Larry's Tax Law

Barnes v. Commissioner, 712 F.3d 581 (D.C. Cir. 2013) aff’g T.C.M. 2012-80 (2012) is illustrative of the point that understanding the basis adjustment rules is vital.

If this case was made into a movie, the name of the movie would tell the entire story – S corporation shareholders are not allowed to just make up the basis adjustment rules!  Also, as I have repeatedly stated, poor records lead to disastrous results.  The DC Circuit affirmed the US Tax Court in April of 2013 to finally put an end to the case.

S corporations and their shareholders must keep track of stock and debt basis.  Failure to do so can lead to disastrous results.  Nathel v. Commissioner, 105 AFTR 2d 2010-2699 (2d Cir 2010), illustrates this point.

In Nathel, the government and the taxpayer stipulated to the facts.  Two brothers and a friend formed three separate S corporations to operate food distribution businesses in New York, Florida and California.  All three shareholders made initial capital contributions to the corporations.  The brothers also made loans to two of the corporations.

In 2001, one corporation was liquidated.  In a reorganization of sorts, the friend ended up owning 100% of the second corporation and the two brothers ended up equally owning the third corporation.

In late 2000, before the reorganization, the brothers made loans to the corporations totaling around $1.3 million.  In 2001, they made capital contributions totaling approximately $1.4 million.  Also, in 2001, they received loan repayments combined in excess of $1.6 million.

Immediately before the repayment of the loans, the brothers had zero basis in their stock and only nominal basis in the loans.  Ouch!  To avoid the ordinary income tax hit on the delta between the $1.6 million in loan repayments and their nominal loan basis, the brothers, with the likely help of their handy dandy tax advisor, asserted the $1.4 million in capital contributions was really tax-exempt income to the corporation, excludable under IRC Section 118(a), but which, under IRC Section 1367(b)(2)(B), increased their loan basis.  Therefore, the ordinary income tax hit on the loan repayments was nominal.

Please join me for the NYU 73RD Institute on Federal Taxation.  This year’s Institute will be held in San Diego at the Hotel Del Coronado November 16 – 21, and in New York City at the Grand Hyatt New York October 19 – 24.  Please see the attached brochure.  The coverage of tax topics is both timely and broad.  This year’s presentations will cover topics in the areas of:  executive compensation and employee benefits; partnerships and LLCs; corporate tax; closely held businesses; and trusts and estates.  What is so terrific about the Institute, in addition to a wonderful faculty and the interesting current presentation topics, you can choose the presentations you want to attend.  In other words, you can pick and choose the topics that relate to your tax practice.

This is my second time speaking at the Institute.  My topic this year is: "Developments In The World Of S Corporations."  I plan to deliver a White Paper that will provide attendees with an historic overview of Subchapter S and a look through a crystal ball at the future of Subchapter S, including a review of the recent cases, rulings and legislative proposals impacting Subchapter S.

I hope to see you in either San Diego or New York.

Best,

Larry

Taproot Administrative Services v. Commissioner, 133 TC 202 (2009), 679 F3d 1109 (9th Cir. 2012), is an S corporation shareholder eligibility case.  It was decided by the US Tax Court in 2009 and eventually made its way to the 9th Circuit Court of Appeals, where a decision was rendered in 2012.

Background

Prior to the enactment of the American Jobs Creation Act of 2004, only the following were eligible S corporation shareholders:

• • US citizens and resident individuals;
  • Estates;
  • Tax-exempt 501(c) charities and 401(a) retirement plans; and
  • Certain trusts, including QSSTs, ESBTs and grantor trusts

As a result of the lobbying efforts of family-owned rural banks, as of October 22, 2004 (the effective date of the American Jobs Creation Act), a new eligible shareholder was added to the list, IRAs, including Roth IRAs, provided two criteria are met:

• • The S corporation must be a bank, as defined in Section 581 of the Code; and
  • The shares must have been owned by the IRA on October 22, 2004, the enactment date of the American Jobs Creation Act.

As you might imagine, having an eligible IRA shareholder will be rare. The exception to the S corporation eligibility rules provided by the American Jobs Creation Act is quite narrow.

Montgomery v. Commissioner, T.C. Memo. 2013-151 (June 17, 2013) illustrates what appeared to be the obvious – neither a guaranty of the corporation’s debt by a shareholder nor an unpaid judgment against a shareholder for the S corporation’s debt creates basis.

In Montgomery, the taxpayers, Patrick and Patricia Montgomery, claimed a net operating loss on their 2007 joint return, which they carried back to 2005 and 2006.  In the calculation of their net operating loss, they included:  losses UDI Underground, LLC (“UDI”), incurred in 2007 that were passed through to Patricia Montgomery as a 40% member; and losses Utility Design, Inc., an S corporation (“Utility Design”), incurred in 2007 that were passed through to Patrick and Patricia Montgomery as shareholders.

The IRS challenged the amount of the net operating loss for 2007 on two grounds:

• •  First, the IRS asserted Patricia Montgomery did not materially participate in UDI during 2007.

• •  Second, the IRS asserted portions of the losses from Utility Design were disallowed under Section 1366(d)(1).

• •  The IRS asserted Patricia Montgomery’s share of the 2007 losses from UDI were losses from a passive activity.  Specifically, the IRS argued Patricia Montgomery did not materially participate in UDI.

The Tax Court disagreed, holding Patricia Montgomery did materially participate in UDI.  In 2007, Patricia Montgomery handled all of the office functions, managed payroll, prepared documents, met with members of the company and attended business meetings.  Additionally, she continuously worked on company matters and daily discussed the company's business with Patrick Montgomery.  The court ultimately concluded Patricia Montgomery participated in UDI for more than 500 hours during 2007 and her participation was regular, continuous, and substantial.  Thus, Patricia Montgomery’s UDI activity was a non-passive activity.