s corporation tax loss loans

Tax basis can limit a shareholder’s loss from an S corporation. If an S corporation has a tax loss but the shareholder doesn’t have sufficient tax basis to take the loss, the shareholder will typically have to loan money to the S corporation. This tax debt basis makes the loss allowable in the current year. This is a common tax planning technique.

But what if the taxpayer makes the loan to the S corporation from another entity the taxpayer owns? Does that tax debt basis count? The court addresses this in Messina v. Commissioner, Nos. 18-70186, 18-70187 (9th Cir. 2019)

Facts & Procedural History

The taxpayers owned a majority interest in a S corporation.

The S corporation borrowed money from a third party. Before the loan was paid off, the taxpayers formed another S corporation. The second S corporation purchased the loan (account receivable) from the third party.

Then, the original S corporation reported a tax loss on its return–which flowed through to the taxpayer’s personal tax returns as the shareholders.

The taxpayers took the position that they had sufficient tax debt basis that made the flow through loss allowable. This tax debt basis was due to the loan to the second S corporation.

The IRS audited the return and disallowed the loss, arguing that there was no debt basis. The U.S. Tax Court agreed with the IRS. The taxpayers appealed, which resulted in the most recent court decision.

Tax Losses for S Corporation Shareholders

The ability to have tax losses flow through to the shareholder’s personal tax returns is one reason people choose to use S corps.

It is preferable to use the flow through loss to offset other items on the taxpayer’s personal tax returns, rather than have the losses trapped in the legal entity to be used at some future date (the TCJA reduced this benefit has been reduced starting in 2018 for those who prefer to carryback NOLs to prior years, as NOL carrybacks are no longer allowed).

The general rule is that a loss from an S corporation is allowable to the extent of the taxpayer’s basis in the S corporation stock. This basis is generally the taxpayer’s investment plus any increases (income and gain earned by the S corporation) and decreases (distributions, losses, and deductions from the S corporation) over time.

In addition to stock basis, the shareholder can count tax debt basis for any loan from the shareholder to the S corporation. But who is the shareholder? Does the shareholder include another S corporation that the shareholder also owns? That brings us back to this case.

Who is a Shareholder?

The taxpayer argued that the term “shareholder” includes the second S corporation that they wholly owned. It based its argument on the economic substance and the step-transaction doctrine.

The taxpayer also argued policy, i.e., that the taxpayer had non-tax reasons for acquiring the loan using the second S corporation. Thus, there was apparently no tax planning to minimize taxes.

The courts concluded that these doctrines are not available to taxpayers. They are only available to the IRS, as the IRS isn’t a party to the transactions. Thus, they are to protect the government to prevent aggressive tax planning.

Thus, the trial and appeals courts concluded that the term “shareholder” does not include another wholly owned entity owned by the taxpayer.

This is consistent with the term “shareholder” as defined in the Code. The Code defines the term “shareholder” as “a member in an association, joint-stock company, or insurance company.”

Tax Planning for S Corporation Losses

The takeaway is that taxpayers have to carefully plan for tax losses.

The IRS scrutinizes tax losses, which results in quite a few tax disputes with the IRS. To the extent the taxpayer needs to preserve the ability to take a loss, the shareholder should make the loan to the S corporation directly.

And the loan should be documented with a promissory note. Interest should be paid on the loan.

These steps can help ensure that the tax debt basis will be respected, allowing the S corporation’s losses to be taken in the current year.

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