Two brothers’ additional capital contributions to S corporations of which they were shareholders could not offset their ordinary income from payments for loans they made to the corporations, the Tax Court held. The court rejected their argument that their capital contributions restored the previously reduced basis of their shareholder loans. Instead, the court held, the contributions increased the taxpayers’ stock basis.
Shareholders in an S corporation have an initial stock basis equal to the amount of their capital contributions to the corporation. If shareholders loan money to the S corporation, their loan basis equals the loan amount. Subsequently, under section 1367, the shareholders’ stock basis is increased for their share of the S corporation’s items of income, including tax-exempt income, and is decreased (but not to less than zero) for their share of any loss items. If the stock basis has been reduced to zero, any additional loss items will decrease (but not to less than zero) the shareholders’ basis of loans made to the S corporation. Later, if items of income exceed loss items, the net increase first increases and restores the basis of the shareholder loans. Distributions to shareholders exceeding the basis of their stock will result in the recognition of capital gain, but loan repayments to the shareholders exceeding their loan basis will result in ordinary income.
Two brothers, Ira and Sheldon Nathel, each owned 25% of the stock of three S corporations, G&D Farms Inc. (G&D), Wishnatzki & Nathel Inc. (W&N) and Wishnatzki & Nathel of California Inc. (W&N CAL). The brothers also made loans to G&D and W&N CAL. As of Jan. 1, 2001, losses had reduced each brother’s stock basis and loan basis in the S corporations to $0 and $116,150, respectively. During 2001, each brother received loan repayments of $649,775 from G&D and $161,250 from W&N CAL. The payment from W&N CAL was made as part of a reorganization of the three corporations that resulted in each brother’s becoming a 50% owner of W&N, the liquidation of W&N CAL and the termination of the brothers’ interests in G&D. Also as part of this process, the brothers each made capital contributions of $537,228 to G&D and $181,396 to W&N CAL. When filing their 2001 federal income tax returns, each brother increased his loan basis by $718,624 (the amount of their 2001 capital contributions) on the theory the capital contributions were an item of income under section 1367—in other words, tax-exempt income. The IRS stated no such increase is permitted and assessed deficiencies against both taxpayers.
After petitioning the Tax Court for relief, the brothers argued the loan basis increase was proper since the capital contributions were an S corporation tax-exempt item of income. They based their argument on the 2001 holding in Gitlitz v. Commissioner, 531 U.S. 206. In it, the Supreme Court held that income from the discharge of an insolvent S corporation’s debt under IRC § 108(a) results in a positive stock basis adjustment. The Supreme Court further stated that “§§ 101 through 136 employ the same construction [as § 108] to exclude various items from gross income.” Since capital contributions are excluded from income under section 118, the brothers argued that their capital contributions were an item of income that should increase the basis of their loans.
The Tax Court disagreed, stating such an interpretation would contradict three longstanding tax principles: (1) capital contributions of shareholders increase stock basis, (2) capital contributions are not income of the corporation and (3) debt and equity are two different things treated differently by the Tax Code and courts. Furthermore, Treas. Reg. § 1.118-1 states that capital contributions are not income to the recipient corporation. Since loan proceeds and capital contributions are not items of income, they cannot increase an S corporation shareholder’s loan basis, the Tax Court said.
Note: In the Job Creation and Worker Assistance Act of 2002, Congress amended section 108(d)(7)(A) and thus overturned the Supreme Court’s decision in Gitlitz.
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.