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RING AROUND THE ROSEY FAILS AN S CORPORATION SHAREHOLDER

July 31, 2002

Entrepreneurs often set up a new S corporation every time they set up a new business. The attorney gets to fill out a new set of corporate organization documents, the accountant gets to do a new tax return, and the client gets to isolate each business from the potential lawsuits of each other business. The whole team wins!

Unless, of course, one of these businesses loses money. S corporation shareholders can only deduct losses to the extent of their basis in the S corporation stock, plus their basis in any direct loans made to the S corporation. (S corporations do not pay taxes on their earnings; their shareholders instead report the income or loss on their individual 1040s. To learn more about S corporations, click here.) This basis is reduced by taxable losses; when an S corporation is thinly capitalized, basis can disappear quickly.

GAMES PEOPLE PLAY. Sometimes taxpayers only find out that they are out of basis at tax time. If they are counting on their S corporation losses to reduce their taxes, they can get very upset. They can also get imaginative. They may imagine, for example, that they borrowed money from their profitable S corporations before year-end and loaned it back to the loss corporation. They then prepare their tax returns deducting losses against their imaginary basis. The technical name for this technique is “fraud.”

Wiser taxpayers arrange for sufficient basis before year-end. Donald G. Oren, a Minnesota trucking company entrepreneur, recently learned the hard way how difficult this can be to accomplish. Shortly before the end of the tax year, the shareholder borrowed money from his profitable S corporation, Dart Transit Co., and loaned it to his loss S corporation, Highway Leasing. The loss corporation then promptly loaned the funds directly back to the profitable S corporation – closing the circle and getting the cash right back where it started.

SO WHAT’S THE PROBLEM? The taxpayer did everything the right way in executing the transactions. He had checks written, rather than simply making bookkeeping entries. He had notes executed, and he completed all of the transfers before year-end. The Tax Court said this wasn’t enough. The court said that the circle of money and loans – from the profitable corporation to the taxpayer to the loss corporation and back to the profitable corporation – had no substance. And even if there was substance, said the court, the loan wasn’t “at-risk,” so it would not be available to allow a loss deduction.

WHAT DOES THIS CASE TELL US? Taxpayers with multiple controlled S corporations need to be very careful how they get basis for losses. In many cases, the best solution is to put controlled S corporations into a single S corporation holding company – an option that was unavailable in the tax years covered in this case. Such a holding company structure can be treated as a single S corporation with a single basis, avoiding the need to move funds around when one corporation has losses. This idea also works using LLCs; in both cases, each business is protected from liabilities of the others.

Where a common holding company structure is impractical, taxpayers should first use funds from their personal resources to fund S corporation losses. If they must use funds from other S corporations, they should consider having the profitable corporation make distributions to the shareholders, rather than loans; distributions of S corporation earnings are generally tax-free. The shareholders should consider contributing funds to the loss corporation as capital, rather than as debt. The loss corporation should refrain from loaning the injected funds back to the profitable corporation.

IS THIS THE LAST WORD? Mr. Oren will owe nearly $5,300,000 in additional federal taxes and an unknown amount of state taxes if this case is not reversed on appeal. An appeal seems likely.

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