o payments, either direct or indirect, to a subchapter S corporation always create an increase in the taxpayer’s basis? The Tax Court recently decided that they do not.
Sid and Al Ruckriegel were 50% shareholders in Sidal Inc., a subchapter S corporation, set up in Indiana. They were also 50% partners in Paulan Properties Partnership. Sidal incurred ordinary losses in 1999 and 2000. Between 1997 and 2000 Paulan transferred approximately $4 million directly and $2 million in bank loans indirectly to Sidal. The petitioners argued that Paulan was acting as their agent and that their basis in Sidal should be increased by $6 million. Because the petitioners were not the direct source of the funds, the IRS disagreed and assessed combined tax deficiencies of $220,000 and $250,000 for 1999 and 2000, respectively. The Ruckriegels petitioned the Tax Court.
Result. For the IRS as to the direct payments, for the Ruckriegels as to the indirect payments. The Ruckriegels argued that the payments were in substance back-to-back loans through them that had created a debtor-creditor relationship. They also claimed that, under Indiana law, intent governed whether a debtor-creditor relationship existed, and that board of directors’ minutes, promissory notes and accounting entries, along with the “incorporated checkbook” concept, as discussed in Yates and Culnen , provided evidence that this was their intent.
The Tax Court said the evidence had to show the Ruckriegels, not Paulan, made the loans to Sidal and that Sidal’s indebtedness was to them, not Paulan, regardless of the source of the funds. The court held that, for the direct payments, it did not. The promissory notes and board minutes were created three months to three years after the payments; the accounting treatment of the loan principal and interest was inconsistent; and the number of checks written by Paulan for the petitioners was simply too small to constitute an incorporated checkbook.
At the same time, the court found the evidence was sufficient for the Ruckriegels to claim they had made the indirect payments. In summary, the court stated that the petitioners had paid insufficient attention to the details that were needed to justify the tax treatment they were claiming.
Thus, the Ruckriegels were allowed to deduct a small portion of Sidal’s 1999 ordinary loss, but could not deduct any of the 2000 ordinary loss.
Ruckriegel v. Commissioner, TC Memo 2006-78.
Prepared by Michael H. Brown, CPA, PhD, assistant professor of accounting, Tabor School of Business, Millikin University, Decatur, Ill.