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By James Kehl
Weil, Akman, Baylin & Coleman, P.A.,Timonium, MD
Practitioners generally understand that an S corporation shareholder may deduct losses passed through from an S corporation only to the extent of the sum of (i) the shareholder's adjusted basis in his or her S corporation stock, plus (ii) the shareholder's adjusted basis in any debt directly owed to the shareholder by the S corporation.1 A shareholder's basis in S corporation stock is increased by the shareholder's contributions to the S corporation's capital. However, the Tax Court has held that, in order for a shareholder to have an investment in an S corporation (and realize an increase in stock basis), the shareholder must make an "actual economic outlay."2 Further, in order for a shareholder to make an "actual economic outlay" of funds, the transaction must result in a "significant change" in the shareholder's "economic wealth" and must result in the shareholder being "poorer in any material sense" after the transaction is executed.3 Circular transactions that do not result in any change in the economic positions of the parties involved will not satisfy the "actual economic outlay" test.4
An individual may own and control several S corporations. In several cases, direct loans between commonly controlled entities have not been treated by the Tax Court as loans from one of the controlled S corporations to the shareholder, followed by loans from the shareholder to the other controlled S corporation.5 On the other hand, there are also two cases where the corporations furnishing the funds were characterized as "incorporated pocketbooks" in the sense that the corporations were habitually used by the owners to pay their expenses. Loans from these "incorporated pocketbooks" to the other controlled S corporations were treated as shareholder loans.6
The Tax Court has recently ruled that a distribution of assets to a shareholder from one of his controlled S corporations and a subsequent contribution of the distributed assets by the shareholder to another S corporation controlled by the shareholder resulted in an increase in the shareholder's basis of his stock in the S corporation to which the contributions were made.7 The Tax Court stated that the taxpayer could increase his basis in the stock of the recipient S corporation despite the "synergistic business relationship" between the two S corporations and the common ownership of both corporations, as long as the distributions and contributions actually occurred.
James and Joy Maguire owned the stock of two S corporations. One of these S corporations was an auto dealership ("Auto Acceptance") that purchased and sold used cars; the other S corporation ("CNAC") purchased installment notes related to the vehicles sold by Auto Acceptance. CNAC was a profitable corporation and Auto Acceptance was a loss corporation. The years at issue in the case were 2004, 2005 and 2006. James Maguire owned 100% of Auto Acceptance's stock at December 31, 2004 and, after a gift of 49% of the stock in Auto Acceptance to his son Marc, owned approximately 51% of the stock of Auto Acceptance during 2005 and 2006. James and Joy Maguire owned approximately 51% of the stock of CNAC during the years 2004, 2005 and 2006; Marc owned approximately 49% of the stock of CNAC during those years.
Before the end of 2004, James Maguire was advised by his accountants that he did not have sufficient basis in his Auto Acceptance stock to deduct his share of the 2004 losses that would be passed through to him by the S corporation. The accountants advised James to have CNAC make a distribution to each shareholder of the accounts receivable owed to CNAC by Auto Acceptance. Marc then lent James his share of the distributed CNAC accounts receivable, and James subsequently contributed to Auto Acceptance the accounts receivable distributed to him by CNAC and lent to him by Marc.
This strategy was carried out by the parties for the years 2004-2006. James executed a note payable to Marc for the accounts receivable he borrowed from Marc. Written shareholder resolutions for each company documenting the distributions and contributions were prepared at the end of each year. Adjusting journal entries were made on the books of CNAC and Auto Acceptance in the year that followed the taxable year to which the distributions and contributions related. Notwithstanding the series of steps taken by parties, the IRS contended that the corporate resolutions and journal entries did not result in an increase in James' stock basis in his Auto Acceptance stock, because actual distributions and contributions of accounts receivable never occurred.
Tax Court Opinion
Because it concluded that there was an actual economic outlay at the time the accounts receivable were contributed to Auto Acceptance, the Tax Court allowed James Maguire to increase his stock basis in Auto Acceptance. The Tax Court reasoned that the distributions and contributions had real financial consequences that altered the parties' economic positions, because the accounts receivable had real value, were assets of CNAC, and were liabilities of Auto Acceptance. James' capital contribution reduced the liabilities of Auto Acceptance, increased Auto Acceptance's net worth, and increased the amount of assets subject to the claims of the creditors of Auto Acceptance. Simultaneously, the assets and net worth of CNAC, as well as the ability of its stockholders to receive future distributions on a tax-free basis, were reduced. The fact that the distributed CNAC accounts receivable were contributed to a related entity did not cause the Tax Court to find that there was no economic outlay, because the Tax Court had held in previous cases that an "actual economic outlay" can occur when funds lent by a shareholder to an S corporation originated with another entity owned or controlled by the lending shareholder.8
For controlling shareholders of multiple S corporations who find themselves in a situation at year-end similar to the circumstances of the Maguire case, the Tax Court apparently endorsed the distribution/capital contribution strategy when it stated that "while it is appropriate to scrutinize the validity of transactions between related parties, we see no reason why shareholders in two related S corporations should be prohibited from taking distributions of assets from one of their S corporations and investing those assets into another of their S corporations, in order to increase their bases in the latter."9 The Tax Court even stated that the fact that the series of transactions was motivated by the desire to save taxes "is not fatal," because "any one may so arrange his affairs that his taxes shall be as low as possible."10
A surprising aspect of the Maguire case was that the capital contribution to Auto Acceptance by only one of the shareholders did not result in the IRS asserting the second class of stock issue. It is conceivable, however, that the IRS will raise the issue in a similar case in the future. Practitioners employing this strategy should also be cognizant of §311, and not allow a corporation to distribute appreciated assets to its shareholders. Otherwise, the S corporation may recognize gain as a result of the distribution.
Relying upon the strategy employed in the Maguire case also is probably a sounder strategy for taxpayers than relying upon the "incorporated pocketbook" cases cited above, because the Maguire strategy appears to have a stronger economic foundation. However, taxpayers applying the strategy should observe the formalities of having corporate resolutions adopted. Further, the accountants for each corporation participating in the transaction should ensure that the proper journal entries are promptly recorded on each set of books. In Maguire, proper bookkeeping entries and appropriate legal documents were very persuasive in leading the Tax Court to conclude that the distributions and contributions represented real transactions with economic consequences.
For more information, in the Tax Management Portfolios, see Starr and Sobel, 731 T.M., S Corporations: Operations, and in Tax Practice Series, see ¶4280, Basis of Stock and Debt.
2 See Underwood v. Comr., 63 T.C. 468, 477 (1975), aff'd, 535 F.2d 309 (5th Cir. 1976); Perry v. Comr., 54 T.C. 1293 (1970), aff'd, 27 AFTR2d 71-1464 (8th Cir. 1971); Oren v. Comr., T.C. Memo 2002-172.
3 Oren v. Comr., T.C. Memo 2002-172.
4 Id. See also Kaplan v. Comr., T.C. Memo 2005-218.
5 See Shebester v. Comr., T.C. Memo 1987-246; Burnstein et. al v. Comr., T.C. Memo 1984-74.
6 Culnen v. Comr., T.C. Memo 2000-139; Yates v. Comr., T.C. Memo 2001-280.
7 Maguire v. Comr., T.C. Memo 2012-160.
8 The Tax Court pointed out that this issue was decided in Ruckriegel v. Comr., T.C. Memo 2006-78; Culnen v. Comr., T.C. Memo 2000-139; and Yates v. Comr., T.C. Memo 2001-280.
9 Maguire v. Comr., T.C. Memo 2012-160.
10 Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935).
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