Did you attach your S corporation basis schedule to your recently filed Form 1040? If you did, was it correct? If you didn’t, why not? It is now a requirement.
If you are selected for an IRS or state audit, the examiners will request copies of your basis schedules. They are looking for adjustments and will scrutinize your records to try and determine if you properly accounted for flow-through losses, distributions, loan repayments, and sales of stock. As demonstrated from the case discussed below, the results of an IRS audit can have significant financial implications for shareholders in an S corporation.
In a recent court case, the IRS challenged the taxpayer’s basis calculation and the Tax Court and Eleventh Circuit both upheld the IRS’ assessment of more than $2.6 million.
The taxpayer in the case was a real estate developer who deducted on his personal income tax return nearly $13 million of flow-through losses from an S corporation. Because the taxpayer could not prove sufficient basis to allow him to utilize the losses, the IRS disallowed the losses and issued and an assessment.
This case centered around the taxpayer’s claimed debt basis. The IRS agreed that the taxpayer had basis in his S corporation up to the amount of funds that he personally contributed to the S corporation, but it rejected the basis he alleged acquired by having affiliated entities pay certain expenses of the S corporation.
During the years in question, the taxpayer’s S corporation entered into hundreds of transactions with affiliated partnerships, S corporations, and limited liability companies in which he held an interest. These affiliated entities regularly paid expenses on behalf of the S corporation and recorded the payments as accounts receivable. This was done to simplify accounting and to enhance liquidity. Similarly, the S corporation recorded these items as accounts payable.
After the close of the S corporation’s taxable year, and in connection with the preparation of its tax returns, the S corporation’s tax preparer would reclassify any net accounts payable as shareholder loans in order to establish that the shareholders had debt basis. Importantly, though, these changes were not supported by any loan documentation between the taxpayer and the S corporation.
Shareholders of S corporations can deduct losses from the S corporation only up to the amount of their stock basis in the corporation, which includes cash contributions to the corporation and loans that are directly made to the corporation. In order to establish debt basis, a shareholder must provide proof of a bona fide indebtedness that runs directly from the shareholder to the corporation, and that there was an actual economic outlay.
The taxpayer did not have any direct loans running from him to the S corporation, so he asserted two alternative arguments in support of his claimed debt basis: the “back-to-back loan” theory and the “incorporated-pocketbook” theory.
Under the back-to-back loan theory, a shareholder can acquire basis in an S corporation if he borrows funds from a third-party and then loans the borrowed funds to the S corporation. In this case, the taxpayer argued that the affiliated entities should be treated as lending money to him that he then lent to the S corporation.
The taxpayer did not prevail with this argument because the payments were not contemporaneously documented as loans from the taxpayer, and the form of the transaction was not consistent with such treatment – the payments were documented as intercompany loans from the affiliated entities to the S corporation. The courts thus held taxpayer to the form in which he cast the transactions. In addition, many of the purported loans were made by entities that were not wholly-owned by the taxpayer.
The taxpayer also failed to succeed with the incorporated pocketbook theory. Under this theory, a shareholder can acquire basis in an S corporation if he can show that he had a “habitual” practice of having a single, wholly-owned corporation make loans to the S corporation on his behalf, i.e., the wholly-owned corporation functioned as his incorporated pocketbook. But under the facts of the case, which the court said were a “far cry” from the decisions endorsing this theory, many of the affiliated entities had co-owners besides the taxpayer, and the taxpayer did not show any “habitual practice” of those entities making payments on his behalf. Moreover, the affiliated entities did not book the payments as loans to the taxpayer; rather, they booked them as capital contributions, payroll expenses, or intercompany accounts payable and receivable, and only relabeled them as shareholder loans after the close of each tax year.
Because the taxpayer failed to convince the IRS and the reviewing courts that he had debt basis relating to loans he made directly to the S corporation, he had insufficient basis to deduct the S corporation losses on his personal income tax return.
This case demonstrates the importance of proper planning and contemporaneous recordkeeping. The taxpayer in this case likely would have prevailed, and avoided the time and expense of this protracted litigation, if he simply documented the transactions as loans from the affiliated entities to him, and then as loans from him to the S corporation. This simple fact cannot be underestimated because courts routinely hold taxpayers to their chosen form, absent exceptional circumstances. As the U.S Supreme Court stated in 1974, “a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.”
This case also highlights the importance of the new basis reporting requirements on recently-revised Schedule E to the individual tax return (Form 1040). Shareholders in S corporations now need to affirmatively report to the IRS their basis in S corporations if they receive flow-through losses, distributions, loan repayments, or dispose of their S corporation stock. This is reported on line 28, column (e), of Schedule E.
If you have any questions relating to S corporation basis, a current tax examination, or the new basis reporting requirements, please fill out the form below.