S corp. shareholder basis for circular or certain back-to-back loans.

• Author: Klahsen, Rick

Practitioners routinely face the challenge of helping S corporation shareholders increase their basis for purposes of deducting passthrough losses under Sec. 1366(d) (1). Often, planning to increase basis will result in shareholders making loans to the S corporation at year end. With regard to shareholder loans to S corporations facilitated by borrowings from a related entity, back-to-back, and circular loans, three Tax Court decisions, including one in 2009, continue the court-imposed requirement that shareholders make an "economic outlay" to acquire basis and demonstrate why practitioners need to exercise care in the construction of shareholder loans to S corporations to provide the best opportunity for increasing basis for deduction of losses.

Back-to-Back Loans

In Ruckriegel, T.C. Memo. 2006-78, two 50% shareholders in an S corporation that incurred losses were also 50% partners in a partnership. Upon the advice of the businesses' outside CPA, the partnership advanced funds directly and indirectly, through the S corporation. Certain of the direct loans were recorded through year-end adjusting journal entries as shareholder loans. Shareholder loans were evidenced by promissory notes, although the shareholders had no clear recollection of when the notes were executed, and were documented in the S corporation's board of directors' meeting minutes.

The Tax Court looked at several factors in ruling that the S corporation's shareholders acquired no basis in the partnership's payments directly to the S corporation but did acquire basis in the back-to-back loans the partnership made to the S corporation's shareholders that were then loaned by the shareholders to the S corporation.

With regard to the taxpayers' arguments that the direct payments from the partnership to the S corporation were essentially back-to-back loans through the S corporation's shareholders, the court considered the limited history of the partnership's directly paying expenses on behalf of its partners. The court also considered the advice of the outside CPA to the S corporation's shareholders who, following a disallowance of basis in shareholder loans in a previous IRS examination, believed he had structured the subsequent partnership advances to the S corporation in a manner intended to constitute bona fide back-to-back loans, as evidenced by the promissory notes, corporate minutes, and accounting for the partnership advances. It was apparent that the promissory notes...