receive annual loans from their wholly owned partnership and loan the proceeds to their wholly owned S corporation, which would then loan an equivalent amount back to the partnership. The court found that such circular loans lacked economic substance and ruled that the S corporation's shareholders did not make an economic outlay.
The IRS, and the courts in general, have long considered a properly structured back-to-back loan as a legitimate economic outlay that can increase a shareholder's basis in his or her S corporation. Tax practitioners who advise clients with S corporations would be wise to keep the following in mind:
- Identify S corporations that may have basis limitation issues early so that shareholders can properly structure back-to-back loans that will increase their basis.
- Be aware that attempts to reclassify direct loans as back-to-back loans are unlikely to pass the scrutiny of the IRS and the Tax Court.
- Properly document and report all transactions as flowing from the lender to the shareholder and from the shareholder to the S corporation (and vice versa).
- Avoid circular loans. Loan proceeds that start and end with the same entity are unlikely to be considered an economic outlay on the shareholder's part.
Mark G. Cook, CPA, CGMA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.