In this episode of Tax Notes Talk, the second of a three-part series, Damien Martin and Tony Nitti of EY discuss their top tax cases from 2024, focusing on two S corp cases: Maggard v. Commissioner and Estate of Thomas Fry et al v. Commissioner.
Tax Notes Talk is a podcast produced by Tax Notes. This transcript has been edited for clarity.
David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: top 2024 tax cases, part 2.
We’re back this week with another set of top tax cases in 2024 from Damien Martin and Tony Nitti at EY. This is part two, so if you missed part one, you can find a link in the show notes to catch up. And for those of you listening, you can find this episode on YouTube to see me, Tony, and Damien. All right, let’s go to this week’s discussion.
Damien Martin: All right, well how about we go to our next case here, our third case we’ll tee up: It’s Maggard v. Commissioner, it’s T.C. Memo. 2024-77, decision came out in August of last year. And I got to say this one, like the headline on this one, it’s something that I guess just on the surface makes you turn your head a little bit, right? It’s looking at — we always talk about the finer points, we were just talking about it in the subcase space, but in this case we’re talking about S corps, right? Again, to your point of evening things out with partnerships and S corps and C corps.
But the whole second class of stock disproportionate distributions, that’s what we had here, and it sounds like, again, on the surface we didn’t blow our S election. So walk me through that. What happened here? As you do, set us up and tell us, and give us the context, the background, and how did we not blow our S election, when we had disproportionate distributions?
Tony Nitti: Well, let me preface it by saying if not for Denham Capital, this would’ve been number one I think on our list, right? For a couple of reasons. Number one, there are more S corporation returns filed every year than any other entity type. So when you talk about things that people are going to really run into, this is it. Number two, as you just pointed out, it’s just eye-opening; we can learn a lot from this decision. And then number three, the irony of it all, and we will get to that irony here in a minute, but the fact that the election didn’t terminate in this situation is just very ironic, particularly in my line of work because, as you know, D, at EY, I do a lot of diligence on S corp targets that clients are looking to buy. And you do it long enough and you will become a cynic and you will have a little saying, which is, “You show me an S corporation, and I will show you an invalid S corporation.” And yet here, we didn’t have that.
And so to that end, before we even start, buddy, I am going to put you on the spot, and I am going to ask you a question. Answer it if you feel so inclined to take a stab. But I’m going to throw a number at you and you’re going to try to guess, tell me what significance that number has in the S corp world. And that number is 30,000. You tell me what 30,000 means to eggheads like me that work with S corps all the time.
Damien Martin: Tony, I mean going back to, again, you’re putting me on the spot here. I will say that that was contractually what we had asked Tax Notes for, the number of blue M&Ms that I was requesting, didn’t get there in the conversations. So I don’t know, you got me, what does 30,000 have to do with S corps?
Tony Nitti: You’re not doing anything to help what’s being said.
Damien Martin: I know, I know, but I just got to call it out there.
Tony Nitti: 30,000. The IRS processes 30,000 requests for relief a year, from S corporations who’ve realized that their election’s gone bad. 30,000. Now 150 to 250 of those, you end up having to go in for the last resort, a formal private letter ruling, that’s going to cost you $38,000 at least in today’s dollars. That number’s going to increase here in about—
Damien Martin: Oh, plus your time too—
Tony Nitti: Yeah, plus — Yeah, exactly.
Damien Martin: Right?
Tony Nitti: So about 250 going for private letter ruling, so that leaves, oh boy, 29,750 situations where people are asking the IRS for relief via a string of automatic relief revenue procedures that have been issued over the years.
But 30,000, dude, the numbers don’t lie. And so what’s funny is when I am teaching about S corps around the country, and I’m talking about ways you can blow an S election, someone will always come up to me after and go, “I don’t know why you spent an hour of my life talking about blown S elections. I’ve been working with S corps for five years or 12 years, or 20 years, and I’ve never had an S election for a client of mine blow on my watch.” And my response is always the same, which is, “Hey, the numbers don’t lie. And so if you have never had an S election blown on your watch, I would suggest you’re probably just not looking hard enough.” Because it happens constantly.
And there’s good reason for it to happen, D, because S corps are a different animal. You don’t default into being an S corp, the way you do under the check-the-box regs to be a C corp or to be a partnership, or a disregarded entity.
You want to be an S corp, you’ve got to meet strict eligibility requirements under section 1361, and then you have to follow strict procedural requirements under 1362 to file a complete and timely election. Anything goes wrong with those eligibility requirements, anything goes wrong with the election, you don’t have a good S. And so there is a lot that can go wrong. And where we’re focused on here is the eligibility requirements. What does it mean to be an S corporation under 1361(b)(1)? And most of these requirements don’t give us a ton of trouble; we have to have a domestic corporation.
Now what does give us trouble — hopefully we find a little time to talk about this at the end of Maggard — you don’t have to be a corp under state law. You can be an eligible entity like an LLC under state law that uses the check-the-box regs at 301.7701-3, to elect to be taxed as a corporation and then layer on top an S, or you can actually just skip the formal check the box and go straight to an S. But the point is, an LLC can elect S, as long as you’re taxed as a corp for federal tax purposes.
Beyond that, we can’t have more than 100 shareholders; that typically isn’t a problem. As shareholders, we can only have U.S. citizen or resident individuals, six types of trusts, estates, 501(c)(3) organizations. So we can’t have a nonresident alien; we can’t have a partnership; we can’t have another corporate entity. So all of that, we’re accustomed to.
But there’s this one other requirement that I think is largely misunderstood in the tax community, and there is no better way to understand what it means and doesn’t mean than this case, and that’s why I love this case. 1361(b)(1)(D) says, “An S corp can only have a single class of stock.”
So what does that mean, D? Well, we know we can have voting and nonvoting shares. What we mean when we say a single class of stock is the regulations at 1.1361-1(l) says, “Every share of stock has to confer to the holder equal rights to distribution and liquidating proceeds.” So if you and I each own 10 percent of the stock of an S corporation, our shares of stock have to give us equal rights to whatever we get in distribution, and when this S corp is ready to be done, whatever it sends out in liquidation. And so that requirement, what people think they mean is: To prove we have a single class of stock, we have to make every distribution pro rata to the penny. And if we don’t make every distribution pro rata to the penny, it’s cataclysmic; our S election just violently terminates and now we have a C corp on our hands.
But the regulations tell us, and Maggard will prove to us, that’s not really how this works. Those regs at 1361-1(l)(2), what they say is, you know how we determine if every share of stock confers equal rights to distribution and liquidating proceeds? Not by what the corporation does. What we do is we look at things like the articles of incorporation, bylaws, corporate charter, any binding agreement that relates to distribution and liquidation rights — what we collectively refer to as the governing provisions. We look at the governing provisions, and if the governing provisions confer equal rights to distribution and liquidating proceeds, then even if you do occasionally make a disproportionate distribution, it’s OK. It’s not going to terminate your election. Because what we focus on here is not how the corporation behaves, but what its governing provisions say. And I don’t think a lot of people really appreciate that distinction.
And it is a fascinating distinction because what it means is if we have clean governing provisions, and we’re about to find this out in Maggard for sure, clean governing provisions where everyone gets equal rights, even if you not only make a mistake but apparently engage in some pretty egregious behavior, it doesn’t blow your S election. However, the opposite fact pattern is where you need to be concerned, and maybe we’ll talk about it after Maggard: What if you have bad governing provisions? Then in that case, even if you make every distribution pro rata to the penny, your S election has terminated.
That all sets the stage for the facts in Maggard. And they’re not complicated facts. They are very unfortunate facts, but they’re not complicated facts. Maggard owned an S corporation with a buddy of his in the early 2000s, and really simple. It was an inc under state law, I believe California state law, and they had articles of incorporation and bylaws, and every one of those items, everything that would be called a governing provision, just said, “Look, these are all shares of one class of stock. Everyone has equal rights to distribution and liquidating proceeds. One class, that’s all there is to it.” Fair enough.
So eventually Maggard, his one shareholder leaves the S corporation, I don’t know, around that 2007-2008 range, whatever it may have been. And he brings in two guys that he had known, I guess for a while, to be 60 percent total shareholders. So Maggard owns 40 percent, they own 60 percent, and one of them is going to control the books and the tax returns.
Not a great idea, didn’t really work out. Generally speaking, you probably don’t want to give control of the books and majority interest to new people, even if you’ve known them your whole life because things turn bad real quickly. Basically, they start spending corporate funds for personal reasons; they start making distributions to themselves, with Maggard getting nothing.
Eventually he realizes what’s going on, and he hires a CPA to figure out how much he’s been shortchanged, and he goes to them and says, “You guys owe me some money.” And at that point, they really just shut him out of everything. They stopped filing tax returns, which isn’t good, but is very relevant to this fact pattern. They stop letting him come to board meetings, he has no access to the books, and they basically just start taking out a bunch of cash for themselves, with our buddy Maggard here getting nothing.
So he eventually sues them in court and they settle, and they agreed to buy his stock. And so he’s going to get out of this thing clean, or so he thinks. But as I mentioned, over those years, I think it was ’14, ’15, ’16, over those years, he’s not getting tax returns, they’re not filing returns. But Maggard’s a conscientious guy; he wants to be able to file his individual return. Well, as a shareholder in an S corp, we know that you cannot file your individual return unless you reflect your share of the S corp’s income.
And so he actually goes to these people who have done him quite dirty and says, “I need to know, I need to know what my share is of the corporation’s activities for these years.” And you read it same as I did, buddy. Quite literally, they wrote it down on a napkin and said, “$300,000 loss for one year. $50,000 loss for another year.” And I think for the third year, they actually didn’t even give him any information; he just went with zero.
So he files his tax returns reflecting those loss amounts that they said he had been allocated. And so then he sells his stock, he thinks he’s finally washed his hands of this whole situation, and who comes knocking at the door? The IRS. And what the IRS is saying is, “Hey, your buddies there at that S corp, they finally got around to filing those tax returns. And when they did, your K-1s, they don’t show losses. What they show is income. And so you owe us some tax.” And here Maggard and his attorneys made the same argument that I would make; they made an argument that I’ve been really hoping to see at some point to understand how this might work. And I think what you’re going to hear is going to surprise a lot of people.
But the court took a look because Maggard said, “Hey, you want tax? It’s not coming from me; it’s coming from the corporation. Why? Because when the shareholders started taking distributions out without me being involved, without me getting my fair share, when they went through this pattern of behavior over a number of years, where 60 percent of shareholders were getting distributions, and me, 40 percent, I wasn’t getting anything, that created a second class of stock. And as a second class of stock, it terminated our S election, and this isn’t an S corp anymore; it’s a C corp. So if you want your tax, go knock on the door of the corporation and get the tax from the C corporation.” A very compelling argument.
And the Tax Court agreed that — maybe they didn’t think it was a compelling argument, but it was a compassionate argument — they agreed that like, “Hey, we know this is tough for you. None of this has been very fair, but we are beholden to the law, and the law requires us to look here at the regulations and say, ‘What does it mean to have a second class of stock?'” And in doing that, they said, the regs at 1361-(1)(l)(2) says, “Don’t worry about how the corporation behaves. Look at the governing provisions.”
And so when they looked at those governing provisions, as I said earlier, there was nothing there, nothing to suggest there were multiple classes of stock. Whether it was state law rights, whether it was the governing provisions themselves, everything conferred equal rights to distribution and liquidating proceeds. And so the fact that the corporation didn’t make proportionate distributions, even though that pattern was long-standing and egregious, did not terminate the S election. So after all that, we can come back to what I said was the third interesting thing about this case, which is the irony.
And the irony is that 30,000 times a year, S elections terminate when people don’t want them to terminate, and here we’ve got a case where someone is begging for the election to have terminated, and the court is saying, “Didn’t terminate. It stays intact.” And I don’t know, man, this one is tough for me, D, because remember about S corps, unlike partnerships, you have no flexibility in how you allocate income. It’s per share, per day. And so if you’re allocating income pro rata, but you’re not making distributions pro rata, the economics are entirely out of whack. And I understand what the regs say about governing provisions, but don’t you think there should be a point of no return, a point where a pattern is so egregious, a pattern is so long-standing, that maybe it creates almost like an implicit governing provision, or something like that? Or even if you don’t want to use a governing provision, there’s other reg sections that talk about, “If you’re doing this or this or this, like issuing warrants or options, or excess comp, if you’re doing it with a principal purpose to avoid the single class of stock rule, it will terminate your S election.”
Boy, it feels like in a fact pattern like this, maybe there should have been some relief for poor Maggard, but the takeaway for the public is that in Rev. Proc. 2022-19, the IRS told us, “If you have clean governing provisions and make disproportionate distributions, don’t bother us for a private letter ruling because you don’t need one, your election hasn’t terminated.” And boy has that been reinforced in this Maggard case, because quite honestly, if the pattern here didn’t cause the court to say, “This is a second class of stock, this has this evil motive to circumvent the rules,” I don’t know what would. And so it’s just a reality that I think a lot of people may not appreciate around the S corp world, which is, you can make disproportionate distributions, apparently almost criminally, and it will not terminate your election, as long as your governing provisions are OK.
Damien Martin: Yeah, it’s quite fascinating. And again, I think it really helps to reinforce and understand that. As you were going through the relief rev. procs, and understanding that. But it probably does, again, and I always look at it through the lens of practitioner and working with people, and as you said, there are so many S corporations that do get filed, it goes back to, “OK, if…” Again, as a tax practitioner, you form relationships with the clients and those that you’re helping, and you think, “OK, well, we want to make sure we’re preserving our S election, but maybe to that end, we take a look and make sure we revisit and we understand what those governing provisions are.”
Tony Nitti: Yeah.
Damien Martin: Because maybe to your point that in the absence of something changing in that front, of saying that maybe we should have this — the fact that you’re operating as if your governing provisions were really something different, that well then maybe you should change your governing provisions. You know what I mean? To actually protect yourself. So again, just word for the wise there, right?
Tony Nitti: Yeah, no, you’re absolutely right. And again, what Maggard tells us is that apparently if your governing provisions are clean, you can do a whole lot from a disproportionate distribution perspective. But the public needs to appreciate what we were saying before, the opposite situation, if your governing provisions aren’t clean, if they’re not identical, it doesn’t matter. It doesn’t matter if you’ve made every distribution pro rata on the penny; you have a big problem on your hands. And this is where people might be like, “Well, Tony, Damien, when am I going to have a governing provision for an S corp that says I have preferred and common stock?” Right? It doesn’t make sense because everyone’s getting their pro rata share of income. So why would I have different classes of stock for a state law corporation? You’re not going to, for a state law corporation.
But that’s not what we’re seeing, right, in the marketplace. What are we seeing for all these S corps lately? They’re not state law incs; they’re state law LLCs. And I’ve given this public service announcement more times that I can count at this point, D, I might as well do it one more time. If you have a state law LLC that is elected S, history has taught me that you have better than coin flip odds that you have a problem on your hands. And why? Because, D, an LLC doesn’t have articles of incorporation or bylaws, or a corporate charter. What is the binding agreement that an LLC has that relates to its distribution and liquidating proceeds? Damien, you tell me.
Damien Martin: Yeah. An operating agreement there typically, right?
Tony Nitti: Yep. You’ve got an operating agreement, and operating agreements are crafted by attorneys. And when the attorneys are drafting that operating agreement, they may know that the entity is going to operate as an S, they might not. And so they might prepare for the eventuality that that LLC is going to actually operate as a partnership. And what partnerships can do that S corps can’t is make special allocations. But if you want special allocations to be respected, what you typically do is you want to comply with what we call the substantial economic effect safe harbor, of the regs at 1.704-(1)(b)(2). And to do that, those regs say certain language has to be in your operating agreement. And if you think about every operating agreement you’ve ever seen, other than those with targeted capital counts, they all have this boilerplate. Number one, we’re going to maintain capital accounts in accordance with the rules of 704(b), and that just means you put it in property, it goes up by fair market value. You take it down, it goes down by fair market value, depreciation’s allocated a certain way and computed a certain way, fine.
But then second, liquidating distributions have to be made in accordance with those end result final balances of your 704(b) capital accounts. And so that language is present in almost every operating agreement you look at. But here’s the thing: While that language is awful nice, if you’re going to operate as a partnership and make special allocations, the second you elect S, the mere presence of that language in your operating agreement terminates your S election, it’s gone. It is not a valid S election because by definition, that 704(b) maintenance language, and liquidating distributions in accordance with 704(b), does not confer equal rights to distribution and liquidating proceeds.
And you don’t have to take this from me and you, Damien. Anyone listening, the IRS has issued probably 50 private letter rulings in the last half decade about this issue, and they got so tired of issuing private letter rulings, that in October of ’22, they gave us Rev. Proc. 2022-19, and section 3.06 of that rev. proc. says, “If you have this nonidentical governing provision problem, we want you to be able to fix it without a private letter rule.”
And so if you’ve got an operating agreement in a drawer somewhere for an S corp client, and you pull it out today and you see that you have this language, you see a bunch of numbers that start with seven, that’s a bad start. And so what you then want to do is flip open section 3.06 of Rev. Proc. 2022-19, and hope that you can fix it not only without PLR, but without even having to mail anything to the Service. You just gather a couple statements, and you fix the language in your operating agreement.
But one of the reasons I compel people to look and find and flush out these problems as soon as you can, is because the fine print of 3.06 says, “If you have actually made any disproportionate distributions, whether real or constructive,” like maybe you paid personal expenses on behalf of a shareholder, which happens constantly, “You can’t use the relief procedure to fix it for free.” And so the minute you can’t use it for free, you’re in PLR land, which is going to cost you $38,000.
And so I keep imploring people around the country when I do conferences and stuff, just kick the tires, do your own audit on the S election to flush out these problems, because most of the relief procedures that exist, whether it’s Rev. Proc. 2013-30 or 2004-35, or 2022-19, they have limits to their generosity. Whether it’s time limits, whether it’s action limits, like here, but find it and fix it before it costs you a private letter rule. That’s what we tell people all the time.
Damien Martin: We got to keep on going here. We’ve got Estate of Thomas Fry; it’s T.C. Memo. 2024-8. Last January, January 14, and here we’ve got the Tax Court holding in favor of our taxpayer, so at least we got that going for us here. And avoiding, I guess we’ll say, because I can’t avoid the bad tax dad jokes here or puns, allowing maybe to avoid wasting his deductions, and of course, he was in a waste processing business. We’re looking at basis issues again here, but I guess on a S corporation’s context. So let’s walk through all of that again. Let’s take what we did in Surk and get it over to the S corps.
Tony Nitti: One of the reasons I wanted to talk about this one is because I know I’m starting to sound like a bad human because the other cases all went against the taxpayer, and I said I agreed with the decision. What’s interesting is this one, as you pointed out, goes for the taxpayer, and it’s not that I don’t agree with it, it’s just I had to read it several times, knowing what I know about the evolution of the S law and how things work, I had to read it several times to figure out how did this work out for this taxpayer? How did it happen, and what does it mean for us going forward, because it’s really interesting?
All right, so let’s lay down some law if it’s OK, before we get into the facts, because —
Damien Martin: Please do.
Tony Nitti: —the law is really important here. We talked earlier about basis in a partnership, and as you said, now we’re just shifting over to this concept of basis in an S corporation, and they’re largely parallel regimes with some subtle differences. And we’re going to key in on one of those differences now, maybe it’s not so subtle, but just like with a partnership, with an S corp, base is going to go up, going to go down, and under 1366(d), losses are going to be limited to the extent that you have basis.
But when we talk about that loss limitation, we actually have two types of basis in an S corp: We have basis in our stock, and then we have basis in debt. Now, people who work with partnerships all the time, you’re familiar with section 752, and 752 is really expansive. Because of the aggregate theory of partnerships, because of partners treated as owning their slice of everything inside a partnership, partners are given basis for all of the partnership’s liabilities, bank debt, accounts payable, whatever it is, they get basis for those amounts. And it creates some complexity in the partnership world, because liabilities go up, your basis goes up, liabilities go down, your basis goes down. There’s just so much tracking that has to take place.
In the S corp world, in general, and then specific to this, things are much more simple than in the partnership world. When we say that a shareholder can have debt basis in an S corporation, and this is really the thrust of this entire case, the loan must be made directly from the shareholder up to the S corporation. That’s it.
So if an S corporation borrows from a bank, if a shareholder guarantees an S corporation’s bank debt, none of that moves the needle for an S corp shareholder. You only get basis if you reach into your pocket and make a loan directly to that S corporation. And so over the decades, buddy, people have tried any number of ways to kind of argue around that. It used to be the argument of, “I guarantee the S corp’s bank debt.” Regulations that were changed under 1366-(2), in 2014, made it very clear that guaranteeing a debt does nothing for you.
And then we often would see things related to related parties, if you will. And so just imagine a very simple situation, and it actually is the situation we’ll be dealing with here, but imagine, D, that you own two S corps, 100 percent. And one S corp’s doing well; one S corp’s not doing so well. The one that’s not doing so well is allocating losses to you. It needs cash to fund its operations, and maybe you have cash in your individual capacity, maybe you don’t, but your profitable S corporation has cash.
And so you sit there and you go, “I own 100 percent of both of these, they’re my pocketbooks, if you will. Why would I make a loan or put money into my loss corporation when I’ve got this profitable company that’s flush with cash? And so I’m just going to have that profitable company make a loan over to the loss company. And since I own 100 percent of the profitable company, it should be treated as if I am the one who made the loan, and I should get debt basis for that.”
And the courts over the years have almost universally said, “This doesn’t work.” And it doesn’t work because the statute is clear. The loan has to come directly from you and go up to the S corporation. And so we got cases in the past like Underwood, like this Meruelo case, where people have tried to pull this off, tried to make a loan from a wholly owned related party over to a loss company, and argue that it gives them basis. And the IRS has argued, and the tax courts have generally agreed, that the form matters. The form matters that you make the loan in your individual capacity up to the corporation. And so I come into this case, Estate of Thomas Fry, with that understanding, that background, that if you have related S corporations and a loan goes from one to the other, it does nothing to give you basis.
So then we get this case, and the fact pattern of this case is exactly what we described. So our guy, Thomas Fry here, he owns 100 percent of two S corps, and they’re very much interrelated. We’ve got Crown, which is this profitable S corporation that is, to the best I recall, it would gather up recyclable materials. And then we have this related S corp, that he owns 100 percent of, that we’ll call Maintenance.
So what’s happening here is things go bad for Maintenance for a couple different reasons, and it needs cash to survive. And so Thomas Fry here, he’s saying, “These two S corps, they’re my babies. I love them equally. It’s got the same, obviously, shareholder, me; it’s got the same internal team; it shares the same facilities. These are both my babies, and it’s really important to me that Maintenance continues its life here. But I’m not going to sit there and put a bunch of money in myself. I’ve got this Crown S corporation that’s profitable, that has a bunch of cash, and so I’m going to have Crown — every time Maintenance needs money, I’m going to have Crown cover those expenses.”
And so every time that happens — and we’re talking millions, tens of millions of dollars — every time that Maintenance needs money, Crown is the one footing the bill. And so when we think about it from a debits and credits perspective, on the Crown books, they are crediting cash and they’re debiting a due-from account. So we’re receivable. And then on the Maintenance books, they are debiting the expense and they are crediting a due-to. So yeah, they’re booking this as a due-to, due-from, so a loan effectively, and I don’t want to use the word loan because, we’ll see, that’s the whole thrust of the case, but they’re treating it as a loan, but there’s no documentation, there’s no instrument, there’s no formal loan agreement. But there is a due-to, due-from, on the balance sheet, on the tax returns, reflecting this as an advance, if you will, from Crown over to Maintenance.
And so we’ve already established here that Maintenance was on some hard times. It’s pushing out these big losses to Thomas Fry, and what he’s saying is, “I’ve got basis because of these loans that have been made from Crown over to Maintenance.” And of course, the first time I’m reading this case, I’m like, “This is going to be open and shut, because Underwood, because Meruelo tell us form matters. The loan has to be made directly from the shareholder up to Maintenance.” And that’s not what happened here. It was all being financed and funded by this 100-percent-owned related S corporation.
But then, turned out, I was very much wrong, the Tax Court actually rules in favor of the shareholder here, and they do it via two steps, two really interesting steps that I do think listeners will find fairly fascinating. Number one, they’re saying, “Hey, that loan, those advances from Crown to Maintenance, wasn’t really debt; it was equity. It was an equity investment.” And for anybody listening, you’re going to be like, “Well, wait a minute, you told me these were two S corporations. And so if you’re saying now that Crown made an equity investment in Maintenance, and Crown is an S corp and so is Maintenance, there’s one of those 30,000 times a year that an S election has just terminated, because you can’t have a corporate shareholder in an S corporation. And so if Crown put equity into Maintenance, we got a bigger problem.” But what the court did is they took a second step: They said, “Not only was it equity, but what it was was a constructive distribution of the amount that was advanced from Crown to Maintenance, first to Fry, and then a contribution from him up to Maintenance.”
And so they really worked hard to help the taxpayer here. They said, “We’re going to create two” — not two fictions —”We’re going to have one interpretation and one fiction. The interpretation is that these advances that you booked and treated as receivables and payables, weren’t receivables and payables. They were actually equity from Crown to Maintenance, and then we will treat it as if Crown distributed the amounts first to the shareholder and then the shareholder then contributed it up to maintenance, and that will give you basis to use these losses.”
And so we had to deal with both parts of that analysis. And in the first part of that analysis, you’re just dealing with an age-old question, buddy, that does not have a great answer, which is: When an amount is advanced from, for example, a shareholder to a corporation, what is it, is it debt, is it equity? There’s just not a situation here where that is clear cut. We have code that tries to help us in section 385, but in this case, we didn’t even use 385. Because 385 tells us, “Hey, we’re going to issue regulations that help us determine what is debt, what is equity from a federal tax perspective.” And 385(c) very importantly says, “However the two parties treat it, they’re bound by that.” So that could have been case closed right there because the two parties clearly treated this as debt, but the taxpayers successfully argued that 385(c) doesn’t apply here, because there is no formal instrument to analyze under 385. We didn’t issue a debt instrument.
And so there’s nothing here to use these factors to look at it, to say, “Is it debt? Is it equity?” Because 385(c) is not applicable because there was no formal debt instrument, we have to go somewhere we often go in the tax law, and often on this podcast, we have to go to the judicial precedent. We have to go to factors, factors analysis that have been decided by, or established by, the Ninth Circuit, largely in a case called Hardman, where we’re going to use these 11 factors to figure out whether something is debt or equity.
And D, I don’t know where we’ve used factor tests in our podcast, I’m sure we’ve done it on dealer versus investor. We’ve definitely done it for hobby losses, right? We’ve probably done a hobby loss case, but sometimes you just lay out the factors in the tax law, and you go — keep a scorecard. Did I win? Did I lose? Did I win? Did I lose? And if you win more than you lose, you’re in good shape; you lose more than you win, it’s not going to be a happy day.
And so the factors we’re looking at, no need to list them all out, we can group them together. The biggest group they’re going to look at is just simply, where are the formalities here? If this is debt, we would expect some formal indicia of debt, we would expect an instrument, we would expect collateral, we would expect a maturity date, we would expect an interest rate. If none of those things are present, it doesn’t really feel and look like debt; it looks like equity. When you don’t have that formal indicia, it looks like equity. And then you just start looking at more like economic factors, which is if you didn’t get repaid any of this amount, did you enforce it? Because if it’s really debt, you’re going to go knocking on the door and say, “I would like my money back.”
And they said, in this case, when a couple of years have gone by — and what’s amazing about this case, by the way, we haven’t talked about, is somehow, some way, eventually it all got repaid — but what they’re saying is, if you didn’t try to get it enforced, if you didn’t press for it, then that’s not really how creditors act; creditors want to get repaid. They’ll look at, again, whether or not repayment is going to come only out of profits, because true debt holders, they expect to get repaid whether you’re profitable or not. But if you’re only going to get repaid if things go well, that looks more and sounds more like equity. And so they’re laying out all these different factors, and they’ve come to one that I like to use, which is just, would you be able, in your situation, to borrow from an independent third party, the same amounts and on the same terms that you borrowed in this situation?
And when you look at it through that lens, in this case, you’d be like, “Hey, there’s no way Maintenance, with everything it had been through, would be able to go out to a bank and borrow the amounts that it borrowed from Crown. And so this could only come from a shareholder, for example.” And so the majority of these factors, D, just said, this is equity.
And so you lay out those factors, and this is what we have to do, in a lot of cases, debt versus equity, just lay out these factors. But when you look at them, they said, “This is equity.” Which is only solving half of the problem, because what that meant now is we have equity between Crown and Maintenance, which isn’t doing anybody a lick of good, and so now we need to create a fiction. And again, it felt to me in this case, like the court was going through great pains to help the taxpayer out, which I have no problem with, it’s just there’s a lot of machinations going on here, a lot of gymnastics.
So now they had to ask a question, which I think we’re going to talk about later, instead, but this concept of, was this really an advance by Crown to Maintenance, or was this a constructive distribution from Crown to the shareholder, who then put it into Maintenance? And there, this concept of constructive distribution, we live in this space a lot in the tax world, where you don’t have to formally announce a distribution for it to be a distribution. If you’re an S corp or C corp and you pay personal expenses on behalf of a shareholder, that’s going to be a constructive distribution. If you pay somebody in the C corp context too much compensation, the IRS can reclass that excess as a constructive distribution.
And so the body of law that’s been established there, again under the Ninth Circuit, says, “When you’re trying to think about if something’s a constructive distribution, two things need to be present. One, whatever was spent at the entity level should not have been a deductible expense.” And that wasn’t the case here. Crown wasn’t deducting these items. They were crediting cash, and they were debiting due-from, so they weren’t taking a deduction.
And so then the second question is, whose benefit? Is it the corporation or is it the shareholder? And if the primary benefit goes to the shareholder, then it’s treated as a constructive distribution. And so looking at it through this back pattern, they just said, “Fry testified that these were his two babies, that he wanted more than anything for Maintenance to stay alive as long as it could. They were clearly interrelated.” And I don’t know. From my perspective, D, we talked about the relationship between the two companies. I could see how the argument can be made that Crown benefits from keeping Maintenance around, if it’s the one turning its recyclables into alfalfa. But here, they just said it was ultimately Fry who benefited the most because these were his babies, he wanted to keep them alive, and so we will treat this amount that was paid by Crown as a constructive distribution to Fry, followed by a contribution up, because he benefited, not Crown.
I don’t know what your thoughts were on this case, I’d love to hear them. It’s just living in the S corp world, it’s rare that I’m going to get that surprised by a decision, and for me, I start off by seeing a related party makes a loan, case closed, we’re done, we’re not going to get basis. We end up finding out that not a loan, equity, not an ineligible shareholder, deemed distribution followed by deemed contribution. Surprising, but curious in what you thought when you read it.
Damien Martin: Yeah. Well, I’ll give you my two reactions. One is — and this is a little something I’ve picked up, really from you, because I know you’ve played this game when you’re following the decisions as they come out — the fun game to play is to say, “All right,” after you’ve read enough of these cases, “Let’s see where this one might go.” Take a guess just by — you start reading through and it’s always telling, sometimes it’s like, “Why’d they mention that one seemingly random fact?” And then it comes back around or whatnot. Agree, you pop this one open, and it’s like, “I know where this one’s going.” Because you’ve seen it so many times and we’re always preaching on the, “Hey, we need a document and we need to have the right form and whatnot.” So there’s that.
I’ll share your level of surprise there in the outcome, but perhaps maybe then the follow-through, and this is maybe a little theme from what we were talking about earlier, is with the governing document and provisions, and knowing what those are, I mean, I think the same thing applies here. It worked out certainly, for Fry, in terms of got the answer that was favorable, in terms of being able to not get stuck with limitations on the losses, but I mean, he easily could have been there too, if the facts had landed a little bit differently. Because whenever you go through these factor tests and you’re looking at facts and circumstances, it’s not as cut and dry. So probably the practical — I always like to look at the practical, what we’re going to do as a practitioner here is, you can do things — they could have done things to have more intentionally driven how this would’ve gone in terms of documentation and the flow and the format, and thought about this on the front end. And I think that would maybe be the, “Well, what do you do with this?” Again, fascinating, really interesting how it landed, but maybe being a little bit more intentional and directive of steering your facts, setting your form, that can give you a little more comfort that that’s the answer.
Tony Nitti: Yeah. It is just so odd that this case, it almost rewards informality. Because there was no formal loan document, it almost — I don’t know where we go from here because all the previous law had been so clear, and keep in mind, they rewrote the regs in 2014 to put an end to a lot of shenanigans and say, “You need to create a bona fide debt between the shareholder and the corporation.” And I didn’t think going through these steps to create that debt would necessarily be on the Tax Court’s radar. But just interesting because like I said, had they been more formal with the loan, this probably goes very badly for the taxpayer, but by having that informality and being able to argue, “We need to go through the 11 factors of the Ninth Circuit Hardman case, to figure out if it’s truly a loan or equity, and then take that extra leap of this is a constructive distribution.”
I don’t know that I’d be eager to use this as precedent in the future if I had this fact pattern. I don’t know, to me, it feels a little bit anomalous at this point. But to your point, the lesson for S corp shareholders is be more intentional. You want to do this, take a distribution out of Crown and make the loan or put the cash into Maintenance. Create a bona fide debt between the shareholder and the corporation. Don’t rely on one interpretation and one fiction to get you where you want to be.
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