Change in 2014 S Corporation Loan Regulations Did Not Change Result When Loans Came from Related Corporations

In the case of Meruelo v. Commissioner, TC Memo 2018-16 a taxpayer argued that an IRS change in regulations related to S corporations loans made in 2014 meant that he did not need to show he was actually economically worse off following a purported loan to obtain basis for deducting losses.  Unfortunately for the taxpayer, the Tax Court ruled that the new regulations did not remove the requirement that the taxpayer show he/she is economically worse off to obtain basis in what the taxpayer claims is a loan from him/her to the S corporation.

In 2014 the IRS revised the regulations related to S corporation debt.  As the preamble to the final regulations noted:

Courts developed the actual economic outlay standard, which requires that shareholders be made "poorer in a material sense" to increase their bases of indebtedness. Some courts concluded that an S corporation shareholder was not poorer in a material sense if the shareholder borrowed funds from a related entity and then lent those funds to his S corporation. See, for example, Oren v. Commissioner, 357 F.3d 854 (8th Cir. 2004), aff'g, T.C. Memo. 2002-172. Instead of applying the actual economic outlay standard, the proposed regulations provided that shareholders receive basis of indebtedness if it is bona fide indebtedness of the S corporation to the shareholder.[1]

The final regulations specifically provided at Reg. 1.1366-2(a)(2):

The term basis of any indebtedness of the S corporation to the shareholder means the shareholder's adjusted basis (as defined in § 1.1011-1 and as specifically provided in section 1367(b)(2)) in any bona fide indebtedness of the S corporation that runs directly to the shareholder. Whether indebtedness is bona fide indebtedness to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.

In this case the taxpayer had several related S corporations, one of which was Merco of the Palm Beaches, Inc. (Merco).  Merco had purchased a condominium complex in bankruptcy.  As sometimes happens, the taxpayer made payments of expenses out of entities that often weren’t the one that incurred the expense, creating a significant amount of inter-affiliate debts.  As the Court explained the matter:

During 2004-2008 Merco entered into hundreds of transactions with various partnerships, S corporations, and LLCs in which petitioner held an interest (collectively, Merco affiliates). Merco affiliates regularly paid expenses (such as payroll costs) on each other's or on Merco's behalf to simplify accounting and enhance liquidity. The payor company recorded these payments on behalf of its affiliates as accounts receivable, and the payee company recorded such items as accounts payable.

During 2004-2008 Merco affiliates made payments in excess of $15 million to or on behalf of Merco. Merco repaid its affiliates less than $6 million of these advances. On December 31 of each year, Merco's books and records showed substantial net accounts payable to its affiliates.

The taxpayer’s CPA, recognizing that debts from the affiliates to Merco did not create basis for the shareholder, made journal entries each year to transfer any net amount due at the end of the year to a shareholder loan account in an attempt to “fix” this problem.  The CPA, recognizing that a mere journal entry wouldn’t create a true debt on its own, drafted a promissory note from the corporation to the shareholder for a $10 million line of credit, with interest due at 6%.

But the Court pointed out some issues with this credit line.  The opinion notes:

…[T]here is no documentary evidence that such adjustments to principal were actually made or that Merco accrued interest annually on its books with respect to this alleged indebtedness. There is no evidence that Merco made any payments of principal or interest on its line of credit to petitioner. And there is no evidence that petitioner made any payments on the loans that Merco affiliates extended to Merco when they transferred money to it or paid its expenses.

As well, the Court found that nothing indicated that at the time these amounts were transferred that the affiliates intended this to be a credit line transfer.  As the Court notes:

There is simply no evidence that Merco and its affiliates, when booking these transactions, intended to create loans to or from petitioner. Mr. Carreras' adjustments to a notional line of credit, uniformly made after the close of each relevant tax year, do not suffice to create indebtedness to petitioner where none in fact existed. See Delta Plastics v. Commissioner, 54 T.C. 1287, 1291 (1970) (disregarding promissory note that did not reflect an “intent by both parties, substantially contemporaneous to the time of such transfer, to establish an enforceable obligation of repayment”); Parson v. Commissioner, T.C. Memo. 1974-183, 33 T.C.M. (CCH) 789 (finding no indebtedness to common shareholder of multiple S corporations, which had loaned each other money, until such time as the shareholder himself repaid the advances), aff'd without published opinion, 554 F.2d 1070 (9th Cir. 1977).

The Court had also noted that Mr. Meruelo was not economically worse off following the purported “loan” from him to Merco than he was immediately before the transfer—rather, the risk of loss was borne by the affiliated corporation, a separate entity.

But Mr. Meruelo argued that this was no longer relevant, citing the 2014 regulations that, per the preamble, were meant to replace the “poorer in a material sense” test with a “bona fide debt” test that was to be based on general Federal tax principals.  But the Tax Court noted that those “general Federal tax principals” the reality of an actual economic outlay had always been considered.

The Court noted:

The test set forth in the new regulation — limiting basis to “bona fide indebtedness of the S corporation that runs directly to the shareholder” — is the same test set forth in prior case law. See, e.g., Hitchins, 103 T.C. at 715 (“[T]he indebtedness of the S corporation must run directly to the shareholders[.]”); Prashker v. Commissioner, 59 T.C. 172, 176 (1972) (“Clearly there must be a debt running directly to the shareholder in order to permit the deduction * * * of a corporate net operating loss.”).

Moreover, the new regulation provides that the existence of bona fide indebtedness shall be determined “under general Federal tax principles.” The “actual economic outlay” doctrine is a general tax principle that this Court has applied, in cases too numerous to mention, to determine whether a shareholder has made a bona fide loan that gives rise to an actual investment in the corporation. See, e.g., Hitchins, 103 T.C. at 715; Ruckriegel v. Commissioner, T.C. Memo. 2006-78, 91 T.C.M. (CCH) 1035, 1040; Oren v. Commissioner, T.C. Memo. 2002-172, 84 T.C.M. (CCH) 50, 57, aff'd, 357 F.3d 854 (8th Cir. 2004). And principles developed in other tax contexts, requiring that a corporation's indebtedness to a shareholder be genuine and reflect economic reality, apply with equal force for purposes of section 1366(d)(1). See, e.g., Geftman v. Commissioner, 154 F.3d 61, [*12] 73 (3d Cir. 1998) (requiring “objective indicia of an obligation” to support the existence of indebtedness between related parties), rev'g in part, vacating in part T.C. Memo. 1996-447.

Requiring that the shareholder have made an “actual economic outlay” is a general tax principle that may be employed under the new regulation, as it was applied under prior case law, to determine whether this test has been met.

The result in this case was that the taxpayer was denied $8,051,826 of loss from Merco when the complex was repossessed by the bank in 2008.  The loss in question was very real—Mr. Meruelo simply didn’t have any remaining basis against which to claim the loss.

In the end this case was just like many other before it—a shareholder cannot obtain basis in an S corporation debt when a related entity, rather than the shareholder him/herself, makes the loan.  Unfortunately, getting clients to stop making such transfers and instead place funds into the loss corporation themselves from their own accounts (even if they take eventually have to take distributions from the related entities to replenish their accounts) is often difficult.

However, the accountant here, like the one you can read about in the Ruckriegel[2] case noted above, appears to have given up on changing the client’s behavior, and rather attempted to paper over the problem when the tax return was prepared.  And, unfortunately, the result in this case was the same as in Ruckriegel—a very real economic loss could not be taken as a deduction. 

[1] T.D. 9682; 79 F.R. 42675-42678

[2] Ruckriegel v. Commissioner, T.C. Memo. 2006-78