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TAXPAYER APPEALS IRS ATTACK ON S CORPORATION BASIS TRANSFERS

August 28, 2003

A while back we discussed the Tax Court's Oren decision, in which the Tax Court ruled that a shareholder had too little basis to take the losses generated by his S corporation. Shareholders can only deduct their S corporation losses to the extent they have basis in their S corporation stock. This basis is increased by the shareholder's share of corporate income, and by shareholder contributions and loans to the corporation; it is reduced by shareholder withdrawals and corporate losses.

Donald Oren was an owner of multiple S corporations. Mr. Oren borrowed money from one of his S corporations and loaned it to his money-losing S corporations before year-end so he would have enough basis to deduct their losses for the year. While all of the formalities of the year-end transactions were in order, the Tax Court ruled that they lacked "substance" and therefore should be ignored.

Mr. Oren has appealed the decision, and the briefs are available in PDF format. The taxpayer briefs are here and here; the IRS brief is here. Over $5,000,000 in federal taxes are at stake.

The Tax Court's decision makes it hard for taxpayers with multiple S corporations to be sure that they have enough basis for their losses. The taxpayer argues that the IRS wants to add its own "substance" requirement for S corporation basis that is not required by the tax law.

WHAT TO DO?

At least until the Appeals Court (8th Circuit) rules on this case, taxpayers need to be extra careful in executing year-end basis transactions with their S corporations.

Taxpayers using year-end loans to S corporations should try not to fund the loans with borrowings from other S corporations; they should instead use personal funds or actual distributions from the other corporations. They should also avoid circular transactions that cause the cash to end up in the same entity where it started.

Many taxpayers with multiple S corporations will find an S corporation holding company the best answer. The holding company format was not available in the years at issue in Oren. This format puts all S corporation basis in one place, eliminating the need to shift basis around each year from profitable corporations to loss corporations.

Perhaps the 8th Circuit will have a decision in time for 2003 year-end planning. Stay tuned.

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