Eleventh Circuit affirms denial of S corporation shareholder’s losses

Tax Hot Topics newsletter The 11th Circuit Court of Appeals recently affirmed a Tax Court decision in Meruelo v. Commissioner (No. 18-11909) that an S corporation shareholder lacked sufficient basis in stock and debt to claim flow-through losses from the S corporation on his individual income tax return. The court determined certain debt at issue in the case was not bona fide debt between the shareholder and his or her S corporation. Generally a shareholder’s ability to deduct his or her proportionate share of an S corporation’s losses is limited by the sum of basis in S corporation stock and debt, which includes only corporate indebtedness directly between the shareholder and the S corporation.

The taxpayer in Meruelo owned approximately 50% of an S corporation in addition to several other flow through entities. During the life of the S corporation, many of the related entities paid various expenses on behalf of the S corporation, and when these payments occurred the amounts were recorded on the books of the entities as accounts payable and accounts receivable between the two entities. At the end of every tax year, the taxpayer’s accountant would re-characterize the net payables owed by the S corporation to the related entities as shareholder loans to the S corporation. In 2008, the S corporation had significant losses and the shareholder claimed his proportionate share on his tax return. The IRS disallowed the loss claiming that the shareholder lacked sufficient basis. The taxpayer argued that the “back-to-back” loan regulations under Treas. Reg. Sec. 1.1366-2(a)(2) applied to his situation such that the re-characterized loans between the S corporation and the related entities should be viewed as direct loans from the shareholder to the S corporation.
The 11th Circuit rejected the taxpayer’s argument and ruled that the debt at issue was not bona fide debt between the taxpayer and the S corporation. Therefore, the taxpayer did not have sufficient basis in stock and debt to claim the entire amount of his allocated 2008 loss from the S corporation. In its decision, the court held that the taxpayer could not argue “substance over form” and was therefore bound to the actual form of the transactions, which were loans between the S corporation and the affiliated entities. The court then reasoned that the taxpayer’s attempt at an after-the-fact reclassification at the end of the year did not satisfy the requirement that the debt be bona fide indebtedness directly between the S corporation and the shareholder.
Bryan Keith
Managing Director
Washington National Tax Office
T +1 202 861 4116
Jack Stringfield
Senior Associate
Washington National Tax Office
T +1 202 521 1518
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