If your S corporation is losing money, you may only deduct your share of the losses on your 1040 to the extent of your basis in the stock, or in loans you have made to the corporation (loan guarantees don't work). The critical element of year-end tax planning for such losses is making sure you have enough basis to use them.
Donald Oren and his wife together owend 100% of three S corporations in 1995, 1996 and 1997. Two of the corporations -- Highway Sales and Highway Leasing -- were generating tax losses. Mr. Oren arranged to borrow money and loan it to the money-losing corporations. This technique, called "back-to-back loans," is a standard S corporation planning technique.
Mr. Oren got in trouble by borrowing the money for the back-to-back loans from his family's third S corporation, Dart Transit Company. Mr. Oren loaned the funds borrowed from Dart to Highway Sales and Highway Leasing, taking care to execute notes, transfer checks, and otherwise get the paperwork in order. Highway Sales and Highway Leasing then loaned proceeds of their loan from Mr. Oren to Dart, getting the cash back to where it started.
The Appeals Court agreed with the Tax Court's conclusion that this arrangement failed to create basis that would enable Mr. Oren to deduct his share of the losses from Highway Sales and Highway Leasing.
NO "ACTUAL ECONOMIC OUTLAY"
The courts found that Mr. Oren had no "actual economic outlay" in its loans around the circle. The Eighth Circuit decision says:
"True, Oren and his corporations observed all of the formalities necessary to create legal obligations. The notes were signed; checks were issued and cashed. But there were no arm’s length elements in these transactions. No external parties were involved... one must assume the occurrence of a great number of unlikely facts as a postulate to a circumstance in which Oren would suffer personal economic loss as a result of the lending transactions."
Not satisfied with saying that the loans lacked substance, the courts ran up the score on Mr. Oren. The Eighth Circuit said that even if the loans were respected, the basis created would not be "at-risk" under the Tax Law.
The "at-risk" rules are a relic of the tax-shelter battles of the 1970s. These rules were designed to prevent taxpayers from deducting losses attributable to secured borrowing if the borrower isn't on the hook for the loan if the lender forecloses on the property. The rules treat loans as not "at-risk" if it is "borrowed from a person with an interest in an activity or a related person," or if a transaction "is structured - by whatever method - to remove any realistic possibliity that the taxpayer will suffer an economic loss." Using the same factors that convinced it that the loans lacked substance, the Eighth Circuit decided that there was no such realistic possibility.
WHAT TO DO?
Owners of related S corporations now need to be very careful with their year-end basis planning. It's not just enough to make sure the paperwork is in place by year end; you need "substance," whatever that is.
S Corporation holding companies are probably the best way to deal with this problem if you own more than one S corporation. This technique only works if all of the S corporations are owned in identical proportions among all shareholders - for example, it would work if the same individual owned all of the shares of two S corporations. In such a situation, the taxpayer can incorporate a new corporation to serve as a holding company and contribute the shares of the existing corporations to the new corporations. This way there is only a single basis for all of your corporations, and you don't have to worry about shuffling the basis around at the end of the year. This usually can be done tax-free. Unfortunately for Mr. Oren, this technique was only made available starting in 1997.
Distributions and contributions might succeed where back-to-back loans fail. The Eighth Circuit may be hinting at this technique when it says of Mr. Oren:
It should be noted that he would suffer no additional loss (over his previous investments), as a result of the loans, by a simple decline in the value of any of the corporations. He has not increased his total investment in any of the businesses.
If Dart had instead made a cash S corporation distribution to Mr. Oren, and if Mr. Oren had then contributed the cash to the loss corporations, Mr. Oren would probably have gotten his losses. If the loss corporations then had loaned the contributed funds right back to Dart, the transaction might have still failed, but the IRS would have had a tougher argument. If the funds were left in the loss corporations, it's hard to see where the IRS would have been able to challenge the losses.
If you must do back-to-back loans, borrow from a bank or another unrelated party. The tax law is much more willing to respect a transaction if you leave the family out of it.
When you lack enough basis to deduct your S corporation loss, it is deferred, not denied. You can take the loss in any year in which you restore your basis. Mr. Oren now owes over $5 million to the IRS on over $14 million disallowed losses. If he didn't restore his basis since 1995, he now has the opportunity to shelter $14 million in income. He can be pardoned if that doesn't exactly cheer him up.
Prior coverage of the Oren case:
For more information on S corporations generally, go here.
The items included in the Tax Update Blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation.
Joe Kristan writes the Tax Update items, and any opinions expressed or implied are not necessarily shared by anyone else at Roth & Company, P.C. Address questions or comments on Tax Updates to