Shifting receivables between S corps. increases basis

BY CHARLES J. REICHERT, CPA
September 1, 2012

The Tax Court held that taxpayers could increase the basis of their stock in an S corporation by contributing accounts receivable to it after they had received those receivables in a distribution from a related S corporation. The increased basis in their stock in the first S corporation enabled them to deduct passthrough losses from it.

Taxpayers who own stock in an S corporation may deduct losses that pass through to them from the entity to the extent of their basis in the stock plus their basis in any debt owed to them by the entity. Taxpayers can increase the basis in their stock by making additional capital contributions. To make a capital contribution, the shareholder must incur a cost or be poorer after the contribution.

James Maguire owned a majority interest in Auto Acceptance (AA), a car dealership, and with his wife, Joy, a majority interest in CNAC Inc., a finance company that bought customer notes from AA. Both companies were S corporations. Their son, Marc Maguire, owned the remaining interests in the two corporations. CNAC operated at a profit in 2004, 2005, and 2006, while AA had a loss each year. For all shareholders to have sufficient basis in their AA stock to deduct their share of AA’s losses in those years, CNAC distributed accounts receivable (owed to CNAC by AA) to the shareholders at the end of each of the three years in proportion to their ownership interests. Then, each year, the shareholders contributed those accounts to AA, increased their respective basis, and deducted their share of AA’s losses on their individual income tax returns for the three years. Written shareholder resolutions were prepared, and entries were made on the books of both corporations for the distributions and contributions. The IRS disallowed the losses due to insufficient basis, claiming the contribution of the receivables lacked the economic realities required to increase their basis. The taxpayers petitioned the Tax Court for relief.

The IRS argued the taxpayers should not be allowed to increase their basis since they had not made an economic outlay and the year-end distributions and contributions never actually occurred and should be disregarded as related-party transactions. The court rejected these arguments and allowed the taxpayers to increase their stock’s basis. It held that the tax-free distributions from CNAC had economic consequences since they reduced the shareholders’ ability to deduct their share of future losses of CNAC and reduced CNAC’s assets. It also held that the contributions had economic consequences since, after the distributions, AA’s net worth increased and the shareholders were poorer because they could no longer collect the receivables themselves. Furthermore, based on the testimony of the taxpayers’ CPAs, the court determined that the distributions, contributions, and related journal entries actually occurred before the end of each of the three years. Lastly, according to the court, “the fact that the two S corporations have a synergistic business relationship and are owned by the same shareholders” did not preclude the transactions “so long as the underlying distributions and contributions actually occurred.”

Maguire, T.C. Memo. 2012-160

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.

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