The rules for obtaining basis for S corporation loans are often best viewed as emphasizing form over substance. The fact that a shareholder might be economically “on the hook” for ultimate repayment of the debt will not generally impact whether that person will be able to claim the debt as basis. The shareholders of an S corporation ran into this issue in the case Messina et ux. et al. v. Commissioner, TC Memo 2017-213.

In this situation, the controlling shareholders of an S corporation formed another S corporation that loaned funds to a qualified S corporation subsidiary (QSUB) of the first S corporation. The shareholders then attempted to claim losses from the first S corporation by use those loans as additional basis in the corporation—a position the IRS and, ultimately, the Tax Court disagreed with.

The second S corporation was formed on the advice of the taxpayers’ counsel in order to work around a problem. The loan was to be used to refinance third party debt to the QSUB. However, by terms of the agreement with other creditors (who had sold the business to the S corporation originally), any amounts borrowed from the shareholders of the S corporation had to be subordinated to the original owner’s debts. The attorney advised the taxpayers by using a new S corporation, no subordination of the new debt would be required.

The taxpayers first argued that the debt should be allowed because the new S corporation represented an “incorporated pocketbook” of the controlling shareholders, basing their position on prior caselaw. As the opinion summarizes the taxpayers’ position:

Petitioners rely on a theory distilled from caselaw as summarized in Broz v. Commissioner, 137 T.C. at 62, that direct payments from a related entity to the taxpayer's S corporation constitute payments on the taxpayer's behalf where the taxpayer used the related entity as an “incorporated pocketbook.” See Yates v. Commissioner, T.C. Memo. 2001-280; Culnen v. Commissioner, T.C. Memo. 2000-139, rev'd on other grounds, 28 F. App'x 116 (3d Cir. 2002). This Court has held that the term “incorporated pocketbook” refers to the taxpayer's habitual practice of having his wholly owned corporation pay money to third parties on his behalf and that whether an entity is an incorporated pocketbook is a question of fact. See Broz v. Commissioner, 137 T.C. at 62 (citing Ruckriegel v. Commissioner, T.C. Memo. 2006-78).

But the Court found that, unlike the cases they relied upon, the taxpayers in this case hadn’t regularly used the new corporation to pay payments on behalf of the taxpayers.

The “incorporated pocketbook” rationale is inapposite here. In both of the cases petitioners cite — Culnen and Yates — the taxpayers sought to regularly direct funds from one of their entities through themselves and on to an S corporation. Here, petitioners concede that Messrs. Messina and Kirkland did not use KMGI habitually to pay Casino's or their personal expenses. Instead, they argue that this is not a requirement but only evidence of indebtedness running directly to the shareholder. To the extent we [*33] would agree with that statement, the fact that KMGI did not make payments habitually does not help petitioners' case. To the contrary, it would be evidence against a finding that indebtedness runs from Club One and Casino directly to Messrs. Messina and Kirkland. At any rate, we disagree with petitioners' interpretation of Culnen and Yates. Frequent and habitual payments are key to a finding that a corporation served as an incorporated pocketbook. KMGI did not make frequent and habitual payments on behalf of its shareholders. Accordingly, we find that it did not function as Messrs. Messina and Kirkland's incorporated pocketbook.

The taxpayers next argued that the new S corporation should be treated as merely acting as an agent for the taxpayers.

Petitioners emphasize that Messrs. Messina and Kirkland contributed to KMGI, which had no assets or other business activity besides the loan acquisition, all the funds necessary to purchase the D.B. Zwirn loan and that KMGI served effectively as a conduit for payments from Casino. Petitioners also contend that Messrs. Messina and Kirkland advised the parties involved in the loan acquisition that [*35] KMGI was purchasing the loan on behalf of Messrs. Messina and Kirkland and that doing so allowed the CGCC to grant its approval to the transaction more quickly than if the two owners had applied to CGCC in their individual capacities. Petitioners thus would have us hold that KMGI acted as agent for Messrs. Messina and Kirkland in purchasing the D.B. Zwirn loan from the Fortress Fund.

The Tax Court did not accept this view either. Looking at the nine factors outlined by the Supreme Court for an agency relationship in the cases of Nat'l Carbide Corp. v. Commissioner, 336 U.S. 422, 437 (1949) and Commissioner v. Bollinger, 485 U.S. at 349-350 (1988), finding that only one of those factors resolves in favor of an agency relationship, while the others suggest the opposite result. Ultimately the Court holds:

The weight of the factors instead shows KMGI to be a distinct corporate entity. Accordingly, we find that KMGI was not Messrs. Messina and Kirkland's agent, nor was it a conduit.

The taxpayers next tried to argue that the actual economic outlay was by the taxpayers and not the new S corporation, but the Court rejected that as well:

Petitioners, by their argument about actual economic outlay, essentially rehash the conclusion of their other two theories that KMGI was nothing more than a conduit or incorporated pocketbook that ought to be disregarded. We have already disposed of those theories. KMGI was a corporation with its own separate existence. Likewise it was not simply a shell corporation but a distinct entity with at least one substantial asset, the D.B. Zwirn loan, and a significant business purpose. Cf. Ashdown v. Commissioner, T.C. Memo. 1989-40, 56 T.C.M. (CCH) 1160, 1161 n.5 (1989) (“Neither party defined the term shell corporation although each of [*44] them used it. We assume it means a corporation which has no assets or has assets of very little value although it appears to be prosperous and successful on paper.”). And the reclassification, from shareholder loans to additional paid-in capital, of Mr. Messina's and Mr. Kirkland's contributions of funds to KMGI in its books and records is further evidence as to the transaction's substance. Mr. Messina's and Mr. Kirkland's capital contributions, combined with KMGI's other indicia of actual corporate existence, are compelling evidence of economic outlay.

Finally, the taxpayers tried to argue the Court should use a step transaction theory to collapse the transactions into a loan from the taxpayers to the original S corporation—but the Court declined to do so.

Under the step transaction doctrine “interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction.” Commissioner v. Clark, 489 U.S. 726, 738 (1989). The acquisition of the D.B. Zwirn loan consisted of only two steps: Mr. Messina's and Mr. Kirkland's transfers of funds to KMGI and the latter's purchase of the loan from the Fortress Fund. KMGI did not go on to resell the loan to Messrs. Messina and Kirkland or any other entity. Therefore, there was no step the consolidation of which with the other steps would allow the D.B. Zwirn loan to be treated as running directly from Messrs. Messina and Kirkland to Club One and Casino. Accordingly, we find that petitioners may not invoke the step transaction doctrine to hold that Messrs. Messina and Kirkland and not KMGI became the holders of the D.B. Zwirn after its acquisition from the Fortress Fund.