Intercompany Loan Treated As Constructive Distribution and Contribution
Heads I Win, . . .
When closely held corporations that are under common control engage in any intercompany transaction, it is prudent for the corporations and their shareholders to ensure that the transaction is being undertaken for a bona fide business reason. It is also important that the form of the transaction, and the parties’ intent for engaging in such transaction, as manifested by its form or structure, be consistent with the income tax consequences arising therefrom as reported by each of the parties.
As a general rule, a taxpayer is bound by the form of their transaction, which makes sense because the taxpayer planned the transaction – they had the opportunity to consider its business purpose, the structure by which it would be effectuated, and the resulting tax consequences.
The IRS, however, may challenge the form chosen by the taxpayer to determine its underlying economic substance, especially where the taxpayer is transacting with a related party. In that case, the IRS may recharacterize the transaction for tax purposes to reflect its economic reality; for example, what purported to be a loan of funds from one corporation to another, commonly owned corporation may be disregarded by the IRS for tax purposes and instead be treated as a distribution of those funds from the “lending” corporation to its shareholders.
. . . But Not Always
Notwithstanding this general rule, a recently issued opinion of the U.S. Tax Court described a taxpayer who convinced the Court that the form chosen by the taxpayer for a transaction between their two wholly owned corporations was not consistent with its true nature.
Individual Taxpayer was the sole shareholder of two S corporations, Corp A and Corp B, which were engaged in separate but related businesses that they conducted business operations in a highly integrated manner. The two corporations shared the same principal place of business (a facility owned by Taxpayer, for which both corporations paid rent). They used the same maintenance, payroll, corporate officers, and accountant. Taxpayer was the president and treasurer of both corporations, and received officer compensation from each corporation.
At some point, Corp B ceased to be profitable (for a variety of reasons) and required substantial financial support to meet its obligations.
The “Loan”
At that time, Corp A began providing financial support to Corp B to allow it to continue operating. Taxpayer and his Vice President would meet each month to review the financial positions of the two corporations to determine whether Corp B required additional funds from Corp A to meet its obligations.
If Corp B was unable to meet its obligations for that month, Taxpayer would instruct Corp A to transfer funds via check or bank-to-bank transfers directly to Corp B (the “Transfers”). Corp A did not distribute cash to Taxpayer, nor did Taxpayer contribute cash to Corp B. Corp B used the Transfers to pay general business operating costs. During this period, Corp A, on behalf of Corp B, also made payments directly to Corp B’s vendors for certain expenses such as wages, payroll taxes, workers’ compensation insurance, and employee benefits (the “Payments”).
By the end of the taxable year in question (the “Tax Year”), the net total of the Transfers and the Payments exceeded $36 million. This figure reflected Corp B’s repayment of a portion of the Payments back to Corp A; Corp B had not made any transfers back to Corp A of any portion of the Transfers. (However, within seven years after the Tax Year, Corp B had transferred back to Corp A the total amount of the Transfers and the Payments.)
Despite the Transfers and the Payments by Corp A of some $36 million, Corp B did not provide any promissory notes regarding the Transfers and the Payments and did not have any written due dates for a return of the money. No security interest was requested by Corp A or granted by Corp B. Furthermore, Corp B did not make, nor promise to make, interest payments related to the Transfers and the Payments.
On the Books
Corp B initially accounted for each of the Transfers from Corp A as a “Loan Payable” in its general ledger liability, and then as “Due to Corp A” in another general ledger liability account. Thus, Corp B documented the Transfers and the Payments internally as liabilities between Corp B and Corp A.
Similarly, Corp A initially accounted for the expenses it paid on Corp B’s behalf as “Due from Corp B”; it then documented the Transfers and the Payments as liabilities between Corp A and Corp B.
Corp B intended to repay Corp A for the Transfers and the Payments if it was profitable.
On the Tax Returns
Corp B reported the Transfers and the Payments as a balance due to Corp A on its tax returns and characterized them as debts. Corp B did not report the Transfers and the Payments as additional capital contributions from Taxpayer.
Similarly, Corp A reported the Transfers and the Payments as a liability due from Corp B on its tax returns; it characterized these transactions as indebtedness.
Taxpayer did not report distributions from Corp A to Taxpayer on their tax returns and Corp A did report distributions and repayment of shareholder loans on Taxpayer’s Schedules K–1, Shareholder’s Share of Income, Deductions, Credits, etc.
On its tax return for the Tax Year, Corp B reported an ordinary loss, for which Taxpayer claimed a flowthrough loss deduction on their individual return for such year.
Post-Sale
A couple of years after the Tax Year, Corp A and Corp B received about $70 million cash in exchange for the sale of most of their assets. Over the next few years, Corp A distributed its share of the net sale proceeds to Taxpayer.
Following the distribution of the sale proceeds to Taxpayer, Corp A had insufficient assets to make any further distributions to Taxpayer. Still, the corporation reported “distributions” on its tax returns for subsequent tax years. According to the accountant for the corporations, the loans from Corp A to Corp B were written down on the former’s books and this reduction in Corp A’s assets was reported on its federal tax return as a “distribution,” though no such distribution actually occurred because Corp A lacked sufficient cash and assets after the distribution of the sale proceeds to make the distribution alleged to have occurred. The accountant explained that these adjustments were merely accounting entries intended to balance Corp A’s balance sheet by offsetting the amounts owing from Corp B to Corp A.
Also during the post-distribution period, Taxpayer reported losses from Corp A.
The Issue is Joined
Following its examination of Taxpayer’s income tax return for the Tax Year, the IRS determined that the flowthrough loss from Corp B to Taxpayer was much lower than was reported. The IRS also disallowed much of the flowthrough loss because, according to the IRS, Taxpayer did not have sufficient stock basis.
Consequently, the IRS issued Taxpayer a notice of deficiency determining a deficiency in income tax, and Taxpayer petitioned the Tax Court to set aside the IRS’s determination.
Taxpayer’s Position
Notwithstanding that Corp A reported the Transfers and Payments on its books and tax returns as debt owing from Corp B, Taxpayer asked the Court to find that the Transfers and the Payments were equity, not debt. Taxpayer contended that the Transfers and the Payments were constructive distributions from Corp A to Taxpayer and constructive contributions by Taxpayer to Corp B. Therefore, Taxpayers argued that Taxpayer had sufficient stock basis to allow Taxpayer to claim the flowthrough losses from Corp B on their tax return for the Tax Year.
IRS’s Position
The IRS argued that Taxpayer had insufficient stock basis to claim the disallowed flowthrough loss.
The IRS further argued that because Taxpayer had consistently characterized the Transfers and the Payments between Corp A and Corp B as debt between the two S corporations, they were prohibited from recharacterizing them as equity contributions.
The IRS averred that permitting Taxpayer to recharacterize the debt as equity would result in prohibited flowthrough losses for Taxpayer. Furthermore, the IRS noted that Taxpayer had the prior opportunity to characterize the Transfers and the Payments as equity when filing their tax returns and preparing their financial documentation, but elected to treat the Transfers and the Payments as loans.
Tax Court’s Analysis
The issues before the Court were whether the Transfers and Payments from Corp A to Corp B were bona fide debt or equity, and whether Taxpayer had adequate basis to claim the disallowed flowthrough losses from Corp B.
According to the Court, the substance of a transaction, not its form, “controls the characterization of a taxable transaction.” Likewise, the determination as to whether a particular interest is characterized as debt or equity is generally made with reference to various factors that indicate the economic substance of a transaction. The fact a transaction involves related parties, the Court explained, does not necessarily indicate a lack economic substance, though such situations are subject to close scrutiny.
Whether an advance of funds is treated as genuine debt, the Court stated, “must be considered in the context of the overall transaction.” The determinative question, applying the relevant caselaw factors, the Court continued, is whether the taxpayer intended to create a debt with a reasonable expectation of repayment, and if so, whether that intent comports in substance with the creation of the debtor-creditor relationship. “The outward form of the transaction is not controlling,” the Court stated; “rather, characterization depends on the taxpayer’s actual intent, as evidenced by the circumstances and conditions of the advance.”
The Court then considered various factors that have identified as relevant in determining whether a transfer to a corporation by a shareholder was debt or a contribution of capital. No one factor is controlling or decisive, the Court stated, and all the “particular circumstances of each case” have to be examined. “The object of the inquiry is not to count factors, but to evaluate them.”
The Court identified the following factors as potentially relevant to the debt-vs-equity inquiry, then proceeded to consider each one:
(1) the names given to the certificates evidencing the debt;
(2) the presence or absence of a fixed maturity date;
(3) the source of the payments;
(4) the right to enforce payments of principal and interest;
(5) whether the advances increase participation in management;
(6) whether the “lender” has a status equal or inferior to that of regular creditors;
(7) objective indicators of the parties’ intent;
(8) whether the capital structure of the “borrower” is thin or adequate;
(9) the extent to which the funds advanced are proportional to the shareholder’s capital interest;
(10) the extent to which interest payments come from “dividend” money; and
(11) the ability of the “borrower” to obtain loans from outside lending institutions.
Names Given to the Certificates Evidencing the Indebtedness
The issuance of a debt instrument such as a promissory note indicates debt, and the issuance of an equity instrument such as a stock certificate indicates an equity contribution. If the document at issue includes wording typically contained in a promissory note and does not include wording typically contained in a stock certificate, then this factor will weigh in favor of a finding that the transaction at issue was debt rather than equity. This factor does not squarely fit in the context of an S corporation since there is generally no issuance of stock for capital; rather, capital is accounted for internally when contributed (or retained) by the shareholders as basis.
The Court found this factor was neutral because there was no creation of a formal debt instrument indicating indebtedness; nor was there recognition of a capital contribution by Corp B.
The Presence or Absence of a Maturity Date
A fixed maturity date is evidence that a debt exists because it requires fulfillment of the financial obligation at a specific time. The lack of a fixed maturity date indicates that payment is linked to the success of the business and is evidence of an equity interest. Similarly, an advance made with a fixed maturity date that has been postponed for a prolonged period suggests that “the nominal lender does not intend to require repayment and that the transfers are equity.” Here, Corp B intended to make repayments to Taxpayer if Corp B was profitable; therefore, this factor weighed in favor of equity as the record showed that repayments were dependent on the success of Corp B and not due at any fixed time.
The Source of Payments
Payments that depend on earnings or come from a restricted source indicate an equity interest. A true lender is concerned with a reliable return on its investment in the form of interest and repayment of principal. If timely payments to the alleged lender are not made, or if they can plausibly be made only out of future earnings, an inference arises that the advances were contributions to capital. When repayment is not dependent upon earnings, the interest is more likely to be characterized as a loan. Because of its relatively poor financial condition, the repayment of the Transfers and the Payments by Corp B was conditioned on the future profitability of Corp B. This factor weighed in favor of equity.
The Right to Enforce the Payment of Principal and Interest
The right to enforce payment of principal and interest is evidence of debt. A lender’s failure to take any of the “customary steps” to ensure repayment, such as obtaining a security interest, despite an enforceable right to repayment, supports a conclusion of equity. Nevertheless, the lack of a security interest in connection with a promise to repay is indicative of an equity interest, but it may be less important where the transaction is between related parties.
As of the end of the year in question. Corp B had failed to repay more than $9.6 million to Corp A. The record did not indicate that Corp A ever made a written request to demand payment from Corp B, nor was interest collected on the Transfers and the Payments. Furthermore, Corp A never obtained a security interest. This factor weighed in favor of equity.
Participation in Management
If a taxpayer’s advances to a corporation entitle them to greater participation in its management, the advances are more likely to be treated as equity. Both Corp A and Corp B only one shareholder at the time of the relevant transactions – Taxpayer – and their ownership interest never changed as a result of the Transfers and the Payments. Accordingly, this factor was neutral.
Status Equal to or Inferior to That of Regular Corporate Creditors
If a shareholder’s rights to repayment of principal and interest are subordinated to the rights of regular creditors, then the shareholder’s advances are generally indicative of an equity interest. Even absent an explicit subordination clause, the failure to demand timely repayment or to take collateral effectively subordinates the alleged debt to the rights of other creditors, who may receive payment or foreclose on their security in the interim.
The Court concluded that Corp A’s right to repayment was subordinated to the rights of regular creditors. Taxpayer and Corp A never demanded payment from Corp B, and repayment of the Transfers and the Payments was subordinated to the claims of Corp B’s creditors. The Transfers and the Payments were necessary for Corp B to continue operating and pay its creditors and operational expenses. There was no evidence in the record to suggest that Corp A was repaid before other creditors. Accordingly, this factor weighed in favor of equity.
The Intent of the Parties
The Court examined whether the parties to the transaction intended the interest to be debt or equity. The Court looked at the objective evidence of whether the parties intended to create a “definite obligation, repayable in any event.” The intent at the time of the creation of the interest was persuasive, but the Court used all the factors to determine the “true intent” concerning the creation of the interest.
When the Transfers and the Payments were initially structured, it was likely that Taxpayer, Corp A, and Corp B intended them to be debt. Corp B accounted for the transfers from Corp A as a “Loan Payable” in its general ledger liability and then accounted for the Payments paid by Corp A as “Due to [Corp A]” in another general ledger liability account. From inception, Corp B documented the Transfers and the Payments as liabilities between Corp B and Corp A but did not document the additional contributed capital or loans from Taxpayer on its financial documents. Corp A accounted for the expenses it paid for Corp B as “Due from [Corp B].” Corp A documented the Transfers and the Payments as liabilities between the two corporations. Corp B reported the Transfers and the Payments as a balance due to Corp A on its tax returns and characterized them as indebtedness on the return. Corp B did not report Taxpayer’s additional capital contributions on its returns. Corp A reported the Transfers and the Payments as liabilities due from Corp B on its tax returns and characterized them as indebtedness.
Thus, this factor weighed in favor of indebtedness as the ledgers and tax returns of the parties seemed to indicate that the parties intended this to be classified as debt at the time of creation.
Thin or Adequate Capitalization
The purpose of examining the alleged borrower’s debt-to-equity ratio is to determine whether it was so thinly capitalized that it would be unable to repay the debt if its financial condition worsened. Thin capitalization tends to indicate that a transaction is a capital contribution. A corporation’s debt-to-equity ratio is determined by comparing all of its liabilities to the shareholders’ equity.
At trial, CFO testified that on the basis of the losses of Corp B at the end of the Tax Year, Corp B would not have been able to repay any loans from a commercial lender. Furthermore, Corp B experienced significant losses. This suggested that Corp B was undercapitalized and would not have been able to repay debts. However, in the absence of financial statements, it was not possible to calculate debt-to-equity ratios for the Tax Year.
Thus, this factor was neutral.
Identity of Interest Between Creditor and Stockholder
Advances made by shareholders in proportion to their stock ownership indicate capital contributions. Where a stockholder owns “debt” in the same proportion to which he holds stock in the corporation, the characterization of their advances as “debt” may be suspect. The Court noted that it had previously determined that where the same family controlled the issuing and borrowing entities, the interests between borrower and lender were “significantly intertwined” and the factor weighed in favor of equity.
Taxpayer was the sole shareholder of both Corp A and Corp B. Each month, Taxpayer reviewed the financial position of both corporations and directed Corp A to transfer sufficient funds to Corp B to allow the latter to continue operating. As the interests of Taxpayer and the two corporations were “significantly intertwined,” there was likely an identity of interest.
Accordingly, this factor weighed in favor of equity.
Extent to Which Interest Payments Come from “Dividend” Money
A true lender is concerned with reliable payments of interest. A lack of interest payments and the alleged debtor’s lack of ability to make them suggests that the party who advanced funds is looking to the corporation’s future earnings to achieve a return on his investment, which is indicative of equity. There was no expectation that Corp B would make interest payments to Corp A, nor did Corp A make such a demand.
Thus, this factor favored equity.
The Ability of the Corporation to Obtain Loans from Outside Lending Institutions
If the corporation is able to obtain funds from outside sources on substantially the same terms as those imposed by the payor of the advance, an inference arises that the advance may be debt. Evidence that the corporation would not have been able to obtain a loan from an independent source indicates equity. Where there is no evidence that a taxpayer was unsuccessful in attempts to obtain independent financing, the Court will consider this factor neutral.
CFO testified that on the basis of the losses of Corp B no lender would have loaned $36 million to Corp B to replace the Transfers and the Payments from Corp A. CFO also testified that Corp B had never attempted to get a commercial loan outside of the Transfers and the Payments from Corp A. No other evidence was presented regarding the credit worthiness of the two corporations.
Accordingly, the Court found this factor was neutral.
Outcome of the ForegoingFactors
Of the 11 factors considered by the Court, 4 were neutral, 6 favored equity, and 1 favored debt. After weighing the factors in the context of this case the Court concluded it was more likely than not that the Transfers and the Payments in question did not constitute true indebtedness.
Next, the Court sought to determine whether the transactions in question could be recharacterized as constructive distributions from Corp A to its shareholder, Taxpayer, followed by contributions of capital to Corp B.
Constructive Distribution/Contribution
A distribution need not be formally declared or even intended by a corporation to be deemed a constructive distribution. “It is well established that transfers between related corporations may result in constructive dividends to a common shareholder.” “A greater potential for constructive dividends * * * exists in closely held corporations where dealings between stockholders and the corporation are commonly characterized by informality.”
The Court explained that, under caselaw, a constructive dividend occurs where a two-part test is met: (1) the expenditures in question do not give rise to a deduction on behalf of the distributing corporation and (2) the expenditures create “economic gain, benefit, or income” to the shareholder. The Court concluded both prongs of this two-part test were met.
According to the Court, the crucial determination of whether a constructive dividend exists turns on the question of whether the distribution was primarily for the benefit of the shareholder. A showing that the corporation, rather than the shareholder, was the primary beneficiary of a distribution is required to avoid constructive distribution treatment. Whether the shareholder primarily benefited from the distribution is a question of fact.
“Generally, a constructive distribution occurs when corporate assets are diverted to or for the benefit of a shareholder without adequate consideration for the diversion.” A transfer between related corporations, the Court stated, can be a constructive dividend to common shareholders even if those shareholders do not personally receive the funds.
In order to meet the second prong of the test, the shareholder must receive an actual, direct benefit.
Taxpayer argued that the second prong was met since the Transfers and the Payments primarily benefited Taxpayer. The Transfers and the Payments allowed Corp B to continue operating, reduced the need for Taxpayer to continue Corp B’s operations with personal funds, and allowed Taxpayer to continue collecting salary and rent from Corp B. Taxpayer further argued that because of the interlinked business operations of Corp B and Corp A, had Corp B failed, Corp A would not have been profitable.
The Court agreed with Taxpayer that the Transfers and the Payments primarily benefited Taxpayer. There was no discernable business reason for Corp A to make the Transfers and the Payments, which was in accordance with the Court’s finding there was no true expectation of interest or timely repayment. The Transfers and the Payments directly benefited Taxpayer since they allowed his other business entity, Corp B, to continue operations. In fact, Taxpayer’s Vice President testified that Taxpayer wanted to ensure that both corporations continued operating. Thus, the Court found that Taxpayer showed that the Transfers and the Payments were for the primary benefit of Taxpayer.
The first prong of the test, the Court continued, requires that the expenditures not give rise to a deduction on behalf of the distributing corporation. Under this prong the Court sought to determine whether some benefit existed for the corporation to make the distribution. The Court has found that a distribution was made for the benefit of the corporation when it claimed a deduction as a result of the distribution. As discussed above, there was no discernable business reason for or business deduction attributable to Corp A’s Transfers. Moreover, the IRS did not dispute that the Payments were business deductions attributable to Corp B, not Corp A.
With that, the Court found that both prongs of the constructive dividend test were satisfied as the constructive distributions were made primarily for Taxpayer’s benefit. Accordingly, the Court concluded that the Transfers and the Payments constituted constructive distributions from Corp A to Taxpayer, followed by constructive contributions from Taxpayer to Corp B.
Taxpayer’s Basis
Still, the IRS argued that Taxpayer had insufficient stock basis in their shares of Corp B stock to claim the flowthrough loss from Corp B for the Tax Year.
Taxpayer countered that the Transfers and the Payments, when reclassified as deemed distributions from Corp A to Taxpayer and deemed capital contributions from Taxpayer to Corp B, provided additional basis in Taxpayer’s shares of Corp B stock to claim these losses.
As noted above, the Court agreed with Taxpayer’s contention that the Transfers and the Payments in question were deemed distributions from Corp A to Taxpayer followed by deemed capital contributions from Taxpayer to Corp B. Thus, it instructed the parties to calculate Taxpayer’s stock basis in each of Corp B and Corp A.
The IRS’s Remaining Objections
Next, the Court addressed and dismissed the IRS’s argument that the fisc would be harmed by acceding to Taxpayer’s position that the Transfers and Payments from Corp A to Corp B were actually distributions followed by contributions. The Court also rejected the IRS’s affirmative defense, based on the duty of consistency, that Taxpayer was estopped from recharacterizing the Transfers and Payments.
Harm
According to the IRS, Taxpayer would have had a zero basis in Corp A after its distribution of the sale proceeds (described above), thereby resulting in insufficient basis for Taxpayer to claim losses in subsequent years from Corp A. The IRS claimed that because the period of limitations for such years was closed, thereby precluding the IRS from examining the tax returns for those years, the fisc would be harmed if Taxpayer were allowed to recharacterize the debt as equity and claim flowthrough losses for the Tax Year.
Taxpayer disputed the IRS’s argument of harm by contending that the IRS’s basis calculations, which purported to demonstrate that the distributions from Corp A exceeded Taxpayer’s basis for their Corp A stock, were incorrect because they included the accountant’s above-described post-sale adjustments, which were not actual distributions. Rather, Taxpayer argued that the accountant merely corrected the incorrect prior characterizations of the Transfers and the Payments as “due from” Corp B on Corp A’s balance sheet and returns. The purported loans written down as they were incorrectly classified as assets on Corp A’s balance sheet. On Form 1120S, this reduction appeared as a “distribution,” but no such distribution actually occurred as Corp A lacked sufficient cash and assets to make the distributions alleged to have occurred.
The Court agreed with Taxpayer and instructed the parties to submit revised basis calculations reflecting Taxpayer’s bases in each corporation and confirming that adequate bases remained in both entities to support the losses claimed by Taxpayer with respect to the closed tax years
Duty of Consistency
According to the Court, for the duty of consistency to apply, the following elements must exist: (1) a representation or report by the taxpayer, (2) reliance by the IRS, and (3) an attempt by the taxpayer after the period of limitations has run to recharacterize the situation in such a way as to harm the fisc. If all three elements are present, the IRS may act as if the taxpayer’s previous representation continues to be true, even if it is not. The taxpayer is estopped to assert the contrary.
Based upon the corporations’ tax returns as filed, the Court found that the first two elements were met. Unfortunately for the IRS, the Court also found that the IRS did not sufficiently demonstrate that the fisc would be harmed upon a finding by the Court that the Transfers and the Payments were equity rather than debt.
Parting Thought
Accordingly, the Court held that the Transfers and the Payments were interests in equity rather than genuine indebtedness and Taxpayer was eligible for the flowthrough loss claimed.
A “forgiving” opinion by the Court and a fortuitous outcome for Taxpayer considering the inconsistent positions taken by Taxpayer and their two corporations.
Indeed, one may reasonably conclude there was some tax gamesmanship here notwithstanding the Court’s determination to the contrary. After all, what taxpayer describes a transaction one way on their books and tax returns but then takes a contradictory position during the audit of such returns when such a change in posture will benefit the taxpayer?
In any case, the behavior of Taxpayer and their corporations does not provide a roadmap to be followed by other closely held businesses and their owners.
Instead, such taxpayers should be careful to ensure their dealings with related persons are conducted on as close to an arm’s length basis as possible. In addition, prior to engaging in a transaction with a related person, they should decide upon the character of such transaction and its expected tax consequences, and they should document and report the transaction accordingly.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967). According to the Third Circuit:
“[A] party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”
T.C. Memo. 2024-8 Estate of Thomas H. Fry v. Commissioner.
You can’t make this up.
At trial, the Vice President for the two corporations testified that Taxpayer treated them like his “baby” and wanted to ensure that both continued operating.
IRS Form 1040, Schedule E, Part II.
IRC Sec. 1366(d). Subchapter S corporations are flowthrough entities. A shareholder in an S corporation is entitled to deduct his share of entity level losses in accordance with the flowthrough rules of subchapter S. IRC Sec. 1366(a). Section 1366(d)(1) limits the amount of losses and deductions the shareholder may deduct as not exceeding the sum of the shareholder’s adjusted basis in their stock and the shareholder’s adjusted basis in indebtedness of the S corporation to the shareholder.
The IRS asserted that the “duty of consistency” and the “doctrine of election” prohibited the recharacterization of the Transfers and the Payments from debt to equity as their original characterization was debt.
The IRS argued that under IRC. Sec. 385(c) “[t]he characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest” but shall not be binding on the IRS.
The IRS asserted that Sec. 385(c) should be applied to bind Taxpayer to their characterization at the time of filing the return for the Tax Year and to prohibit the recharacterization of the interest as equity since the Transfers and the Payments were classified by Corp A and Corp B as debt on their tax returns and general ledgers.
The Court, however, agreed with Taxpayer’s position that Sec. 385(c) did not apply to the facts presented because there was no formal issuance of any instrument evidencing the creation of an interest in stock or equity. In the absence the issuance of a promissory note or a stock certificate, Sec. 385(c) was inapplicable.
Because appeal of this case would lie to the Ninth Circuit, the Tax Court considered the 11 factors that the Court of Appeals for the Ninth Circuit applies to characterize a taxpayer’s interest in a corporation. IRC Sec. 7482(b)(1)(A).
At least by the Ninth Circuit Court of Appeals.
The Court added that the taxpayer bears the burden of establishing that the interest in question should be characterized as debt or equity.
The Court noted that the record contained insufficient information for the Court to recalculate Taxpayer’s adjusted bases in Corp B and Corp A. Accordingly, the Court instructed the parties to calculate such bases in the light of the Court’s decision, pursuant to Tax Court Rule 155. This calculation would also be used to determine the appropriate amount of flowthrough loss the Taxpayer was entitled to for the Tax Year.
The party asserting the duty of consistency bears the burden of proving that it applies. Tax Court Rule 142(a).
Pursuant to Tax Court Rule 155.
The corporations reported the Transfers and Payments as indebtedness and the IRS relied on those returns (filed under penalty of perjury).
The third element of the duty of consistency requires an attempt by the taxpayer, after the period of limitations has expired, to change the previous representation or to recharacterize the situation in such a way as to harm the Commissioner. Courts have previously found that this element was met in cases where allowing the taxpayers to recharacterize a previous representation would result in significant tax avoidance as a result of the closed period of limitations. The duty of consistency was created to avoid “tax gamesmanship” where “the Commissioner can no longer collect the tax deficiency occasioned by [the taxpayers’] turnabout.”
Provided the Rule 155 computations described earlier supported Taxpayer’s claim of adequate bases.