Federal Income Taxation

• Publication year: 2020

Federal Income Taxation

Nikolai Karetnyi

Ruoxi Zhang

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Federal Income Taxation

by Nikolai Karetnyi^* and Ruoxi Zhang^**

In the year 2019, the federal courts within the Eleventh Circuit handed down several notable opinions on federal tax issues.¹ This Article surveys two of those opinions involving the taxation of shareholder loans to S corporations and the application of gross valuation-misstatement penalty to partnerships.

I. Meruelo v. Commissioner

The S corporation regime, instituted by Subchapter S of Chapter 1 of the Internal Revenue Code (the Code),² allows certain electing "small business corporations" to pass corporate income, losses, deductions, and credits through to their shareholders for federal income tax purposes.³ This permits qualifying S corporations to fuse the advantages of the legal treatment afforded to corporations under state law with the benefits of partnership flow-through taxation. A particular advantage is that an S corporation shareholder may deduct its pro rata share of the S corporation's losses.⁴ As with partnerships, this flow-through treatment also necessitates close scrutiny of dealings between S corporations and their shareholders to prevent potential abuses of the S corporation

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regime's benefits. Such safeguard limits a shareholder's ability to deduct the S corporation's losses to the extent of its adjusted basis in the stock of the S corporation and the adjusted basis of any indebtedness of the S corporation owed to such shareholder.⁵ This safeguard is further strengthened by Treasury Regulations section 1.366-2(a)(2) (as amended in 2014) specifying that only "bona fide indebtedness of the S corporation that runs directly to the shareholder" can give rise to such basis.⁶ In Meruelo v. Commissioner,⁷ the United States Court of Appeals for the Eleventh Circuit tackled these rules and examined whether a complex web of transfers between an S corporation, its shareholder, and several other affiliated S corporations resulted in bona fide indebtedness that ran directly to the shareholder, ultimately affirming the Tax Court's decision to partly disallow the shareholder's claimed deductions stemming from these loans.⁸

Homero Meruelo (Meruelo), a Florida real estate developer, conducted his business through a bevy of S corporations, partnerships, and limited liability companies. One of these entities was Merco of Palm Beaches, Inc. (Merco), an S corporation incorporated in 2004 in which Meruelo held 49% of the stock. Merco was initially formed to purchase a South Florida condominium complex in a bankruptcy sale. The bankruptcy court approved the sale and required Merco to pay a $10 million non-refundable deposit to secure the property.⁹ Meruelo financed his share of the deposit by obtaining a personal loan. Meruelo then transferred $4,985,035 of the loan proceeds to Merco Group at Akoya, Inc. (Akoya), an S corporation where each of Meruelo and his mother owned 50% of the stock. Akoya then transferred $5 million into Merco's escrow account, of which $4,985,035 constituted proceeds from Meruelo's personal loan and $14,965 constituted Akoya's own funds. The remaining $5 million of the $10 million deposit was previously transferred by Akoya to Merco.¹⁰

Subsequently, from 2004 to 2008, Merco entered into numerous transactions with affiliated entities (such as partnerships and other S corporations) in which Meruelo held an equity interest. Aiming to simplify accounting practices and enhance liquidity, these affiliated entities often paid expenses on behalf of each other or Merco. Typically, these payments were recorded by the payor entity as accounts

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receivable, whereas the payee entity recorded them as accounts payable. During this time, affiliated entities paid more than $15 million on behalf of Merco, with Merco repaying its affiliates less than $6 million. On its tax returns, Merco netted its accounts receivable and payable from its affiliates. If Merco had net accounts payable, then this amount was reported as a "shareholder loan" on its tax return, and a percentage of this indebtedness was subsequently allocated to Meruelo based on his interest in the affiliated entities that had transferred funds to Merco.¹¹

In connection with the purchase of the condominium complex in 2004, Meruelo granted to Merco a promissory note making available a $10 million unsecured line of credit at a 6% interest rate. Merco's tax returns from 2004 to 2008 included an annual charge to this line of credit equal to Meruelo's calculated share of Merco's net accounts payable to its affiliates for the preceding taxable year.¹²

In 2008, banks foreclosed on the condominium complex causing Merco to incur a loss of $26,605,840. Meruelo was allocated 49% of this loss ($13,036,861), which he took as an ordinary deduction on his 2008 tax return. Meruelo reported a net operating loss of $11,793,865 (accounting for other income and deductions) on his 2008 tax return. In 2009, Meruelo was granted a refund to carry back these net operating losses to 2005, thereby reducing his tax liability for 2005 by $3,897,470.¹³

In examining Meruelo's tax returns from 2005 through 2008, the Internal Revenue Service (IRS) disallowed $8,051,826 of the carried back net operating losses for lack of sufficient basis and sent Meruelo a notice of deficiency for 2005. The IRS limited Meruelo's basis in the Merco stock to the $4,985,035 of the proceeds of the bank loan contributed by Meruelo through Akoya.¹⁴

In response, Meruelo petitioned the Tax Court for redetermination of the IRS's alleged tax deficiency. Meruelo argued that he possessed sufficient basis in Merco stock to fully deduct his share of Merco's losses. In Meruelo's view, his basis in Merco stock consisted of (1) $2.7 million of the first $5 million Akoya deposit; (2) the entirety of Akoya's second $5 million deposit; and (3) his $6,616,857 share of the intercompany transfers. Meruelo's argument was predicated upon two theories, each purportedly establishing that the transfers from the

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affiliated entities to Merco were shareholder loans from Meruelo to Merco.¹⁵

Under the first "back-to-back loan" theory, Meruelo argued that the affiliated companies should have been treated as lending him funds that he then lent back to Merco.¹⁶ Based on an example in the Treasury Regulations, where both of the back-to-back loans constitute bona fide indebtedness that run directly to the applicable creditor, the debt from the first shareholder creditor to the ultimate S corporation debtor would constitute a shareholder loan (effectively disregarding the intermediate debtor/creditor S corporation).¹⁷

Under the second "incorporated pocketbook theory," Meruelo contended that because the affiliated companies were a mere conduit for paying Merco's expenses on his behalf, Meruelo should be treated as directly making these payments to Merco.¹⁸ This theory concludes that a "taxpayer can obtain debt basis in an S corporation through payments made by a wholly owned corporate entity if that entity functions as the shareholder's 'incorporate pocketbook,' meaning that the taxpayer has a 'habitual practice of having his wholly owned corporation pay money to third parties on his behalf.'"¹⁹

The Tax Court dismissed both of Meruelo's arguments and ruled for the IRS, determining that Meruelo was not entitled to any of the $8,051,826 of the disputed basis in Merco stock.²⁰ In reaching this conclusion, the Tax Court reiterated that a shareholder may increase his basis in S corporation stock by the amount of the adjusted basis of any indebtedness owed by the S corporation to the shareholder.²¹ After assessing earlier decisions and legislative history, the Tax Court further asserted that in order to increase basis, the loan requires an "actual economic outlay" by the shareholder. That is, the shareholder must demonstrate that "he incurred a cost in making a loan or that he was left poorer in a material sense after the transaction."²² The Tax Court interpreted Treasury Regulations section 1.1366-2(a)(2)²³

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(amended in 2014 to limit debt basis to "bona fide indebtedness of the S corporation that runs directly to the shareholder") as essentially codifying the "actual economic outlay" doctrine and requiring a shareholder to prove that an S corporation's indebtedness ran directly to him in order to deduct his proportionate share of the S corporation's net operating loss. This sweeping interpretation has proven to be controversial as the preamble to the final Treasury Regulations promulgating Treasury Regulations section 1.1366-2(a)(2) instructed that the new "bona fide" standard was meant to provide a new test for courts "[i]nstead of applying the actual economic outlay standard."²⁴

The Tax Court first rejected Meruelo's back-to-back loan theory on formalistic grounds, finding that there was no evidence that the funds were first lent to Meruelo and then lent back to Merco.²⁵ Bona fide back-to-back loans (from an affiliated company to a shareholder and then from the shareholder to an S corporations) can increase a shareholder's basis in S corporation stock. However, the Tax Court also noted that shareholders are bound by the form of the loan transactions initially chosen and cannot simply reclassify transactions directly between affiliated companies (especially when such transactions do not involve the shareholder) as back-to-back loans for tax purposes. As a result, because the Merco affiliates did not initially treat the transactions amongst themselves as shareholder loans, the Tax Court reasoned that such treatment would be inappropriate in this instance. Rather, these transactions were initially labelled as accounts receivable and payable, wage payments, or capital contributions, and then subsequently re-labelled as shareholder loans on Meruelo's tax returns.²⁶ The Tax Court also incorporated the actual economic outlay doctrine into its analysis because...