Appeals Court Follows Form on S Corporation Loss

Sometimes, the IRS insists on following “form over substance,” despite appearances. And, if your clients intend to challenge this approach in the courts, they’re fighting an uphill battle by going against the letter of the law.

Feb 24th 2020
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Sometimes, the IRS insists on following “form over substance,” despite appearances. And, if your clients intend to challenge this approach in the courts, they’re fighting an uphill battle by going against the letter of the law.

That was the scenario in a new case decided by the Ninth Circuit Court, Messina, CA-9, No. 18-70186, 12/27/19,  where S corporation owners attempted to deduct losses in excess of their basis.

The basic ground rules are pretty simple. When  you’re a shareholder of an S Corporation, items of items of expenses of the company are passed through to you and reported on your personal tax return. If you show a loss from the S corporation for the year, you may use it to offset other taxable income. But the tax law generally limits such losses to the amount of your basis in the stock you own, plus any outstanding loans made directly from you to the corporation.

The IRS and S corporation shareholders often differ on what constitutes the basis of the entity, including amounts relating to loans.

In the new case, the taxpayers, who were joint owners of an S corporation, relied on the debt owed to another S corporation they owned to increase their basis for loss deduction purposes. An S corporation’s indebtedness to another entity, even one wholly owned by the shareholder, doesn’t affect the amount of pass-through deductions a shareholder can claim. Because the relevant debt runs to a related entity, but not the taxpayers themselves, it does not increase the debt basis that taxpayers may claim in the S corporation.

After losing in Tax Court, the taxpayers appealed to the Ninth Circuit Court, arguing that the  debt runs directly to them in substance, if not in form. Therefore, they asked the court to disregard the form in this instance.

However, the Court said it has consistently held that it doesn’t rely on a “substance over form” doctrine. In fact, it has previously rejected the notion that a taxpayer can “escape the tax consequences of a business arrangement which he made upon the asserted ground that the arrangement was fictional.”

Accordingly, the loss deduction was limited to the established basis in the S corporation stock. The debt owed to the second S corporation didn’t provide the requested advantage.

Be aware that the IRS is ramping up efforts to ferret out S corporation losses claimed in excess of basis. Clients may be advised to instead make capital contributions to the S corporation to legitimately increase their basis in S corporation stock. Be careful to meet the requirements of both “form” and “substance” in these transactions.

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