A recent Tax Court decision serves as a reminder to take care in structuring loans by shareholders to their S corporations if the shareholders intend to use the loans to support losses generated by the S corporation.
In Dana D. Messina, T.C. Memo 2017-213 (October 30, 2017), a corporation (KMGI) that was owned by two persons, had loaned money to a wholly owned subsidiary (Casino) of an “S” corporation (Club One) in which they were controlling shareholders. In the tax year in question, the shareholders had deducted losses of Club One (the “S” corporation) that were in large part generated by its subsidiary (Casino) and used the amounts loaned by KMGI to Casino to support the losses. Even though a shareholder of an S corporation can claim losses of the corporation on the shareholder’s tax return, the amount of losses that can be claimed by the shareholder is limited to the shareholder’s tax basis for its stock in the S corporation and the tax basis in any indebtedness of the corporation to the shareholder.
At issue in Messina is whether two of the shareholders of Club One (the S corporation) could include debt owed by Casino (a subsidiary of the S corporation) to KMGI, a separate corporation wholly owned by the shareholders, to support losses of Club One (the S corporation).
The Tax Court found that even though Casino had elected to be taxed as a qualified Subchapter S subsidiary (“Q-Sub”) of Club One and as a result, Club One included income and losses of Casino (its subsidiary) in its income, the shareholders chose the form and structure of their loan and the lender was not merely a “conduit” that should be ignored so that the loan by KMGI to Casino could be treated as a direct loan by the shareholders to Club One. As a result, the shareholders did not have a sufficient basis to claim the losses in Club One. In reaching its decision, the Tax Court found that the taxpayers chose the form of the loan and must be bound by the form of the transaction. KMGI and not its two shareholders was the actual lender to Club One (the S corporation) and KMGI should not be treated as a mere conduit and thus disregarded.
The Messina case is yet another in a series of recent cases dealing with tax basis issues from loans by shareholders to S corporations and in certain cases guarantees of entity level loans by the shareholders. This case reminds shareholders to evaluate carefully the tax consequences of structuring debt financing for S corporations, particularly those as to which a tax loss is anticipated.
For more information, please contact Ralph Z. Levy Jr. in our Nashville, Tennessee office at (615) 620-1733.