Nathel v. Commissioner1 provides a good review of S corporation loss utilization, open account debt issues and loss recognition for payment of shareholder guarantees. In the current economic downturn, these are all extremely important issues confronting tax return preparers.
Ira and Sheldon Nathel organized three corporations, all of which elected to be taxed as Internal Revenue Code (IRC) Subchapter S corporations (hereinafter referred to as “S corporations”), which election generally permits income to be subjected to only one level of taxation. They personally guaranteed $2.5 million in loans made by two banks, and they each made substantial personal loans to the food distribution businesses operating pursuant to the corporation’s purposes. The business experienced losses, and under the S corporation rules, these losses were passed through to the shareholders.2 In order to prevent the double deduction of losses, any losses that are passed through from an S corporation to shareholders first reduces the shareholders’ basis in their stock.3 Stock basis cannot be reduced below zero. Deductions which exceed such stock basis then reduce the shareholder’s basis in any indebtedness owed by the S corporation to the shareholder, and losses which exceed these limitations may not be deducted by the shareholders, but are carried forward.4 As the story develops, the importance of the technical basis utilization and restoration rules will become evident.5
As of December 31, 2000, the Nathels each had a zero basis in their stock and a basis of only $112,547 in the loans they made to one corporation, and a basis of $3,603 in loans to another corporation. They had no basis by reason of their guarantees to the bank.6
Loan Repayment The problem arose in February 2001, when their personal loans were repaid in advance of corporate reorganization and restructuring. After receipt of the loan repayment, the Nathels then made capital contributions back to the corporations. The Nathels re-ceived a total of $1,622,050 in combined loan repayments and, in turn, made a combined total of $1,437,248 in capital contributions. The parties stipulated in Tax Court that the capital contributions were made to secure release of their respective guarantees.
Repayment of a loan with reduced basis gives rise to ordinary income if the debt is not evidenced by a note.7 The Internal Revenue Service said that the Nathels therefore must report ordinary income on the excess loan repayment over loan basis.
In an apparent desperate attempt to avoid this income, the taxpayers cleverly asserted that their contribution to S corporation capital increased their loan basis. They asserted that this should be treated as tax free income, and would therefore increase basis under Internal Revenue Code § 1367. As one might suspect, the IRS viewed the situation quite differently, and stated that a capital contribution is not considered income and would not therefore increase the loan basis. However, capital contributions would increase the basis in their S corporation shares resulting in a long term capital loss on the corporate redemption. The Tax Court and the Second Circuit agreed with the IRS.8
This was the worst result for the taxpayers – ordinary income, loss of an ordinary deduction and long term capital loss. Tax practitioners should take careful notice because these situations are not unusual in today’s economic climate. Although the decision is not necessarily surprising, perhaps the result might have been different if the transaction was altered somewhat. For example, what if the third shareholder or the corporation made a payment directly to the bank in order to obtain the releases sought by the Nathels? Perhaps an option could also have been granted to the other shareholder to purchase the Nathels’ shares at the current fair market value, which would have likely been a modest amount due to the corporate loss history and debt obligations. The facts of the case do not indicate that the Nathels were aware of the likely tax consequences, and that indicates a possible practice liability risk for the attorneys and accountants involved.
Payment to Secure Release
An alternative approach advanced by the Nathels was that they are entitled to an ordinary loss under IRC § 165(c)(2), which provides a deduction for losses incurred in a transaction entered into for profit. Such deductions and losses have been allowed for payments made to secure a release of a personal guarantee.9 The Second Circuit clearly stated that in order to utilize a § 165(c)(2) deduction, the taxpayer must meet two tests. The taxpayer must not only show that the transaction was entered into for a profit, but must also prove that the “primary motive” must have been a profit motive and release from the personal guarantee.10 Although the Court noted that in some jurisdictions the taxpayer must prove that the “sole purpose” of the payment must be to secure a release from the loan guarantee, such was not the requirement in the Second Circuit. Therefore, because a case in New York is appealable to the Second Circuit, the primary motive test applies.
After correcting the Tax Court regarding the proper standards, the Second Circuit held that the Nathels failed to meet the test. The stipulation was found to be insufficient. Although the stipulation with the IRS before the Tax Court states that the capital contributions were made in order to secure the release, the stipulation did not state that this was the primary purpose. The Court held that multiple purposes were present and it was not possible to determine what portion, if any, of the taxpayers’ capital contributions were primarily made in order to obtain the release of personal liability.
The taxpayers were unable to prove that the capital contribution was made in order to obtain the release, despite the fact that the redemption or sale was at fair market value. The IRS did not dispute that a profit motive was present, but that the taxpayers failed to show that the primary purpose of the capital contribution was the release of liability.
Again, this seems to be an example of poor planning and poor documentation. It is hard to imagine a more “primary” motive for the contributions to capital, as these seemed to be required by the third shareholder to grant his release. The fact that the redemption was transacted at the full fair market value of the corporation also reinforces this conclusion. However, the Second Circuit required more direct proof. A statement to that effect in the agreement might have saved the day.
In today’s economic climate, many corporate transactions are developing in which shareholder losses and guarantees are present. Tax practitioners need to be ever vigilant of the S corporation basis and loss utilization rules and limitations. Shareholder guarantees do not provide basis for loss utilization and that repayment of reduced basis loans may give rise to ordinary income. Payments to secure the release of personal obligations must be carefully structured. In Nathel, better planning and documentation might have resulted in a more favorable outcome for the taxpayers.
Robert S. Barnett, CPA, JD, MS (Taxation) is a founding partner of Capell Barnett Matalon & Schoenfeld LLP, Attorneys at Law, in Jericho, NY and heads the Tax and Estate Planning departments. He can be reached by phone at (516) 931-8100 or by e-mail at email@example.com.
1. 105 AFTR 2d 2010 (2d Cir. June 2, 2010)
2. IRC § 1366(a)(1)(A).
3. IRC § 1367(a)(2)(B).
4. IRC § 1366(d); IRC § 1367(b)(2)(A). Any net increase in basis in a subsequent year will be applied to first increase and restore the basis in shareholder debt before it is applied to increase the shareholder’s basis in stock. IRC § 1367(b)(2)(B).
6. See Maloof v. Commissioner, TCM 2005-75 (April 6, 2005).
7. Treas. Reg. § 1.1367-2; Cornelius v. Commissioner, 494 F.2d 465 (5th Cir. 1974).
8. The Court stated that they were not aware of a single case supporting the Taxpayer’s position that a contribution to capital would be treated as income, and that IRC § 118(a) specifically provides that “[i]n the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.”
9. Duke v. US, 39 AFTR 2d 77-847 (S.D.N.Y. January 31, 1977); Shea v. Commissioner, 36 T.C. 577 (1961) aff’d, 327 F.2d 1002 (5th Cir. 1964). 10. See, Ewing v. Commissioner, 213 F.2d 438 (2d Cir. 1954). The Court refused to follow contrary and more lenient guidance described by the 10th Circuit in Condit v. Commissioner, 333 F.2d 585 (10th Cir. 1964) (the Court found no primary purpose but nevertheless allowed a deduction under IRC § 165(c)(2)).
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