S Corporation Tax

Capital contributions did not restore or increase shareholders’ tax bases in loans to S corporations Nathel, (2008) 131 TC No. 17

Mike Habib, EA

The Tax Court has held that taxpayers’ capital contributions to S corporations did not constitute income to the S corporations and that the contributions did not restore or increase their tax bases in their loans to the S corporations.

Background. Generally, under Code Sec. 1367 a shareholder’s tax bases in the stock in, and in the loans to, an S corporation are adjusted to reflect the shareholder’s share of income, losses, deductions, and credits of the S corporation as calculated under Code Sec. 1366(a)(1). Under Code Sec. 1367(a)(1), a shareholder’s tax basis in his S corporation stock is increased by, among other things, the shareholder’s share of the S corporation’s income items (including tax-exempt income). Under Code Sec. 1367(a)(2), a shareholder’s tax basis in his S corporation stock is decreased (but not below zero) by, among other things, the shareholder’s share of losses and deductions. If a shareholder’s tax basis in his stock in an S corporation is reduced to zero by his share of the losses of the S corporation, any further share of the S corporation’s losses decreases, but not below zero, the shareholder’s tax basis in outstanding loans the shareholder has made to the S corporation. (Code Sec. 1367(b)(2)(A), Reg. § 1.1367-2(b)(1)) Thus, a shareholder’s tax basis in loans the shareholder has made to an S corporation may be lower than their face amount or zero because of downward adjustments in such basis caused by losses of the S corporation that are passed through to the shareholder. (Code Sec. 1367(b)(2)(A))

Facts. In calculating ordinary income relating to $1,622,050 in loan payments received from two S corporations, for purposes of Code Sec. 1366(a)(1), brothers Ira and Sheldon Nathel treated $1,437,248 in capital contributions they made to the S corporations as income to the S corporations and as restoring or increasing under Code Sec. 1367(b)(2)(B), their tax bases in loans that they previously had made to the S corporations. Ira and Sheldon then used the restored or increased tax bases in the loans they made to the S corporations to offset ordinary income that otherwise would have been reportable by them on their receipt from the S corporations of the $1,622,050 loan payments.

On audit, IRS determined that Ira’s and Sheldon’s $1,437,248 capital contributions were not to be treated as restoring or increasing their tax bases in their loans to the S corporations but as increasing their tax bases in their stock in the S corporations, resulting in additional ordinary income being charged to them on receipt of the S corporation loan payments.

Court’s conclusion. The Tax Court held that for purposes of Code Sec. 1366(a)(1), Ira and Sheldon’s $1,437,248 capital contributions to the S corporations did not constitute income to the S corporations and that under Code Sec. 1367(b)(2)(B), Ira and Sheldon’s capital contributions did not restore or increase their tax bases in their loans to the S corporations.

The Court reasoned that by attempting to treat their capital contributions to the S corporations as income to the S corporations, Ira and Sheldon in effect sought to undermine three cardinal and longstanding principles of the tax law: (1) that a shareholder’s contributions to the capital of a corporation increase the basis of the shareholder’s stock in the corporation; (2) that equity (i.e., a shareholder’s contribution to the capital of a corporation) and debt (i.e., a shareholder’s loan to the corporation) are distinguishable and are treated differently by both the Code and the courts; and (3) that contributions to the capital of a corporation do not constitute income to the corporation.

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