Economic outlay revisited.

• Author: Porcaro, Greg

EXECUTIVE SUMMARY

* Under the economic outlay doctrine, to obtain basis in an S corporation with respect to debt, a shareholder must make an actual economic outlay, the outlay must somehow leave the shareholder poorer in a material sense, and the debt created must run directly between the shareholder and the S corporation.

* If an entity related to an S corporation shareholder transfers funds to the S corporation, the transfer may be treated as a loan from the shareholder if the related entity is treated as the "incorporated pocketbook" of the shareholder.

* The IRS will often use a substance-over-form argument in asserting that an economic outlay did not occur in a transaction. Courts will disallow basis increases for circular transactions in which the shareholder ends up in the same financial position that he or she started out in.

* Although courts carefully scrutinize back-to-back loan transactions, a taxpayer will be allowed to increase his or her debt basis for such a transaction if it is properly executed and documented.

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The economic outlay doctrine is a judicially developed concept that acts like a barrier for S corporation shareholders attempting to create debt basis in their S corporations. The barrier is not impenetrable, but it requires analysis and forethought for the shareholders to break through.

Under Sec. 1366(d)(1), the deductibility of subchapter S losses is limited to the shareholder's stock and debt basis. If the corporation's current-year loss exceeds the shareholder's basis, Sec. 1366(d)(2) provides that this loss may be carried forward indefinitely. This carryforward provides some relief from a temporary lack of basis, but planning opportunities and pitfalls exist, particularly when shareholders own stock in multiple passthrough entities with varying degrees of profitability and the shareholders have varying degrees of basis in those entities.

Shareholders can create stock basis by making capital contributions; however, shareholders often prefer to create debt basis. To avoid expending their personal funds in a direct loan to an S corporation, shareholders have tried to create debt basis in a number of other ways, including: (11 guaranteeing the S corporation's note, (2) obtaining a loan from an unrelated or a related party and lending the loan proceeds to the S corporation (back-to-back loan), and (3) substituting a shareholder's personal note for the corporation's note to an unrelated third party. The IRS and the courts have used the economic outlay doctrine to analyze whether shareholders of S corporations actually create debt basis. Briefly stated, that requires an actual cash investment by the shareholder. This article specifically focuses on how to create debt basis and how to structure debt so that it meets the economic outlay doctrine.

Note: The IRS has put a back-to-back loan project on its current business plan.

It is important to note that the economic outlay concept does not appear to apply to the creation of stock basis. Therefore, in many of the economic outlay cases, legal issues aside, if the S corporation had issued stock instead of debt, the taxpayer would have been successful in creating basis. In situations involving a single S corporation, the fact that personally guaranteed third-party debt does not establish debt basis usually complicates the question of the existence of debt basis. Since it has long been established that guarantees do not create basis, this article does not cover those cases. (1) However, it does discuss the various ways shareholders have tried to establish debt basis through back-to-back loans or loan restructurings where a shareholder replaces the shareholder's note for the corporation's note. Multiple-entity environments provide the opportunity to engage in complex inter-entity transactions in an attempt to increase basis in a loss-generating S corporation, k is these scenarios that make up the factual backdrop for the economic outlay cases and rulings covered here.

Economic Outlay: Background

The Tax Court first developed the economic outlay doctrine in Perry, (2) where an S corporation shareholder attempted to create basis through the issuance of notes between him and the corporation. In Perry, the shareholder issued a demand note to the S corporation in exchange for a long-term note of the same amount. The court concluded that these transactions amounted to little more than the posting of offsetting book entries. The court interpreted the economic outlay doctrine to require the shareholder to make an actual cash investment in the corporation. Since the court found no outlay of cash, the shareholder had no basis in the note.

Likewise, in Underwood, (3) the Tax Court concluded (and the Fifth Circuit affirmed) that no basis is created when a shareholder exchanges demand notes with his or her wholly owned corporations. The court considered the lack of an actual advance of funds by the shareholder and questioned the shareholder's intent to demand repayment. One shareholder controlled both entities; perhaps the result would have been different had the shareholder not been in control. A shareholder can create debt basis by borrowing money personally from an unrelated third party, which is then loaned to the corporation to pay off an existing corporate debt, provided the corporation is thereby released from liability (a back-to-back loan). (4)

Three factors should be considered when using the debt-substitution method of creating basis:

* The shareholder and the corporation should abide by the form of the transaction they have chosen--the corporation should not continue to make payments to the third-party lender;

* The corporation and the shareholder should execute a note; and

* If corporate assets must be used as security for the substituted loan, the corporation should pledge its assets to the shareholder, who then reassigns the security interest to the third-party lender.

Interpretation of Statute

Courts derived the economic outlay concept in part due to a narrow interpretation of Sec. 1366(d)(1)(B), which refers to debt basis as "the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder" (emphasis added). Courts have interpreted this phrase to mean that the debt must run directly from the shareholder to the S corporation. On the surface this means that debt basis is not attributed to a shareholder when the S corporation receives a loan from a controlled entity. However, with the exception of a situation like that in the Culnen case, (5) the direct indebtedness requirement will render many attempts to restructure a shareholder's debt basis among related entities futile.

Culnen is an anomaly because the court found that payments made by a 100% owned S corporation to a second S corporation on the shareholder's behalf constituted direct debt from the shareholder to the second S corporation. The conclusion in Culnen may be different because the parties always accounted for the payments as loans from the first S corporation to the shareholder and loans from the shareholder to the second S corporation...