Payment of S corp.’s expenses by affiliated companies did not increase shareholder’s basis

By Tianhang (Helena) Liu, MSA, Irvine, Calif.

Editor: Mark G. Cook, CPA, CGMA

Deductions and losses of an S corporation are passed through to shareholders and claimed on their personal tax returns. However, according to Sec. 1366(d), shareholders can deduct their pro rata shares of these passed-through items only to the extent of their adjusted basis in the S corporation's stock plus their adjusted basis in any of the S corporation's indebtedness to them. Therefore, correctly calculating the stock and debt basis of shareholders in S corporations is very important in determining the shareholder's loss deductions. The Eleventh Circuit in Meruelo, 923 F.3d 938 (11th Cir. 2019), recently affirmed a Tax Court decision (Meruelo, T.C. Memo. 2018-16), holding that where an S corporation and affiliated entities were partially owned by a taxpayer, payment of the S corporation's expenses by the affiliated entities did not increase the taxpayer's debt basis in the S corporation.


Homero Meruelo is a real estate developer who held interests in various S corporations, partnerships, and limited liability companies (LLCs), including Merco, an S corporation that he incorporated in 2004. During 2008, he held 49% of Merco's stock. Meruelo transferred $4,985,035 of a personal loan from a bank to Akoya, an S corporation in which he and his mother each held a 50% interest. Akoya then transferred $5 million into Merco's escrow account — $4,985,035 of Meruelo's personal loan proceeds and $14,965 of Akoya's own funds.

From 2004 to 2008, Merco entered into hundreds of transactions with various partnerships, S corporations, and LLCs (the Merco affiliates) in which Meruelo held an interest. These Merco affiliates often paid expenses such as payroll costs for each other or for Merco, with the payor company recording the transaction under accounts receivable and the payee company under accounts payable. When preparing Merco's tax return, Luis Carreras, a CPA, would net Merco's accounts payable to its affiliates against Merco's accounts receivable from its affiliates. If Merco had net accounts payable, Carreras reported that amount as a "shareholder loan" on Merco's tax return and increased Meruelo's shareholder's basis.

The IRS did not dispute the increase of Meruelo's basis in Merco by the amount of $4,985,035 because these funds were the proceeds of a loan Meruelo personally borrowed that Akoya transferred directly to Merco. However, the IRS disallowed basis created by the intercompany transfers between Merco and its affiliates.

Basis of indebtedness

According to Regs. Sec. 1.1366-2(a)(2)(i), "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." The regulations further state that the determination of whether debt is bona fide is made under general federal tax principles and depends upon all the facts and circumstances. According to the Tax Court, because the bona fide indebtedness determination is made using general federal tax principles, the regulations incorporate the actual-economic-outlay doctrine. Under this doctrine, basis is only increased if an actual economic outlay has occurred, i.e., a shareholder must show that a cost was incurred in making a loan or that the shareholder was left poorer in a material sense after the transaction.

Meruelo offered two theories why the affiliated companies' transfers to Merco were an actual economic outlay that resulted in basis in Merco: the "back-to-back loan" theory and the "incorporated pocketbook" theory. Under the back-to-back-loan theory, he argued the affiliated companies should have been treated as lending funds to him that he then lent to Merco. Under the incorporated-pocketbook theory, Meruelo argued that he should have been treated as using his funds, which were held by the affiliated companies, to pay Merco's expenses on his behalf. However, as discussed below, the Eleventh Circuit disagreed and held that Meruelo had not made an economic outlay and was not entitled to increase his basis in his Merco shares under either theory.

Back-to-back-loan theory

In a back-to-back loan, company A loans money to a shareholder and the shareholder loans this money to company B directly. Companies A and B are 100% owned by the shareholder. The loan from the shareholder to B constitutes a bona fide indebtedness and increases the shareholder's basis of debt. Meruelo argued that he could claim a debt basis based on the back-to-back-loan theory for two reasons. First, he contended that the monetary transfers between the Merco affiliates should be treated as back-to-back loans based on the economic substance of the transactions rather than the form they took. Second, he alternatively contended that the form of the transactions was sufficient to establish that they amounted to back-to-back loans.

The Eleventh Circuit noted that, in general, a taxpayer, having chosen the form of a transaction, is bound to the results of the form used. However, in another Eleventh Circuit case, Selfe, 778 F.2d 769 (11th Cir. 1985), the court had accepted a substance-over-form argument to find that a taxpayer's transaction was a back-to-back loan establishing basis, but it had only done so because of exceptional circumstances involving an unusual set of facts. The court found that the facts in Meruelo's case did not establish an exceptional circumstance like that in Selfe that would justify disregarding the form of the transactions.

Meruelo also argued that his accountant's end-of-year reclassification of the intercompany transfers, as reflected on his tax returns and in annual adjustments to a line of credit from Meruelo to Merco were sufficient to establish that the transactions amounted to shareholder indebtedness to the S corporation. The Eleventh Circuit, citing Broz, 727 F.3d 621 (6th Cir. 2013), and other cases, found that after-the-fact reclassification cannot satisfy the requirement that the debt run directly from the S corporation to the taxpayer/shareholder in order for debt basis to be established. According to the court, because the transactions were contemporaneously classified as transactions between the affiliates and Merco, the designation Meruelo's accountant gave them at the end of the year did not govern the form of the transactions.

Incorporated-pocketbook theory

Meruelo claimed in the alternative that he had basis in Merco under the incorporated-pocketbook theory, under whicha taxpayer can obtain debt basis in an S corporation through payments made by a wholly owned corporate entity if that entity functions as the shareholder's "incorporated pocketbook." In Broz, 137 T.C. 46 (2011), the Tax Court held that for an incorporated pocketbook to exist, the taxpayer must show that he had a "habitual practice of having his wholly owned corporation pay money to third parties on his behalf."

The Eleventh Circuit found that Meruelo could not use the theory to establish basis in Merco because Merco and its affiliates did not function as his incorporated pocketbook. Instead of using one wholly owned company to disburse funds on his behalf, he was attempting to treat 11 different partially owned affiliates as the incorporated pocketbook. The court observed that many of these affiliates acted more like ordinary business entities than as incorporated-pocketbook companies because they both disbursed and received funds for business expenses from Merco, and, as the Tax Court explained in its opinion, no court has ever ruled that a group of non—wholly owned entities that both receive and disburse funds in this fashion can constitute an incorporated pocketbook.

Furthermore, Meruelo failed to establish that he habitually paid third parties on his behalf through the putative incorporated-pocketbook companies because his evidence established only that the Merco affiliates regularly paid the expenses of other companies within the affiliate group — not his personal expenses.


Mark G. Cook, CPA, CGMA, MBA, 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

All contributors are members of SingerLewak LLP.

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