An important Tax Court decision issued yesterday validates a traditional S corporation planning tactic from an overreaching attack by the IRS. Incidentally, it validates some old Tax Update advice.
S corporations, as longtime readers know, don’t generally pay their own tax. Instead corporation income and loss passes through to the shareholders’ 1040s. The ability to deduct corporation losses is a popular feature of S corporations, but it is limited. Shareholders can only deduct S corporation losses to the extent they have basis in either their stock of the S corporation or loans they have made directly to the corporation.
S corporation basis starts with your investment in the company. Income passed through to shareholders increases their basis, as do capital contributions. Basis is reduced by losses and distributions. Distributions of funds earned as an S corporation are generally a tax-free recovery of basis.
Taxpayers with more than one S corporation often find their basis is in the wrong place. They may have plenty of basis in a profitable corporation, but they need more basis in a sister corporation that is losing money to deduct the losses. The logical answer is distribute funds from the profitable business and contribute it to the loser. That was the strategy used by a Kentucky auto dealer S corporation, Auto Acceptance, and a sister finance company, CNAC. The Tax Court explains how the business worked:
Auto Acceptance is a car dealership, and CNAC is a finance company that deals exclusively with Auto Acceptance’s customers. Auto Acceptance is primarily engaged in the purchase of used vehicles at auction and the resale of those vehicles. CNAC purchases retail installment notes related to the vehicles that Auto Acceptance sells.
From 2004 through 2006 Auto Acceptance was losing money, while CNAC was making money. Their accounting firm advised the common owners of the companies to make distributions from profitable CNAC and contribute them to money-losing Auto Acceptance so they could deduct the Auto Acceptance losses. Unfortunately, CNAC’s cash was tied up in receivables, so instead CNAC distributed the receivables to shareholders, who then contributed them to the capital of Auto Acceptance.
Along comes the IRS, saying that the distributions and contributions never took place. The taxpayers had paperwork that convinced the court that IRS was wrong. The IRS raised an uglier argument: that there was no substance to the transaction.
Respondent also argues that no economic outlay was made, because the resolutions and adjusting journal entries made to the books of the related companies were devoid of any economic reality and did not alter the economic positions of the parties.
This argument is similar to that made regarding “circular loans” among S corporations. The IRS has successfully disallowed basis increases when one S corporation “loans” money to shareholders, who then “loan” the money to another S corporation, which then loans the money back to the corporation where it started. The Tax Court said this case is different (my emphasis, footnotes omitted):
Respondent also argues that no economic outlay was made, because the resolutions and adjusting journal entries made to the books of the related companies were devoid of any economic reality and did not alter the economic positions of the parties. We find that the distributions and contributions did have real consequences that altered the positions of petitioners individually and those of their businesses. As petitioners point out, the distributions and contributions created actual economic consequences for the parties, because the accounts receivable had real value in that they were legitimate debts that Auto Acceptance owed to CNAC and thus were legitimate assets of CNAC. Petitioners’ contribution of the accounts receivable resulted in their being poorer in a material sense in that the accounts receivable were no longer collectible by them individually.
When petitioners received the accounts receivable from CNAC, as they had every right to do, and contributed them to Auto Acceptance, that transaction reduced the liabilities of Auto Acceptance; made Auto Acceptance solvent in terms of its assets exceeding its liabilities; and increased the net worth of Auto Acceptance, exposing a greater amount of its assets to its general creditors. At the same time, petitioners’ bases in CNAC were reduced by the amounts of the accounts receivable that CNAC had distributed to them, thereby reducing their ability to receive future tax-free distributions from CNAC. See sec. 1368.
The fact that the CNAC accounts receivable were distributed to petitioners and then contributed to a related entity does not require a finding that there was no economic outlay.
This supports thoughts I posted in 2004 regarding the owner of the Dart Trucking business, a Mr. Oren, who lost his deductions when the IRS disallowed basis increases from circular loans:
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.
The Moral? The tax law allows S corporation holding companies now. If you have commonly-owned S corporations, you can combine their basis by contributing them to an S corporation holding company and making “Q-Sub” elections. That way you don’t have to worry about shifting basis before year-end. If for some reason you can’t form an S corporation holding company, or really don’t want to, you should use distributions from the profitable corporation — not loans — to restore basis in the loss corporation. You shouldn’t then stash the cash back in the starting corporation.
Also, in this case the shareholders carefully documented their transactions; the paperwork was critical to winning the case. So remember, paperwork really matters.