Stock and Debt Basis: Litigation, Rulings and Other Developments

1
Chapter 3

• Stock and Debt Basis Litigation, Rulings and
  Other Developments
• IRC 1366(d), 1367

2
Circular 230 Disclaimer

• Any tax advice contained in the body of this
  presentation was not intended or written to be
  used, and cannot be used, by the recipient for
  the purpose of avoiding penalties that may be
  imposed under the Internal Revenue Code or
  applicable state or local tax law provisions.

3
Overview

• Importance
• Gain or loss on sale
• Tax free distributions
• Allowable losses

4
Caution

• Basis does not ensure deduction of losses
• At-risk rules
• (Nonrecourse or co-venturer financing)
• PAL rules
• Rental, business w/o material participation
• Others
• Capital loss, investment interest, charitable,
  etc.

5
Sequence of Loss Limits

• Source Loss and Deduction Limits Chapter 2 of
  2003 National Income Tax Workbook. College
  Station, TX, Land Grant University Tax Education
  Foundation, pp. 43-94

6
1 Statutory Provisions For Debt Basis

• Little Amplification
• Regulations never have contained rule
• Frequent litigation

7
Areas of litigation

• Guarantee by shareholder
• Loan from related person
• Origin of funds
• Other

8
101 Guarantees and Similar Arrangements
101.01 Cases decided before 1986.
No form of indirect borrowing, be it guaranty,
surety, accommodation, comaking or otherwise,
gives rise to
indebtedness from the corporation to the
shareholders
until and unless the shareholders pay all or a
part of the obligation
Raynor v. Commr, 50 TC 762 (1968)
9
Cases Decided Before 1986 (cont)

• Perry,
• Borg,
• Neal,
• Blum,
• Cole,
• Smalley,
• Wheat
• Mirow

• Duke,
• Brown, JW
• Brown, F
• Williams,
• Calcutt,
• Harrington,
• Allowed 2.50

10
Guarantees and Similar Arrangements (Cont)

• The Selfe decision
• Pro se 11th Cir, 1985
• Used Plantation Patterns as precedent
• Ct. found constructive
• Bank gt S/H gt Corp

11
Selfe relationships
12
Selfe Result
13
Guarantees and Similar Arrangements (Cont)

• Decisions after Selfe
• Nowhere but 11th Cir.
• Leavitt departed from Selfe
• Schneiderman
• Calcutt

14
Guarantees and Similar Arrangements (Cont)

• 101.04 IRS rulings
• Rev Rul 70-50 no basis until paid
• Rev. Rul. 71-288 later payment later basis
• Rev Rul 75-144 how to create basis

15
IRS Rulings (Cont)

• How to create basis
• Rev Rul 75-144
• Substitute s/h for corp. on note
• Subrogation
• No checks necessary

16
Rev Rul 75-144
17
Rev Rul 75-144 (cont)
18
IRS Rulings (cont)

• More recent rulings
• Rev. Rul. 81-187 economic outlay

19
Substitution of Personal Note for Corporate Note

• SCT 101.05
• Following RR 75-144
• Gilday allowed basis with no subrogation

20
Compare basis of S corp. Shareholder with LLC
member
21
102 Loans from Parties Related to Shareholders
Prashker
22
102 Loans from Parties Related to Shareholders

• Trusts
• Robertson
• Partnerships
• Frankel, Hill Blalock,
• Corporations
• Gurda, Meissner

23
Loans from Parties Related to Shareholders (cont)

• Underwood
• Careful, observed some formalities
• Still lost

24
Underwood, before rewrite
25
Underwood, after rewrite
26
Underwood, (cont)

• No Economic Outlay on part of Mr. Underwood
• Fatal to case

27
Loans from Parties Related to Shareholders (cont)

• Wilson
• S1 loaned to S2 S3.
• Distributed notes from S1 to shareholders
• No basis allowed
• Factual problems

28
Loans from Parties Related to Shareholders (cont)

• Shareholder victory Culnen
• Good books, and pre-taxed income
• But remember litigation cost
• Loss computation upheld in 2002

29
Culnen Illustrated

• Compare cash flow with tax treatment

30
Loans from Parties Related to Shareholders (cont)

• Shareholder victory Yates
• Mr. Y owned stock in 2 S corps (F A).
• A advanced money to F
• Mr. Y then split holdings for liability purposes.
• Kept all stock in A and gave all stock in F to
  his wife.
• After gift A continued to advance money to F.

31
Loans from Parties Related to Shareholders (cont)

• Yates, contYates claimed
• Pre gift advances were distributions from A to Y,
  who then contributed to capital to F

32
Loans from Parties Related to Shareholders (cont)

• Yates claimed
• Post gift advances were loans from A to Mrs. Y,
  who then contributed to capital to F

33
After Culnen and Yates

• Miller (2006)
• Typical guarantee
• Refinanced and restructured, similar to RR 75-144
• Later corporation defaulted
• Other shareholders paid on Millers behalf
• Court found Miller was subject to economic burden
  of repayment in the years in question, allowed
  basis.
• In later year, when other invertors relieved him,
  he had cancellation of debt income.
• Miller v. Commr, TC Memo 2006-125

34
After Culnen and Yates

• In Gleason, there was weak documentation (both
  sides)
• Where money to corporation was clearly traceable
  to shareholders personal borrowing, basis was
  allowed
• For situations where there were no clear tracks,
  no basis was allowed.

35
Back-to-Back and Circular Loans

• 103
• Lender -gt S/H -gt S Corp
• Seven Sixty Ranch Co. v. Kennedy
• Burnstein
• PLR 8747013
• Legitimate basis

36
Back-to-Back Loans (Cont)Seven-Sixty and
Cornelius

• Back to back loan
• Court allowed basis

37
Back-to-Back Loans (Cont)Bader Case

• Circular loan

No basis Bader, PLR 9403003
38
Oren and other Circular Cases

• Bergman
• Oren
• Kaplan
• Kerzner

39
Bergman
40
Bergman (cont)
41
Circularity in Oren
42
Oren Step Transactions

• Loan to create basis in Highway Leasing

43
Oren Step Transactions

• Source of loan to create basis

44
Oren Step Transactions

• Source of source of loan to create basis

45
Circular Loans

• Kaplan
• 12/29/97 - - Sole shareholder of 2 S corps
  borrowed 800,000 from bank.
• Shareholder provided no personal financial
  statements to lender but collateralized loan with
  bank accounts of 2 S corps.
• 12/29/97 -- the shareholder loaned 550,000 to
  one S corp. and 250,000 to second S corp.
• 1/8/98, shareholder borrowed 550,000 from 1st S
  corp. and 250,000 from 2nd S corp.
• 1/8/98, shareholder repaid bank loan.Funds never
  left bank.

46
Circular Loans

• Ruckriegel (2006)
• Two shareholders were also partners in a
  partnership (equal and only in both)
• The partnership advanced money to the corporation
  and to the partners, who advanced to the
  corporation.
• The partner/shareholders were allowed basis for
  amounts they had actually received, but not for
  the transfers from the partnership

47
Kerzner

• Loans from a partnership to its partners to the S
  corporation in which the partners were also
  shareholders
• Shareholders loaned money to the S corporation
• The S corporation paid rent to the partnership.
• All transactions were in identical amounts within
  three days.
• IRS concludes that the entire series of
  transactions was essentially circular.
• Thus the shareholders do not get S corporation
  basis for the funds they borrow from the
  partnership and lend to the S corporation.

48
Kerzner
49
Miscellaneous Basis Litigation

• 104
• Applicability to Successor Corporation
• Carryback of losses
• Open Account loans

50
Applicability to Successor Corporation

• 104.01
• Shareholders basis in survivor included basis in
  loan to merged corp. Hunt

51
Applicability to Successor Corporation (cont.)

• Transferee Liability
• Hitchins
• Hitchins was s/h in Corp 1
• Hitchins made loan to Corp 2
• Corp 1 assumed Corp 2s debt
• Tax Court held no basis to Hitchins

52
Applicability to Successor Corporation (cont.)

• The rationale of Hitchins has been followed in a
  similar circumstance.
• Court upheld the substantial understatement
  penalty of 6661. Bhatia

53
Applicability to Successor Corporation (cont.)

• Taxpayer victory in Rose
• Shareholder loaned to PKV Corporation
• PKV merged into SLPC Corporation, which survived
  the merger.
• IRS and Tax Court denied basis in SLPC
• 11th Cir. Found that shareholder had made
  economic outlay and allowed

54
Unpaid Wages from the Corporation

• 104.02
• No basis for accruals not yet reported as income
  by s/h
• Borg, Leavitt, Sperl

55
Open Account Loans

• Brooks v. Commissioner
• Effect of New Loans in the Same Year as Repayment
• If separate loans, presumably new lending does
  not create basis for prior repayments
• However, if the corporation and shareholders
  maintain open accounts, the Tax Court has ruled
  that all repayments and new loans in same year
  are netted. Brooks v. Commr
• Thus under the Brooks rationale, if year end loan
  balance equals or exceeds the balance at the
  beginning of the year, there has been no
  repayment

56
Brooks Case

• Prior to 1999, the shareholders had advanced
  funds, the basis of which had been reduced to
  zero by 1999.
• In early 1999 the corporation repaid some of the
  advances
• In 1999, the corporation did not have net income,
  so there was no basis restoration to the debt
  repaid early in the year.
• In late 1999, the shareholders advanced the
  corporation enough to cover the prior repayments
  and the 1999 losses.

57
Brooks (Cont)

• According to the IRS, each advance was a distinct
  transaction.
• Therefore, there was no basis in the loan made
  prior to 1999 when it was repaid.

58
Open Account Loans (Cont)

• Anti-Brooks Proposed Regulation
• However, the IRS has proposed amendments to Reg.
  1.13672, which would limit the treatment of
  open account debt as a single instrument only
  when the total balance does not exceed 10,000
  on any day of the taxable year.
• On the first day the debt exceeds 10,000, the
  corporation must begin computing interest, and
  the debt loses its status as open account,
  permanently.

59
Open Account Loans (Cont)

• Anti-Brooks Final Regulation
• However, the Final Regulation adopted in October
  2008 is somewhat more liberal
• The shareholder/creditor will need to keep a
  running balance of all debts from the corporation
  (including written instruments).
• If the total of this running balance exceeds
  25,000 on the last day of the year, the advances
  and repayments will each constitute a separate
  indebtedness from that day forward.

60
105 Basis Adjustments

• Most adjustments in distributions materials
• 105.01 Apportionment of Losses in Excess of
  Basis
• 105.02 Charitable Contributions of Capital Gain
  Property

61
105.01 Apportionment of Losses in Excess of Basis

• Losses may be ordinary, capital, from active
  business, from rental activities, etc.
• Regulations under Subchapter S provide that
  allocation of the basis limit shall be
  apportioned to each loss pro-rata.
• The Code treats charitable contributions as one
  of the items that are limited by shareholder
  basis.

62
Example 1

• Basis 35,000
• Losses deductions total 50,000
• 40,000 ordinary loss
• 10,000 charitable contribution
• Claim 70 (35/50) in current year
• Ordinary 28,000
• Charitable 7,000
• Carry remainder of each forward

63
105.02 Charitable Contributions of Capital Gain
Property

• Temporary rule
• Shareholders reduce stock basis for allocable
  portions of basis in contribution
• Allocate basis when there are multiple losses in
  excess.
• Apply same percentage to charitable deduction

64
Example 2

• Same except contribution was capital gain
  property
• Basis 10,000
• Value 25,000
• Basis reduction and percentage apportionment are
  the same

65
Example 2

• Shareholder claims equivalent percent of basis,
  plus all appreciation, as deduction
• Claim 70 (35/50) in current year
• Ordinary 28,000
• Charitable basis 7,000
• Charitable appreciation 15,000 22,000
• Carry remainder of each forward

66
Adjustments to basis of S corporation debt.

• When losses pass through to the shareholder, and
  the losses exceed stock basis, however, the
  shareholder must reduce debt basis.
• When a shareholder has made multiple loans to a
  corporation, any basis reduction for losses is
  prorated among the various loans.

67
Debt Basis Restoration.

• After debt basis has been reduced, there may be
  subsequent income.
• Such income will first restore debt basis.

68
Basis Adjustments in the Year of Repayment.

• Repayment of reduced basis loan may create
  ordinary income or capital gain to the
  shareholder at the time of repayment.
• Repayment of open account loan is treated as
  ordinary income to creditor.
• If the loan is evidenced by a note, the note may
  be a capital asset to the holder.
• Repayment of a reduced basis note creates capital
  gain.
• If part of the loan is repaid, the lender must
  prorate between basis and gain (analogous to
  installment sale).

69
Adjustments to basis of a loan in the year of
repayment

• The Code is completely silent on the adjustment
  to basis of a loan in the year in which it is
  repaid.
• If any portion of the debt has been repaid, the
  corporation's income restores that basis before
  any other debt or stock.

70
Stock and Debt Basis Distinguished.

• When an S corporation repays a shareholder loan
  after a reduction of basis, the only items that
  can be taken into account for restoration of debt
  basis are the income items flowing through from
  the S corporation to the shareholder.
• In Nathel v. Commissioner, shareholders had made
  open account loans to the corporation and also
  contributed directly to the corporations capital
• When the corporation repaid the loans, the
  shareholders claimed that the contributions to
  the corporations capital should have restored
  debt basis.
• However, the IRS and Tax Court held that the
  capital contributions were increases to stock
  basis, rather than debt basis.
• Because the loans had all been open account
  loans, the gain on repayment was ordinary income.