A back-to-back loan in the S corporation context refers to an arrangement in which an S corporation shareholder borrows funds from an unrelated or related third party, and then lends such funds to the S corporation. A loan may be structured as a back-to-back loan at the outset to enable the shareholder to obtain a basis increase immediately upon the infusion of the funds into the corporation, or the back-to-back loan may arise later when a loan that was originally structured as a direct loan from the third party to the S corporation is restructured as a back-to-back loan, in order to provide a basis increase for the shareholder.
For a number of years, the IRS and the courts have taken a particularly harsh position with respect to loan restructurings between related entities where the purpose of the loan restructuring was to obtain an increase in the taxpayer’s basis in the S corporation, and in turn, enable the taxpayer to deduct losses incurred by the S corporation during the tax year. Almost uniformly, the IRS and the courts have refused to allow a shareholder to increase his basis in an S corporation (at least in the loan restructuring context), where the shareholder obtains funds from a related entity (as opposed to an unrelated third-party lender) which were then loaned or contributed by the shareholder to the S corporation.
Other developments suggest that the IRS may take the position, under certain circumstances, that a basis increase is inappropriate, even where a loan restructuring involves an unrelated third-party lender, and that under certain other circumstances, the IRS may take the position that no basis increase should be granted even if the loan was originally structured (as opposed to restructured) as a back-to-back loan if the shareholder obtains the funds from a related entity.
In Meruelo v. Commissioner, the Tax Court disallowed losses claimed by a shareholder of an S corporation because it found that the shareholder did not establish that he had sufficient basis in the S corporation to claim such losses. Although the Tax Court clearly reached the correct result in denying the basis increase to the taxpayer, it unfortunately reinforced the applicability of the actual economic outlay doctrine despite the fact that the Internal Revenue Service specifically rejected the actual economic outlay doctrine pursuant to the proposed regulations issued on June 12, 2012 and the final regulations issued on July 23, 2014 on back-to-back loans.
The taxpayer was a real estate developer in South Florida who held interests in numerous S corporations, partnerships and LLCs. One of these entities was Merco of The Palm Beaches, Inc. (“Merco”), which was an S corporation in which the taxpayer held 49% of the stock during the year in issue. The taxpayer obtained a personal loan from City National Bank of Florida and transferred $4,985,035.00 of the loan proceeds to Merco Group at Akoya (“Akoya”), an S corporation in which he and his mother each held a 50% interest. Akoya subsequently transferred into Merco’s account $5,000,000.00, the taxpayer’s loan proceeds of $4,985,035.00 plus $14,965.00 of Akoya’s own funds. Akoya had also previously transferred to Merco an additional $5,000,000.00.
During the years 2004-2008, Merco entered into hundreds of transactions with various partnerships, S corporations and LLCs in which the taxpayer held an interest (the “Merco Affiliates”). The Merco Affiliates regularly paid expenses (such as payroll costs) on each other’s or on Merco’s behalf to simplify accounting and enhance liquidity. The payor company recorded these payments as accounts receivable, and the payee company recorded such items as accounts payable.
Taxpayer’s CPA would net Merco’s accounts payable to the Merco Affiliates, as shown on Merco’s books as of the preceding December 31, against Merco’s accounts receivables from the Merco Affiliates. If Merco had net accounts payable as of that date, the CPA reported the amount as a “Shareholder Loan” on Merco’s tax return and allocated a percentage of the indebtedness to the taxpayer, on the basis of taxpayer’s ownership interest in the various Merco Affiliates that had extended credit to Merco. The CPA testified that at the time he prepared the taxpayer’s and Merco’s tax returns for the years 2004 through 2008, he would make an annual charge to Merco’s line of credit for an amount equal to taxpayer’s calculated share of Merco’s nets accounts payable to the Merco Affiliates for the preceding year. However, there was no documentary evidence that such adjustments to principal were actually made or that Merco accrued interest annually on its books with respect to this alleged indebtedness. Additionally, there was no evidence that Merco made any payments of principal or interest on its line of credit to the taxpayer, and likewise, there was no evidence that the taxpayer made any payments on the loans that Merco’s Affiliates extended to Merco when they transferred money to it or paid its expenses.
In 2008, Merco incurred a loss of $26,605,840.00 when banks foreclosed on the condominium complex it had purchased in 2004. Merco reported this loss on Form 1120S and allocated 49% of the loss to the taxpayer on Schedule K-1. In turn, on taxpayer’s individual 2008 federal income tax return, he claimed a loss deduction of $11,795,190.00 which reflected a $13,036,861.00 flow-through loss from Merco ($26,605,840.00 x 49%) netted against gains of $1,241,752.00 from two other S corporations in which the taxpayer held stock. The taxpayer carried back the loss on his 2008 return to his individual federal income tax return for 2005.
The IRS audited taxpayer’s 2005 and 2008 returns and determined that his basis in Merco was only $4,985,035.00 (the proceeds of the CNB Bank loan that taxpayer contributed to Merco through Akoya). Accordingly, the IRS disallowed, for lack of a sufficient basis, $8,051,826.00 of the $13,036,861.00 flow-through loss claimed for 2008.
Code Sec. 1366(d)(1) provides that the total amount of losses and deductions taken into account by an S corporation shareholder for any tax year cannot exceed the sum of:
- the adjusted basis of the shareholder’s stock in the S corporation; and
- the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.
Although Code Sec. 1366(d)(1)(B) provides that a shareholder is entitled to deduct his proportionate share of the S corporation’s losses and deductions to the extent of such shareholder’s adjusted basis in debt of the S corporation to such shareholder, it does not specifically define what constitutes “indebtedness of the S corporation to the shareholder.” A number of cases and rulings interpreting Code Sec. 1366(d)(1)(B) have established two requirements that generally must be met in order for a loan to constitute “indebtedness of the S corporation to the shareholder” within the meaning of Code Sec. 1366(d)(1)(B):
- the indebtedness must run directly from the S corporation to the shareholder; and
- the shareholder must have made an “actual economic outlay.”
It is the second requirement that has proven most problematic for taxpayers and with respect to which the courts have rendered inconsistent and confusing decisions. Specifically, the IRS, and the courts in a number of cases, have found that in order for the S corporation shareholder to receive an increase in basis in connection with a back-to-back loan, the shareholder must have made an “actual economic outlay” in such a manner that the shareholder is “poorer in a material sense” after the transaction than before the transaction began. As will be discussed in more detail below, the application of the “actual economic outlay” and “poorer in a material sense” standards in the back-to-back loan area is inappropriate.
Comments issued by the ABA Section of Taxation rejected use of the actual economic outlay doctrine in the context of back-to-back loans, and simply argued for a rule that when there is a valid debt for tax purposes, that debt should create stock basis regardless of the source of the funds (i.e., whether from an unrelated third-party lender, a related party or under the shareholder’s mattress).
The ABA Tax Section’s comments point out that there is no statutory basis for denying basis increases for back-to-back loans. In effect, an attribution rule is being applied in the context of Code Sec. 1366(d)(1)(B) so that funds which are obtained by a shareholder from a related corporation or other related entity and then loaned to an S corporation controlled by that same shareholder will not be treated as indebtedness of the S corporation to the shareholder under Code Sec. 1366(d)(1)(B). Because there is no such attribution rule that is applicable with respect to Code Sec. 1366(d), there is no authority to apply such a rule either by the courts or the IRS.
In addition to the lack of statutory authority, the ABA Tax Section comments also point out that there is no economic foundation for requiring an S corporation shareholder to have made an actual economic outlay such that the shareholder is poorer in a material sense after the transaction than before the transaction began in order to obtain a basis increase under Code Sec. 1366(d)(1)(B). In an economic sense, a shareholder is never poorer after the shareholder makes a loan to his or her S corporation than before the loan was made (regardless of how the shareholder obtained the funds that were loaned to the S corporation). Rather, the shareholder has merely shifted his or her current assets from cash to notes receivable while such shareholder’s net worth has remained the same. The IRS and the courts are simply assuming that if the loan is between related parties, it will never be repaid and, therefore, that no real indebtedness exists. The concern of the IRS and the courts that funds borrowed by a shareholder from a controlled or wholly-owned corporation will not be repaid is misplaced.
Finally, from an economic standpoint, in situations where the funds are obtained by the S corporation shareholder from a related entity, such funds will in all likelihood have already been subjected to taxation (either at the entity level in the case of a C corporation or at the shareholder or partner level in the case of an S corporation or a partnership). In such situations, the S corporation shareholder clearly has a tax cost basis in such funds, and there is simply no economic reason to support a denial of a basis increase where such funds are then loaned by the shareholder to the S corporation.
The Proposed Back-to-Back Loan Regulations
The preamble to the proposed regulations specifically provides that disputes continue to arise concerning when a back-to-back loan gives rise to an actual economic outlay, in particular whether a shareholder has been made “poorer in a material sense” as a result of the loan. The preamble states that the frequency of disputes between S corporation shareholders and the government regarding whether certain loan transactions involving multiple parties, including back-to-back loan transactions, created shareholder basis of indebtedness demonstrates the complexity and uncertainty about the issue for both shareholders and the government. Consequently, the preamble states that the IRS is issuing the proposed Regulations to clarify the requirements for increasing basis of indebtedness and to assist S corporation shareholders in determining with greater certainty whether their particular arrangement creates basis of indebtedness.
In general, the proposed regulations follow the recommendations made by the American Bar Association Section of Taxation that so long as the loan transaction represents bona fide indebtedness of the S corporation to the shareholder, the shareholder should be allowed to increase his basis in the S corporation under Section 1366(d)(1)(B). Significantly, the preamble provides that so long as the purported indebtedness of the S corporation to the shareholder is bona fide indebtedness to the shareholder, the S corporation shareholder need not otherwise satisfy the “actual economic outlay” doctrine for purposes of Section 1366(d)(1)(B).
ABA Tax Section Comments on Proposed Regulation
On September 17, 2012, the American Bar Association Section of Taxation submitted comments on the proposed regulations addressing basis increases for back-to-back loans by S corporation shareholders issued by the IRS on June 12, 2012.
The ABA Tax Section’s comments generally agree with the approach taken in the proposed regulations rejecting the so-called “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), and suggested a number of clarifications.
Among a number of other comments, the ABA Tax Section recommended that the text (rather than just the Preamble) of the final regulations specify that as long as the indebtedness of the S corporation to the shareholder constitutes bona fide indebtedness, the shareholder be allowed to increase his or her basis in indebtedness of the S corporation under Section 1366(d)(1)(B) without satisfying the actual economic outlay test articulated in court cases.
The Final Regulations
On July 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. In view of the uncertainty and inconsistent judicial decisions regarding basis increases with respect to back-to-back loans, the guidance is welcome and the IRS should be applauded for its response to the request for regulations made by the ABA Tax Section, the AICPA and many tax practitioners, and for its attempted 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 July 23, 2014.
Unfortunately, the final regulations did not incorporate any of the comments made by the ABA Tax Section on the proposed regulations. As discussed above, one of the comments that was not adopted was that although the proposed regulations expressly reject the application of the “actual economic outlay” test and the “poorer in a material sense” concept in the preamble, the final regulations should directly address these concepts in the body of the Regulations. The preamble to the final regulations states that the Treasury Department and the IRS believe that the regulations clearly articulate the standard for determining basis of indebtedness of an S corporation to its shareholder, and that further discussion of the actual economic outlay test in the body of the regulations was unnecessary. As will be seen in the Meruelo case, the IRS was apparently incorrect.
In Meruelo, the Tax Court expressly addressed the taxpayer’s contention that based on the final back-to-back loan regulations, the taxpayer did not need to show that he made an “actual economic outlay” in order to obtain a basis increase in Merco. The Tax Court found that it did not matter whether (or to what extent) the new regulations applied because the outcome would be the same in either event. The test set forth in the new regulation-limiting basis to “bona fide indebtedness of the S corporation that runs directly to the shareholder”- is the same test as set forth in prior law according to the Tax Court. Moreover, the Tax Court went on to state that because the final regulations provide that the existence of the bona fide indebtedness would be determined under general federal tax principles, the “actual economic outlay” doctrine is a general tax principle that the Tax Court has applied to determine whether the shareholders had a bona fide loan that gives rise to an actual investment in the corporation.
The Tax Court, rather than basing its decision on the final regulations requiring that bona fide indebtedness of the S corporation run directly to the shareholder (which in this case, it clearly did not), stated that the actual economic outlay doctrine is a general tax principle that may be employed under the new regulation, as it was applied under prior law, to determine whether the bona fide indebtedness test has been met. As that authors have contended many times before, together with the ABA Tax Section, the application of the actual economic outlay test does not make sense in the back-to-back loan area, and is being applied without any statutory or economic justification. As such, the Tax Court’s conclusion that the actual economic outlay test continues to apply following the final regulations is simply wrong.
Interestingly, the Tax Court expressly rejected the taxpayer’s argument that the “actual economic outlay” doctrine is not congruent with the new regulations as evidenced by the statement in the preamble to the proposed regulations that “… an S corporation shareholder need not otherwise satisfy the actual economic outlay doctrine for purposes of 1366(d)(1)(B).” The Tax Court concluded that in any event, it has never understood the preamble to proposed regulations to be precedential, citing Dobin v. Commissioner. This is one of the reasons the ABA Tax Section specifically recommended that the rejection of the actual economic outlay doctrine be put in the body of the regulations rather than just in the preamble.
The Meruelo decision reaches the correct conclusion that the taxpayer should not have been allowed a basis increase in Merco, but did so for the wrong reasons. Clearly, under the final regulations, the indebtedness must still run directly to the shareholder and not to a related corporation, and here the indebtedness ran to a number of affiliated corporations rather than directly to the taxpayer. This is the basis upon which the decision should have been decided. The Tax Court’s conclusion that the actual economic outlay doctrine continues to be applicable under the final regulations is a huge setback for taxpayers and again is simply inconsistent with the statutory language of Section 1366(d)(1)(B) and contrary to general economic principals.
 See the following authorities which deny a basis increase in situations originally involving related parties: TAM 9403003; Bergman, 74 F.3d 928 (CA-8, 1999); Underwood, 63 TC 468 (1975), aff’d, 535 F.2d 309 (CA-5, 1976); Shebester, TCM 1987-246; Griffith, TCM 1988-445; Wilson, TCM 1991-544; Hitchins, 103 TC 711 (1994); Bhatia, TCM 1996-429; Thomas, TCM 2002-108; Oren, 357 F.3d 854 (CA-8 2004); Kaplan, TCM 2005-217; Ruckriegel, TCM 2006-78; Kerzner, TCM 2009-78; and Russell, TCM 2008-246, aff’d 619 F.3d 908 (CA-8 2010). But see, Rose, 101 AFTR 2d 2008-1888, 2008-1 USTC ¶50,318 (CA-11, 2008), where the 11th Circuit allowed a basis increase in connection with a loan restructuring between related entities. See the following authorities which permit a basis increase in situations originally including unrelated parties: Rev. Rul. 75-144; Gilday; TCM 1982-242; Ltr. Rul. 8747013; Ltr. Ruls. 9811016, 9811017, 9811018; and Miller, TCM 2006-125.
 See Miller, TCM 2006-125, where the IRS argued that no basis increase should be allowed even though the loan originally involved unrelated parties.
 See Kerzner, TCM 2009-78 (based on the facts of TAM 200619021), where the court denied a basis increase where the loan was originally structured (as opposed to restructured) as a back-to-back loan from a related party.
 TCM 2018-16.
 See note 2.
 See Ruckriegel, TCM 2006-78.
 In the case of a loan to a shareholder by a corporation controlled (but not wholly-owned) by such shareholder, the minority shareholders would have the right to bring an action to compel payment of the loan on behalf of the corporation in the event the shareholder does not repay the loan to the S corporation. In the context of a wholly-owned corporation, third-party creditors would likewise have a cause of action to compel payment of the loan by the shareholder to the corporation. Additionally, the shifting of the loans between the parties has economic significance and creates genuine liability exposure, especially in the event of the bankruptcy of one or more of the corporations.
 For a more detailed analysis of why there is neither a statutory nor economic basis for applying the “actual economic outlay” doctrine in the back-to-back loan area, See Looney, “The Actual Economic Outlay Doctrine and Back-to-Back Loans: The Vampire that Refuses to Die,” 44 Corp. Tax’n. 10 (May/June 2017).
 See “ABA Members Seek Regs on Back-to-Back Loans and S Corporations,” 2010 Tax Notes Today 143-19 (July 27, 2010) (“Comments on Qualification of Debt as Indebtedness of the S Corporation to the Shareholders,” in a letter dated July 26, 2010 to IRS Commissioner Douglas Shulman); American Institute of Certified Public Accountants Tax Executive Committee, Pre-Release Comments on Guidance under Section 1367 Regarding S Corporations and Back-to-Back Loans (May 29, 2009), http://www.aicpa.org/advocacy/tax/scorporations/downloadabledocuments/backtobackloan_pre-releasecomments-final.doc (last visited Sept. 21, 2015).
 See “ABA Tax Section Requests Clarification on Proposed Regs on Back-to-Back Loans by S Corp Shareholders,” 2012 Tax Notes Today 181-22 (Sept. 18, 2012) (“Comments on Proposed Amendments to Section 1.1366-2 Regulations,” in a letter dated September 17, 2012 to IRS Commissioner Douglas Shulman).
 See note 9 supra. The court also refused to characterize the loan as a true back-to-back loan and found the “incorporated pocketbook” theory used in Yates v. Comm’r, TCM 2001-280 and in Culnen v. Comm’r., TCM 2000-139 rev’d on other grounds, 28 F.App’x 116 (3rd Cir. 2002), inapplicable to the facts of the Meruelo case.
 73 T.C. 1121 (1980).
About the Author:
Stephen R. Looney is the chair of the Tax and Corporate department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is Board Certified in Tax Law by The Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at email@example.com.