Back-to-back loans may not create basis.

• Author: Grush, Gary

Taxpayers who control more than one S corporation should be aware of the Service's position on back-to-back loans. S shareholders are allowed to deduct losses to the extent of their basis. For purposes of determining basis, shareholders can normally include loans made to their S corporation. However, in Letter Ruling (TAM) 9403003, the IRS National Office ruled that advances made by a shareholder to his wholly owned S corporation did not create basis. As a result, the shareholder was prevented from deducting losses related to his S corporation.

The facts presented are fairly typical of transactions made between shareholders and their wholly owned or controlled corporations. A corporation wholly owned or controlled by the taxpayer will make a loan to an S corporation also wholly owned or controlled by the taxpayer. The S corporation will incur a loss during the year. At the end of the year, the shareholders will restructure the loans between the corporations so that the debt runs from the S corporation to the shareholders.

In the TAM, the taxpayer owned 100% of the stock of an S corporation (S3) and was a majority stockholder in two other S corporations (S1 and S2). In May 1990, S2 borrowed directly from a bank. S2 then loaned those funds to S3, along with additional advances during the tax year. There were no promissory notes issued between S2 and S3.

Following what appeared to be prudent advice, the taxpayer had S3 repay all of its debt owed to S2. The funds were deposited in S2's bank account. S2 then transferred the funds into the taxpayer's bank account. The taxpayer, in turn, transferred the funds into S3's bank account. Promissory notes were issued for the transactions between S2 and the taxpayer and between the taxpayer and S3. At the end of the restructuring, the loans ran from S3 (a wholly owned corporation) to the taxpayer and from the taxpayer to S2 (a controlled corporation).

The IRS concluded that the taxpayer's loan made to his wholly owned corporation did not create debt under Sec. 1366(d). In order for the loan to qualify as debt, an actual economic outlay by the shareholder was required, one that found the shareholder poorer in a material sense after the transaction than when the transaction began (Underwood, 63 TC 468 (1975), aff'd, 535 F2d 309 (5th Cir. 1976)).

In Underwood, the taxpayer owned all the stock of corporations L and A. Over the years, L had advanced substantial funds to A. When it appeared that the taxpayer...