At the ABA Tax Section S Corporations meeting held in Houston, Texas, on 1/30/2015, government officials defended their decision not to include in the final Section 1366 and Section 1367 S corporation back-to-back loan regulations an example on loan restructurings involving a circular flow of funds. The statement was made in a panel presentation at the S Corporations Committee meeting moderated by Stephen R. Looney, with panelists Carolyn Hay, Office of Associate Chief Counsel, Pass-Through and Special Industries, IRS, and Benjamin Willis, Office of Tax Legislative Counsel, Office of Tax Policy, Department of the Treasury. On 7/23/2014, the Department of the Treasury issued final regulations on basis increases for back-to-back loans involving S corporations. The final regulations adopt the proposed regulations without substantive change, except for changes allowing a retroactive effective date and minor clarifying revisions. The final regulations constitute a vast improvement over the prior state of the law which has applied the “actual economic outlay test” and the “poorer in a material sense” concept to determine whether a shareholder is entitled to a basis increase under Section 1366(d)(1)(B). Rather, the final regulations allow for a basis increase under Section 1366(d)(1)(B) if the debt running from the S corporation to the shareholder is a “bona fide debt” under general principles of federal tax law. In view of the uncertainly and inconsistent judicial decisions regarding basis increases with respect to back-to-back loans, the guidance is welcomed and the IRS should be applauded for its response to the request for regulations made by the ABA Tax Section, the AICPA and many other tax practitioners, and for its abandonment of the “actual economic outlay” test with respect to back-to-back loans. The final regulations may be relied on by taxpayers with respect to indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a year for which the period of limitations on the assessment of tax has not expired before 7/23/2014.
Unfortunately, the Final Regulations did not incorporate any of the comments made by the ABA Tax Section on the Proposed Regulations. One of the ABA Tax Section comments not adopted in the Final Regulations was to add an example of a back-to-back loan involving a circular flow of funds. Although the Proposed Regulations provided several examples of back-to-back loans that result in a shareholder being able to increase his or her basis in the S corporation under Section 1366(d)(1)(B), the Proposed Regulations contained no example of loan restructurings achieved through loan repayments involving a circular flow of funds, and the ABA Tax Section specifically suggested that two examples involving a circular flow of funds be included in the Final Regulations which would result in a basis increase under Section 1366(d)(1)(B). The preamble to the Final Regulations provides that the IRS did not adopt this comment and add the two examples on the basis that there are circumstances in which a circular flow of funds would not result in bona fide indebtedness, and as such, the IRS believed the regulations were adequate as drafted.
Because of all the confusion in the area demonstrated by the conflicting court decisions, examples of loan restructurings involving a circular flow of funds resulting in a basis increase for a shareholder provided that the transaction resulted in a bona fide debt running from the S corporation to the shareholder would have been very helpful to taxpayers and tax practitioners. Unfortunately, by not addressing this issue in the regulations, there may be a tendency by IRS agents and the courts to simply treat transactions involving a circular flow of funds as not increasing basis, rather than focusing on whether the debt from the S corporation to the shareholder is a bona fide debt, the standard enunciated in the Final Regulations.
At the ABA Tax Section S corporations meeting, Carolyn Hay said that an example was not added because courts have found that some circular flows are in substance “shams” that are not real. Hay added that normal “substance over form”, “circular flow” and “step transaction ideas” are still there. She emphasized that those are judicial doctrines courts have applied. Looney stated that raising economic substance, sham transaction and step transactions doctrines in the context of a back-to-back loan in effect gives the IRS and the courts “a back door to applying the actual economic outlay test.” Looney added that the lack of example involving a circular flow of funds in the regulations presents a negative connotation that could influence courts and/or IRS agents. Hay responded by stating that a lack of a circular flow example should not be read to imply anything either way. In fact, Hay went on to add that she thought that “if you properly document, you can do” a restructuring involving a circular flow of funds to achieve a basis increase.
Benjamin Willis said that the Final Regulations clearly provide that general federal tax principles and all facts and circumstances continue to be relevant in the back-to-back loan area, specifically including back-to-back loans involving a circular flow of funds. Additionally, Willis stated that questionable loans have been referred to as shams, have been disregarded by courts, and have had the economic substance and step transaction doctrines applied to them. Willis went on to state that taxpayers dealing with equity may get more certainly on increasing basis from the “larger body of law supporting circular flows of cash in the distribution/contribution context,” where the law focuses on a shareholder’s unrestrictive control over the funds and an uncompelled choice to contribute such funds.
These comments were reiterated by May and Willis on 3/6/2015 at the Federal Bar Association Section on Taxation Annual Conference. Although defending their decision not to include a loan restructuring involving a circular flow of funds in the final back-to-back loan regulations, Hay again stated that circular flow transactions could be structured to give rise to genuine debt. Willis said that a recent notice on the economic substance doctrine, Notice 2014-58, may be relevant to the circular flow of funds question. According to Willis, Notice 2014-58 “questions whether or not you look at one step in a particular transaction…or you look at both steps or all the steps that made up a particular transaction.” Willis did, however, go on to note that that the court in Northern Indiana Public Service Co. held that a circular flow of funds resulting from a back-to-back loan has economic substance and thus would be respected.
Observation Although it is encouraging to see comments by IRS and Treasury Department officials stating that a circular flow of funds in the back-to-back loan context could result in a basis increase under Section 1366(d)(1)(B), such officials’ comments on the application of the substance over form, sham transaction and step transaction doctrines is troublesome. In particular, it would have been very easy to include an example in the Final Regulations involving a loan restructuring involving a circular flow of funds which simply could have concluded that if the debt from the S corporation to the shareholder is a “bona fide debt” under general federal tax principles, the shareholder would be entitled to a basis increase (which is the manner in which all of the other examples in the Final Regulations are drafted).
 See Looney, “Back-to-Back Loans and S Corporation Basis: Dazed and Confused,” Journal of Passthrough Entities, May-June, 2011.
 See “ABA Tax Section Requests Clarification of Proposed Regs on Back-to-Back Loans by S Corporation Shareholders,” 2012 TNT 181-22 (Sept. 17, 2012).
 For a discussion of the final back-to-back loan regulations, see Sullivan, Amin, Merrill and Meyercord, “S Corporation Back-to-Back Loan Regulations Finalized,” 16 BET 44 (November/December, 2014).
 See supra note 2.
 See Elliott, “ABA Meeting Officials Explain Lack of Circular Flow Example in Back-to-Back Loan Regs,” 2015 TNT 21-6 (Feb 2, 2015).
 See Madara, “Never Say Never on Circular Flow in Back-to-Back Loans,” 2015 TNT 45-12 (March 9, 2015).
 2014-44 IRB 746.
 115 F.3d 506 (CA-7, 1997).