S corporations and their shareholders must keep track of stock and debt basis. Failure to do so can lead to disastrous results. Nathel v. Commissioner, 105 AFTR 2d 2010-2699 (2d Cir 2010), illustrates this point.
In Nathel, the government and the taxpayer stipulated to the facts. Two brothers and a friend formed three separate S corporations to operate food distribution businesses in New York, Florida and California. All three shareholders made initial capital contributions to the corporations. The brothers also made loans to two of the corporations.
In 2001, one corporation was liquidated. In a reorganization of sorts, the friend ended up owning 100% of the second corporation and the two brothers ended up equally owning the third corporation.
In late 2000, before the reorganization, the brothers made loans to the corporations totaling around $1.3 million. In 2001, they made capital contributions totaling approximately $1.4 million. Also, in 2001, they received loan repayments combined in excess of $1.6 million.
Immediately before the repayment of the loans, the brothers had zero basis in their stock and only nominal basis in the loans. Ouch! To avoid the ordinary income tax hit on the delta between the $1.6 million in loan repayments and their nominal loan basis, the brothers, with the likely help of their handy dandy tax advisor, asserted the $1.4 million in capital contributions was really tax-exempt income to the corporation, excludable under IRC Section 118(a), but which, under IRC Section 1367(b)(2)(B), increased their loan basis. Therefore, the ordinary income tax hit on the loan repayments was nominal.
Please join me for the NYU 73RD Institute on Federal Taxation. This year’s Institute will be held in San Diego at the Hotel Del Coronado November 16 – 21, and in New York City at the Grand Hyatt New York October 19 – 24. Please see the attached brochure. The coverage of tax topics is both timely and broad. This year’s presentations will cover topics in the areas of: executive compensation and employee benefits; partnerships and LLCs; corporate tax; closely held businesses; and trusts and estates. What is so terrific about the Institute, in addition to a wonderful faculty and the interesting current presentation topics, you can choose the presentations you want to attend. In other words, you can pick and choose the topics that relate to your tax practice.
This is my second time speaking at the Institute. My topic this year is: "Developments In The World Of S Corporations." I plan to deliver a White Paper that will provide attendees with an historic overview of Subchapter S and a look through a crystal ball at the future of Subchapter S, including a review of the recent cases, rulings and legislative proposals impacting Subchapter S.
I hope to see you in either San Diego or New York.
The IRS will strike down transactions among related parties that lack economic outlay. At least two recent US Tax Court cases are illustrative of the issue.
Kerzner v. Commissioner, T.C. Memo 2009-76 (April 6, 2009). The Service beat the taxpayers in this case by a nose. Mr. and Mrs. Kerzner were equal partners in a partnership that owned a building. The partnership leased the building to an S corporation which was owned equally by two shareholders, Mr. and Mrs. Kerzner. Over the years, the partnership loaned the Kerzners money. In turn, they loaned the money to their S corporation, which used the money to pay rent to the partnership.
At the end of each year, promissory notes were drafted to document the loans; some of the notes stated an interest rate, some did not. Even though the notes required payment of principal, virtually no payments were ever made because the notes each year were replaced with new notes before any payment was due.
The S corporation had large losses. The Kerzners claimed basis in the loans to the corporation and took the losses on their individual tax returns. Upon audit, the Service claimed the loans lacked economic substance and did not give the Kerzners basis to absorb the losses.
Larry J. Brant
Larry J. Brant is a Shareholder and the Chair of the Tax & Benefits practice group at Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "Entity Classification – The Check-The-Box Regulations Revisited," New York University 81st Institute on Federal TaxationNew York, NY, 10.23.22-10.28.22
- "The Intersection of Code Section 1031 and Opportunity Zones," 2022 OSCPA Northwest Federal Tax Conference10.24.22
- "Entity Classification – The Check-The-Box Regulations Revisited," New York University 81st Institute on Federal TaxationSan Diego, CA, 11.13.22-11.18.22