Eleventh Circuit Avoids Controversial Interpretative Question on S Corporation Taxation

In Meruelo v. Commissioner, 2019 WL 1986618 (11th Cir. May 6, 2019), the Eleventh Circuit was tasked with reviewing a controversial Tax Court decision regarding the basis created by a subchapter S corporation’s indebtedness to its shareholders. Meruelo v. Commissioner, T.C. Memo. 2018-16. In Judge William Pryor’s opinion, the court determined the case on its facts, never addressing the Tax Court’s decision that the common law “actual economic outlay” standard applied despite recent Treasury Regulations intended to override the doctrine.

Meruelo was a shareholder in a real estate development S corporation that failed during the recession, allocating him a $13 million loss. Under section 1366(d)(1) of the Internal Revenue Code, an S corporation shareholder may only deduct losses up to the sum of (i) their adjusted basis in the S corporation’s stock and (ii) their adjusted basis in the S corporation’s indebtedness to the shareholder. Meruelo had $5 million of undisputed basis in indebtedness from a personal loan he had taken on behalf of the S corporation. Meruelo claimed an additional $9.3 million of basis in indebtedness attributable to intercompany transfers to the S corporation from other businesses that he owned. The IRS determined that the $9.3 million in intercompany transfers did not create basis in indebtedness and therefore determined that Meruelo had only $5 million in adjusted basis in the S corporation. Citing section 1366(d)(1), the IRS only allowed Meruelo to deduct $5 million of his $13 million loss.

In determining whether indebtedness from an S corporation to a shareholder creates shareholder basis, the traditional common law test has been the “actual economic outlay” standard, which asks whether the transaction causes a shareholder to become “poorer in a material sense.” The actual economic outlay standard has been applied strictly in practice, denying basis to countless S corporation shareholders over the years.

In 2014, Treasury released Treas. Reg. 1.1366-2(a)(2), instructing that basis in indebtedness is created by “any bona fide indebtedness of the S corporation that runs directly to the shareholder” and that whether a debt is bona fide is a facts and circumstances inquiry “determined under general Federal tax principles.” In 2014, the passage of this regulation was viewed as good news for S corporation shareholders that have long suffered under the strict actual economic outlay standard.

In his efforts to claim his additional $9.3 million of basis in indebtedness, Meruelo pointed to Treas. Reg. 1.1366-2(a)(2), arguing that his intercompany transfers created a “bona fide indebtedness of the S corporation that runs directly to the shareholder.” Both the Tax Court and the Eleventh Circuit rejected his argument, but on different grounds. The Tax Court determined that the S corporation’s debt was not “bona fide,” while the Eleventh Circuit determined that the S corporation’s debt did not “run directly to the shareholder.”

The Tax Court’s decision was a blow to S corporation shareholders, and its analysis has been widely criticized. In the preamble to the final regulations promulgating Treas. Reg. 1.1366-2(a)(2), Treasury explained that the regulation provided a new test for courts to apply “[i]nstead of applying the actual economic outlay standard.” The Tax Court effectively ignored this instruction, deciding the case under the actual economic outlay standard because (a) the regulation defined “bona fide” by reference to “general Federal tax principles” and (b) the actual economic outlay standard is a general Federal tax principle. Critics have argued that the Tax Court’s sweeping definition of “bona fide” left the new regulations meaningless.

The Eleventh Circuit decided the case on different grounds. The court observed that Treas. Reg. 1.1366-2(a)(2) requires the indebtedness to run “directly to the shareholder.” Although the regulations allow certain back-to-back loans be treated as running directly to the shareholder, these intercompany transfers were not back-to-back loans. Under both Tax Court and Eleventh Circuit precedent, transactions such as this one, with advanced funds flowing through closely related pass-through entities, are treated as running directly to the shareholder only in “exceptional circumstance[s]” that were not present here. Because the debt did not run directly to Meruelo, he could not claim basis in indebtedness under Treas. Reg. 1.1366-2(a)(2). Deciding on these grounds, the Eleventh Circuit did not need to analyze whether the debt was “bona fide” or otherwise comment on the merits of the Tax Court’s interpretation of the regulations.

Interested observers had hoped that the Eleventh Circuit would reject the Tax Court’s broad interpretation of “bona fide” under Treas. Reg. 1.1366-2(a)(2). Instead, the Eleventh Circuit dodged the issue. S corporation shareholders may find some comfort in the Eleventh Circuit’s decision not to endorse the Tax Court’s controversial reasoning. However, because it was not expressly rejected, taxpayers are left to deal with the uncertainty created by the Tax Court’s interpretation.

Posted by Phil Ogea.

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