The U.S. Tax Court held that a shareholder of several S corporations did not receive any basis in indebtedness to the S corporations merely from signing as a co-borrower on loans made directly to the various S corporations.
In Hargis v. Commissioner, T.C. Memo. 2016-232, a husband and wife team ran a business that owned and operated nursing homes. The business was structured so that the real property, facilities and equipment of each nursing home was owned by a limited liability company (LLC), while the day-to-day operations of each nursing home was managed by a corresponding S corporation. The husband was the sole shareholder in the various S corporations and the wife owned significant interests in the LLCs together with certain other individuals.
The business strategy involved taking over distressed nursing homes and turning them into profitable businesses. Due to this model, the older S corporations owned by the husband were profitable, while the newer S corporations tended to run up large losses from the costs of restoring recently acquired nursing homes. These newer S corporations were funded with loans from the LLCs (partially owned by the wife), loans from the more profitable S corporations (wholly owned by the husband), and loans from third party banks. For all of the LLC loans and S corporation loans, and for some of the bank loans, the Tax Court determined that the husband was a co-borrower in his individual capacity.
Several of the newer S corporations generated losses, which were subsequently deducted by the husband on his individual return. The IRS disallowed certain of those deductions on the grounds that the husband did not have sufficient stock or debt basis in the relevant S corporations to support the deduction. Section 1366(d)(1) limits the amount of S corporation losses that can be taken into account by a shareholder to the shareholder’s adjusted basis in the S corporation stock plus the shareholder’s adjusted basis in any indebtedness of the S corporation to the shareholder.
The husband argued signing as a co-borrower on the loans was economically equivalent to the husband’s borrowing the money personally and subsequently loaning the proceeds to the various S corporations. Under this argument, the husband would have increased his debt basis for purposes of Section 1366(d)(1) because of the direct loan to the S corporation. In support of this position, the husband noted that the S corporations were thinly capitalized and that the lenders wanted the petitioner to be liable for repayment in the event that the S corporations defaulted.
The Tax Court sided with the IRS and rejected the husband’s attempt to recast the loans as going from the lender to the husband and then from the husband to the various S corporations. The Tax Court considered the actual form of the loans and applied various “economic outlay” case law. (Note that the facts in the case pre-date the finalized “back-to-back loan” regulations promulgated July 23, 2014 (T.D. 9682).) The Tax Court noted that the husband was never required to personally make any payments on the loans; none of the proceeds of the loans were advanced to the husband individually; none of the notes were collateralized by the husband’s own property; and none of the lenders looked to the husband as the primary obligor on the loans received by the S corporation. Thus, the Tax Court ruled that the husband was unable to claim losses from certain S corporations because he lacked sufficient basis under Section 1366.
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