I was talking with a financial advisor from Wells Fargo recently.
No, it was not about personal investments. He advises some heavy-hitting clients, and he was bouncing tax questions off me.
The topic of entrepreneurial money came up, and I mentioned that I still prefer the S corporation, although LLCs have made tremendous inroads over the last decade-plus.
The reason is that S corporations have a longer – and clearer – tax history. One can reasonably anticipate the tax predicaments an S can get itself into. The LLCs – by contrast - are still evolving, especially in the self-employment tax area.
But predictability is a two-edged blade. Catch that S-corporation knife wrong and it can cost you big-time.
One of those falling knives is when the S corporation expects to have losses, especially over successive years.
Let’s take a look at the Hargis case.
Let’s say you buy and renovate distressed nursing homes. You spend cash to buy the place, then pay for renovations and upgrades, and then – more likely than not – it will still be a while before full-occupancy and profitability.
Granted, once there it will be sweet, but you have to get there. You don’t want to die a half mile from the edge of the desert.
Here is the flashing sign for danger:
26 U.S. Code § 1366 - Pass-thru of items to shareholders
(d) Special rules for losses and deductions
(1) Cannot exceed shareholder’s basis in stock and debt The aggregate amount of losses and deductions taken into account by a shareholder under subsection (a) for any taxable year shall not exceed the sum of—
(A) the adjusted basis of the shareholder’s stock in the S corporation (determined with regard to paragraphs (1) and (2)(A) of section 1367(a) for the taxable year), and
(B) the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder (determined without regard to any adjustment under paragraph (2) of section 1367(b) for the taxable year).
An S corporation allows you to put the business income on your personal tax return and pay tax on the combination. This sidesteps some of the notorious issues of a C corporation – more specifically, its double taxation. Proctor & Gamble may not care, but you and I as a 2-person C corporation will probably care a lot.
Planning for income from an S is relatively straightforward: you pay tax with your personal return.
Planning for losses from an S – well, that is a different tune. The tax Code allows you to deduct losses to the extent you have money invested in the S.
It sounds simple, doesn’t it?
Let’s go through it.
Your stock investment is pretty straightforward. Generally, stock is one check, one time and not touched again.
But you can also invest by lending the S money.
OBSERVATION: How is this an “investment” you ask. Because if the S fails, you are out the money. You have the risk of never being repaid.
But it has to be done a certain way.
That way is directly from you to the S. I do not want detours, sightseeing trips or garage sales en route. Here there be dragons.
Hargis did it the wrong way.
What initially caught my eye in Hargis was the IRS chasing the following income:
- $1,382,206 for 2009, and
- $1,900,898 for 2010
Tax on almost $3.3 million? Yeah, that is going to hurt.
Hargis was rocking S corporations. You also know he was reporting losses, as that is what caught the IRS’ eye. The IRS gave him a Section 1366 look-over and said “FAIL.”
Hargis’ first name was Bobby; his wife’s name was Brenda. Bobby was a nursing home pro. He in fact owned five of them. He stuck each of his nursing homes in its own S corporation.
The tax advisor also had Bobby separate the (nursing home) real estate and equipment from the nursing-home-as-an-operating business. The real estate and equipment went into an LLC, and the LLC “leased” the same back to the S corporation. There were 5 LLCs, one for each S.
Again, standard planning.
Bobby owned 100% of the five nursing homes.
Brenda was a member in the LLCs. There were other members, so Brenda was not a 100% owner.
The tax problem came when Bobby went out and bought a nursing home. He favored nursing homes down on their luck. He would buy at a good price, then fix-up the place and get it profitable again.
Wash. Rinse. Repeat.
But it took money to carry the homes during their loss period.
Bobby borrowed money:
(1) Sometimes he borrowed from the LLCs
(2) Sometimes he borrowed from his own companies
(3) Sometimes he borrowed from a bank
Let’s discuss (1) and (2) together, as they share the same issue.
The loan to the S has to be direct: from Bobby to the S.
Bobby did not do this.
The loans were from the other companies to his S corporations. Bobby was there, like an NFL owner watching from his/her luxury box on Sunday. Wave. Smile for the cameras.
Nope. Not going to work.
Bobby needed to lend directly and personally. Didn’t we just say no detours, sightseeing trips or garage sales? Bobby, the loan had to come from you. That means your personal check. Your name on the personal check. Not someone else’s name and check, no matter how long you have known them, whether they are married to your cousin or that they are founding team owners in your fantasy football league.
What part of this are you not understanding?
Fail on (1) and (2).
How about (3)?
There is a technicality here that hosed Bobby.
Bobby was a “co-borrower” at the bank.
A co-borrower means that two (or more) people borrow and both (or more) sign as primarily liable. Let’s say that you and I borrow a million dollars at SunTrust Bank. We both sign. We are co-borrowers. We both owe a million bucks. Granted, the bank only wants one million, but it doesn’t particularly care if it comes from you or me.
I would say I am on the hook, especially since SunTrust can chase me down to get its money. Surely I “borrowed,” right? How else could the bank chase me down?
Let’s get into the why-people-hate-lawyers weeds.
Bobby co-borrowed, but all the money went into one of the companies. The company paid any interest and the principal when due to the bank.
This sounds like the company borrowed, doesn’t it?
Bobby did not pledge personal assets to secure the loan.
Bobby argued that he did not need to. Under applicable state law (Arkansas) he was as liable as if the loan was made to him personally.
I used to like this argument, but it is all thunder and no rain in tax-land.
Here is the Raynor decision:
[n]o form of indirect borrowing, be it guarantee, surety, accommodation, comaking or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation. Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.”
Bobby does not have the type of “debt” required under Section 1366 until he actually pays the bank with some of his own money. At that point, he has a subrogation claim against his company, which claim is the debt Section 1366 wants.
To phrase it differently, until Bobby actually pays with some of his own money, he does not have the debt Section 1366 wants. Being hypothetically liable is not the same as being actually liable. The S was making all the payments and complying with all the debt covenants, so there was no reason to think that the bank would act against Bobby and his “does it really exist?” debt. Bobby could relax and let the S run with it. What he could not do was to consider the debt to be his debt until his co-borrower (that is, his S corporation) went all irresponsible and stiffed the bank.
COMMENT: Folks, it is what it is. I did not write the law.
Bobby failed on (3).
The sad thing is that the tax advisors could have planned for this. The technique is not fool-proof, but it would have looked something like this:
(1) Bobby borrows personally from the bank
(2) Bobby lends personally to his S corporation
a. I myself would vary the dollars involved just a smidge, but that is me.
(3) Bobby charges the S interest.
(4) Upon receiving interest, Bobby pays the bank its interest.
(5) Bobby has the S repay principal according to a schedule that eerily mimics the bank’s repayment schedule.
(6) Bobby and the S document all of the above with an obnoxious level of paperwork.
(7) Checks move between Bobby’s personal account and the business account to memorialize what we said above. It is a hassle, but a good accountant will walk you through it. Heck, the really good ones even send you written step-by-step instructions.
Consider this standard CTG planning for loss S Corporations with basis issues.
The IRS could go after my set-up as all form and no substance, but I would have an argument – and a defensible one.
Hargis gave himself no argument at all.
He owed the IRS big bucks.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.