The Ninth Circuit Court of Appeals affirmed the Tax Court’s 2017 decision in the case of Messina et ux. et al. v. Commissioner.[1] The appellate decision explains why the IRS is allowed to argue substance over form for a transaction, but that argument will not generally be helpful for the taxpayer—as it failed to be in this case.

In 2017 we had previously written about this case when the Tax Court decision came down.[2]  In that article we summarized the facts of the case as follows:

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 using 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.[3]

As we noted at the time, the Tax Court found that such debt from a related party did not give the shareholders basis—they couldn’t ignore the existence of the lending corporation and treat the debt as coming directly from the shareholders.

The taxpayers appealed this decision, and the Ninth Circuit has rendered its decision, agreeing with the Tax Court that the taxpayers could not ignore the corporation that they had voluntarily formed to hold the loans.

The taxpayers argued that the substance of the transaction was a loan from them to the S corporation from which they wished to claim a loss, and that the court should respect this substance.  But the Ninth Circuit rejects the idea that a taxpayer can argue substance over form when the form of the transaction is created by the taxpayer:

We have not held that the “substance over form” doctrine is available to a taxpayer as well as the government. Indeed, we have previously rejected the notion that the taxpayer can “escape the tax consequences of a business arrangement which he made upon the asserted ground that the arrangement was fictional.” Maletis v. United States, 200 F.2d 97, 98 (9th Cir. 1952) (quoting Love v. United States, 96 F. Supp. 919, 921 (Ct. Cl. 1951)).[4]

The government is allowed to argue substance over form for the simple reason that the government was not involved in deciding the form of the transaction.  The taxpayer, on the other hand, was free to choose whatever form he/she wished and, in this case, the taxpayers did not choose to structure this as a loan directly from the taxpayers to the S corporation.

But even when the form over substance doctrine is available to a party, the party still needs to show that the form does not correspond to the substance of the arrangement—and the panel notes that that was not the case here.  The panel continues:

As the Tax Court properly held, the form of the loan acquisition in this case “corresponds to its substance” and should therefore “be respected for Federal tax purposes as it was implemented.” Messina v. Comm’r, T.C. Memo. 2017-213, 2017 WL 4973291, at *16 (2017).

KMGI’s purchase of the third-party loan directly, rather than through Kirkland and Messina, was motivated by a number of non-tax business and regulatory considerations. In all circumstances except their tax returns, Taxpayers treated KMGI as an independent entity that was to acquire the third-party loan and serve as Club One’s creditor. They reaped several benefits from doing so, including avoidance of a foreclosure on the casino that they co-own through Club One and a call on the personal guaranties that they signed in connection with the third-party loan. In addition, KMGI served business functions, including: being able to apply for the Gambling Commission’s permission to acquire the loan; purchasing the loan from the third party potentially to maintain the loan’s seniority to Club One’s other obligations; receiving loan payments from Club One; and returning capital contributions to Kirkland and Messina. Thus, even if the “substance over form” doctrine were available to Taxpayers, it does not alter the outcome here[5]

Since debts have to come directly from the shareholders to the corporation to be basis for loss deductions to the shareholders, these debts fail to qualify to create basis.  Thus, the Tax Court correctly denied the taxpayers the losses they claimed that depended on this debt basis.

[1] Messina et ux. et al. v. Commissioner, Case No. 18-70186, CA9, 12/27/2019, http://cdn.ca9.uscourts.gov/datastore/memoranda/2019/12/27/18-70186.pdf

[2] Ed Zollars, “Loans from Related Corporations Did Not Give Shareholders Basis for Losses,” Current Federal Tax Developments, October 31, 2017, https://www.currentfederaltaxdevelopments.com/blog/2017/10/31/loans-from-related-corporations-did-not-shareholders-basis-for-losses

[3] Ed Zollars, “Loans from Related Corporations Did Not Give Shareholders Basis for Losses,” Current Federal Tax Developments, October 31, 2017, https://www.currentfederaltaxdevelopments.com/blog/2017/10/31/loans-from-related-corporations-did-not-shareholders-basis-for-losses

[4] Messina et ux. et al. v. Commissioner, p. 3

[5] Messina et ux. et al. v. Commissioner, pp. 3-4