We recently told the story of S corporation shareholders who loaned their S corporation money for a few days at the end of the year and, based on the loans, were allowed to deduct their S corporation losses for the whole year. While the taxpayers in that case (Brooks v. Commissioner) won, we didn't think it a good idea to follow their example:
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...
THE "OTHER CIRCUMSTANCES" DEMONSTRATED
Mark Kaplan couldn't use about $800,000 in losses in 1996 because he had no basis* at the end of the year in his wholly-owned S corporation, Marc Construction and Development Co. (MCDC)
He wasn't going to let that happen in 1997. He arranged to borrow $800,000 from a friendly banker on December 29, 1997, which he promply deposited in his account at friendly bank. On the same day he wrote a check for $800,000 to MCDC. The S corporation moments later loaned the $800,000 to two other S corporations owned by Mr. Kaplan; they deposited the checks in their own accounts at friendly bank. Nine days later, Mr. Kaplan "borrowed" $800,000 from the two other S corporations, which he then used to pay off the friendly bank loan.
Based on this 11-day loan sequence, Mr. Kaplan thought he could deduct in 1997 the losses he missed in 1996. He reported his returns showing that he had $800,000 in basis in a loan to MCDC.
SUBSTANCE-FREE SINCE DECEMBER 1997
The Tax Court didn't buy it; they said there was no real substance to the loans:
Similarly, petitioner’s purported loan to Marc involved no actual economic outlay. In this case, as in Oren v. Commissioner, T.C. Memo. 2002-172, the various disbursements between the taxpayer and his S corporations were “the equivalent of offsetting bookkeeping entries, even though they occurred in the form of checks”. The loan proceeds originated and ended with the Bank. The Bank loan as “collateralized” with $800,000 that Lakeview and Pleasant Prairie deposited in their Bank accounts contemporaneously with the Bank loan. In effect, then, the Bank loan proceeds constituted the collateral for the Bank loan. As far as the record reveals, the loan proceeds never left the Bank in the 11 days between the time the note was created and the time it was paid off.
Bottom line: the loan didn't work and the losses weren't deductible.
WHY DID BROOKS COME OUT DIFFERENTLY?
In Brooks, the Tax Court credited an S corporation owner with basis after he made a four-day $800,000 loan to the corporationat year-end. It's not clear why the Tax Court decided the Brooks case differently; perhaps the shareholders loaned their own money to the corporation, rather than borrowed funds. Perhaps the IRS simply failed to raise the issue of whether there was substance to the loan. We have ordered a copy of the briefs filed in Brooks to try to solve this mystery; as the Tax Court charges by the page, we hope the lawyers were succint.
THE MORAL? You put your basis in, you pull your basis out, you put your basis in and you spread it all about, you do the hokey pokey and you turn the cash around, that's what it's all about. Oh, and don't count on short-term advances at year-end for S corporation basis.
CITE: Mark O. Kaplan, T.C. Memo. 2005-218
*click "Read more" for more information about S corporation basis.
S corporation owners report the income and losses of the corporations on their personal 1040s; income and capital contributions increase basis, and losses and distributions reduce it. You have to stop taking losses when your basis falls to zero; the losses only can be used if basis rises above zero. If you loan money to an S corporation, you normally get to count that basis for taking losses.
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