Generally, shareholders of Subchapter S corporations are able to use their distributive share of losses to offset income from other sources to the extent of their basis in stock and debt in the company under IRC section 1366(d)(1). With respect to debt loss, the IRS and the courts historically have held that the indebtedness must be directly between the shareholder and the S corporation in order to be deductible. There are numerous cases where borrowings by an S corporation from a bank do not qualify as a deduction even if the shareholder has personally guaranteed the loan. Similarly, shareholders have been denied deductions for losses where the indebtedness was owed by the S corporation to another entity controlled by the same shareholder.
In Culnen v. Commissioner, TC Memo 2000–139, the Tax Court found an S corporation to be directly indebted to a shareholder even though the funds had been advanced from another corporation that was owned by the shareholder.
The shareholder owned an interest in two corporations, one which was not profitable (Loss Corp.) and another which was (Income Corp.). In order to fund the operations of Loss Corp., the taxpayer instructed Income Corp. to remit funds to, or pay expenses on behalf of, Loss Corp. In all cases, these amounts were recorded on the books of Income Corp. as a loan to the shareholder and recorded on the books of Loss Corp. as a loan from the shareholder. The books of Loss Corp. also recorded interest due to the shareholder for the “loaned” amounts. On his individual income tax return, the shareholder deducted his Loss Corp. losses. He considered the transactions between the two corporations as direct loans between himself—as the common shareholder—and each of the corporations, thereby establishing his basis in these loans under IRC section 1366(d)(1).
The IRS challenged the shareholder’s position and sought to disallow the loss deductions on his return on the grounds that he had not incurred any actual economic outlay due to the direct flow of funds between the two corporations. Presumably, had Income Corp. actually distributed the funds to the shareholder who then contributed or loaned the funds to Loss Corp., the IRS would not have challenged his loss deduction.
The Tax Court disagreed with the IRS assertion that the mere form of a transaction results in a loss disallowance. The court focused on the testimony of the taxpayer, his bookkeeper and outside accountants to corroborate the fact that, for all purposes, these transfers were considered to be on behalf of the shareholder and at no time was there an intention to create an equity or debt interest by Income Corp. in Loss Corp.
Observation: While Culnen is good news for taxpayers and CPAs, it highlights the distinction between the actions of a corporation on its own behalf and those of an agent for the shareholder. To obtain the tax treatment of the former, CPAs should suggest that clients observe the formalities of such an arrangement—that is, recording the amounts consistently as loans, use of promissory notes with interest and, ideally, actual cash transfers to and from the shareholder.
—Vinay Navani, CPA, tax manager,
Wilkin & Guttenplan, PC, East Brunswick, New Jersey.