Taxpayers with ownership interests in flow-through entities cannot deduct entity losses if they do not have basis in those entities. Consequently, a taxpayer’s basis is often scrutinized by the IRS, particularly when basis is claimed based upon debts incurred by a flow-through entity.
In mid-2012, the IRS issued Prop. Regs. Sec. 1.1366-2 (REG-134042-07) to establish a standard for when shareholders can increase basis in S corporations based upon loans to the S corporation. Under this standard, a shareholder may increase basis by “bona fide indebtedness” of the S corporation that runs directly to the shareholder. Partners, in contrast, are subject to the more complex partnership basis rules of Secs. 752 and 465. As basis laws change and develop over time, the IRS will continue to scrutinize reported losses.
The proposed regulations do not establish factors or criteria to determine when S corporation indebtedness is bona fide. Instead, whether indebtedness is bona fide is determined under general tax principles. The preamble to the proposed regulations cites four cases that establish whether a debt is bona fide: Knetsch, 364 U.S. 361 (1960); Geftman, 154 F.3d 61 (3d Cir. 1998); Estate of Mixon, 464 F.2d 394 (5th Cir. 1972); and Litton Business Systems, Inc., 61 T.C. 367 (1973). Geftman, for instance, established three factors to determine whether a loan is bona fide: (1) contemporaneous intent to repay; (2) objective indicia of indebtedness, e.g., the creation of a note, collateral, repayment schedule, etc.; and (3) economic reality.
The proposed regulations provide three examples of debt arrangements that may or may not be bona fide, depending on the facts and circumstances:
(1) A “shareholder loan transaction,” under which a sole shareholder makes a direct loan to the S corporation.
(2) A “back-to-back loan transaction.” In this example, A is the sole shareholder of two S corporations, S1 and S2. S1 first makes a loan to A, and then A makes a loan to S2.
(3 A “loan restructuring through distributions.” In this example, A is the sole shareholder of two S corporations, S1 and S2. S1 makes a loan to S2. S1 then distributes the note from this loan to A, placing A in a creditor position. In each scenario, the shareholder may obtain basis only “if the loan constitutes bona fide indebtedness.”
To determine whether a shareholder loan constitutes bona fide indebtedness, the IRS will evaluate it under federal tax principles such as those in the cases mentioned above. As such, shareholders that wish to obtain basis under similar circumstances should, among other measures, execute notes, use objective third-party interest rates, and abide by repayment schedules to ensure that loans are treated in a manner consistent with third-party loans. It is noteworthy that, in the second and third examples, the proposed regulations do not require a shareholder to make an actual economic outlay to obtain basis.
Finally, the proposed regulations reaffirm the IRS’s position that a shareholder’s guarantee of S corporation debt does not, by itself, create basis. A shareholder that guarantees S corporation debt may obtain basis, but only to the extent the shareholder makes payments on that debt. For the most part, case law supports the IRS’s position with respect to guarantees.
While a shareholder’s guarantee, without economic outlay, was enough to establish basis in Selfe, 778 F.2d 769 (11th Cir. 1985), this case appears to be an anomaly based upon unique and limited circumstances. The shareholder in Selfe personally borrowed from a commercial bank while conducting business as a sole proprietorship. The shareholder subsequently converted the business into an S corporation and transferred the debt to the corporation. The bank required the shareholder to personally guarantee the debt. The Eleventh Circuit held that the shareholder may have been the primary obligor and, therefore, entitled to basis. Thus, the court remanded the case for a determination of whether, based on the facts, the bank looked to the shareholder as the primary obligor. Since Selfe, however, courts have consistently ruled that shareholders cannot obtain basis through guarantees alone. Examples of cases in which shareholder/guarantors were denied basis include Montgomery, T.C. Memo. 2013-151; Sleiman, 187 F.3d 1352 (11th Cir. 1999); and Maloof, T.C. Memo. 2005-75. The proposed regulations, consistent with case law, reinforce the position that guarantees, absent an economic outlay, do not create basis for shareholders in S corporations.
The proposed regulations will be effective only for transactions entered into after the proposed regulations are made final. However, the regulations demonstrate the IRS’s position with regard to S corporation loans and basis.
Basis for Partners in Partnerships
In some respects, the bona fide debt standard for S corporation shareholder loans resembles the standard under which partners may obtain basis for loans made to a partnership. In fact, in Baughman, T.C. Memo. 1989-59, and HGA Cinema Trust, T.C. Memo. 1989-370, the Tax Court evaluated whether alleged recourse loans made to partnerships were bona fide. However, to state that partnership loans must only be bona fide to create basis is an oversimplification. Partnership loans are subject to various complex rules under Secs. 752 and 465. Moreover, a partner, unlike a shareholder, may obtain basis in partnership loans through guarantees without making an actual economic outlay (Regs. Sec. 1.752-2(b)(3)).
Recourse Liabilities And Amounts At Risk
A partner’s basis in a partnership includes that partner’s allocation of the partnership’s liabilities (Sec. 752(a)). A partner is allocated recourse liabilities if that partner bears the economic risk of loss for those liabilities, meaning that the partner would have to pay a creditor upon a constructive liquidation of the partnership (Regs. Sec. 1.752-2(b)(1)). Under a constructive liquidation, all of a partnership’s assets are deemed worthless, and all liabilities become payable in full.
Even if recourse liabilities are allocated to a partner, that partner can deduct only losses that are financed with liabilities for which the partner is at risk under Sec. 465. The determination of whether a partner is at risk under Sec. 465 is often the subject of litigation. The applicable standard for determining whether a partner is at risk differs depending on the controlling jurisdiction. Courts have developed two basic standards to make this determination, the “payer of last resort” standard and the “realistic possibility of loss” standard. These approaches differ greatly.
Under the Sixth Circuit’s payer-of-last-resort standard, the test is whether a partner would be responsible for payments to a partnership’s creditor, applying a worst-case scenario (Emershaw, 949 F.2d 841 (6th Cir. 1991)). The worst-case scenario must be a reasonably realistic scenario but not necessarily a likely one (Leach, 36 F.3d 1098 (6th Cir. 1994)). This is generally thought to be a taxpayer-friendly standard that allows courts to evaluate mere possibilities.
In contrast, jurisdictions that have adopted the realistic-possibility-of-loss standard, including the Second, Eighth, and Eleventh Circuits, evaluate a transaction to determine whether the terms of a loan are structured to eliminate any realistic possibility that a partner will incur economic loss. A worst-case scenario is not considered. It is noteworthy that the Tax Court’s position is that, regardless of which standard applies, all facts and circumstances should be considered to determine whether the transaction has economic substance (see Wag-A-Bag, Inc., T.C. Memo. 1992-581).
Unlike shareholders in an S corporation, partners can obtain basis by guaranteeing a partnership’s debt even if there is no economic outlay (Regs. Sec. 1.752-2(b)(3)(i)). However, basis does not include an obligation to make payment if the partner would be entitled to reimbursement from another partner or the primary obligor (Regs. Sec. 1.752-2(b)(5)). Moreover, a guarantee will be disregarded if the facts and circumstances indicate that the guarantee is subject to contingencies that make it unlikely the guarantor will ever be held liable (Regs. Sec. 1.752-2(b)(4)).
For instance, the Tax Court in Peters, 89 T.C. 423 (1987), determined that the petitioners were not at risk under Sec. 465 since state law entitled the petitioners to reimbursement from the partnership. In contrast, the petitioners’ guarantees were sufficient to create at-risk basis in Abramson, 86 T.C. 360 (1986), because the terms of the guarantees placed the petitioners “in an economic position indistinguishable from that of a general partner.” The IRS’s general position is that a partner cannot obtain basis for a loan’s guarantee unless the partnership agreement specifically states that the partners are not entitled to reimbursement from another partner.
The rules that govern basis for debt in flow-through entities are complex, and failure to pay attention to details can cause the disallowance of otherwise deductible losses. The more the obligation resembles a traditional arm’s-length third-party debt, the more likely the debt will be respected as basis in the entity.
by Mark S. Heroux, J.D., and Colin J. Walsh, J.D. – Edited and posted by Harold Goedde Ph.D. (accounting and taxation)