S corporation shareholders have to have "basis" in either their stock or in loans they have personally made (not just guaranteed!) in their S corporation. The Tax Court yesterday allowed S corporation owners to take losses for year-end loans made to their corporation, even though they took the money back out only a few days later.
S corporations don't normally pay taxes on their income. The income is instead taxed on the personal returns of their owners.
"Basis" is normally your original cost of something. The basis of S corporation stock is adjusted upward for income taxed to the owners and capital contributions, and downward for losses passed to the owner returns, and for distributions of earnings.
BAD YEARS FOR BROOKS AG COMPANY
The owners of Brooks AG Company, Inc. had no basis left in their shares. In order to take losses for 1999, they found they would have to either add to their stock basis or make an advance to their company. The shareholders each advanced funds to the company as follows:
December 31, 1999: $800,000 advanced to company
January 3, 2000: $800,000 advance is repaid.
December 29, 2000: $1,100,000 advanced to company.
Brooks Ag had losses of $882,586 in 1999 and $827,888 in 2000; the losses were split almost equally between two shareholders.
THE IRS VIEW
The IRS argued that the basis of the open account debt should be measured separately for each advance, on a first-in, first-out basis. In their view, the tax effects of the transactions to each shareholder was:
1999 loan from shareholder $800,000 Less: 1999 loss used against loan (441,293) Basis of 1999 loan 358,707 Repayment of loan made in January 2000 (800,000) Taxable (gain) on loan repayment (441,293)
THE TAX COURT SAYS OTHERWISE
Fortunately for the Brooks AG shareholders, the tax law is on their side. The Tax Court explained:
Sec. 1.1367-2(a), Income Tax Regs., provides that advances and repayments of open account debt are treated as a single indebtedness for the purpose of making debt basis adjustments and defines open account debt as "shareholder advances not evidenced by separate written instruments and repayments on the advances".
As a result, the only date that matters in measuring the basis of the advances is December 31. For 1999 and 2000, that means
1999 loan from shareholder $800,000 Less: 1999 loss used against loan (441,293) Basis of 1999 loan 358,707 Repayment of loan made in January 2000 (800,000) Advance Made December 29, 2000 1,100,000 S corp loss for 2000 (413,944) Basis in advanced loans, 12/31/2000 $244,763
In other words, the owners got to take their whole 2000 loss, and they didn't have taxable gain on the January 2000 loan repayment.
DANGERS OF THIS APPROACH
Notwithstanding the taxpayer victory here, we normally wouldn't advise taxpayers to put large amounts of cash into an S corporation right before year-end to take losses and then withdraw it right after year-end. The IRS has other tools they could use to attack such short loans, and those attacks might succeed under other circumstances. They might attack the loan as lacking substance, for example, especially if the check didn't clear before it was repaid; this would be a twist on the Oren case. Or they might say the taxpayer wasn't really "at-risk" for the loan over such a short period, especially if the lent funds were borrowed from a related party as in Van Wyk.
If a deduction for the losses is important, you should at least let the money you put into your S corporation at year-end cool down for a few weeks before you take it back out. Even if you win ultimately, it's easier to win if the IRS isn't tempted to come after you in the first place. While the taxpayers won yesterday, they'd have been happier if they didn't have to go to Tax Court at all.
Cite: Brooks v. Commissioner, T.C. Memo. 2005-204.
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