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Eleventh Circuit Holds Shareholder Did Not Have Basis in Indirect Loans to S Corp

(Parker Tax Publishing May 2019)

The Eleventh Circuit affirmed a Tax Court decision holding that monetary transfers between various business entities partly owned by a taxpayer and an S corporation, which were later classified as loans from the taxpayer to the S corporation, did not constitute bona fide indebtedness running directly to the taxpayer. The Eleventh Circuit agreed with the Tax Court that year-end adjustments by the taxpayer's CPA to a notional line of credit did not suffice to create indebtedness to the taxpayer where none in fact existed and rejected the taxpayer's arguments that the S corporation's debt ran directly to him under a back-to-back loan theory or, alternatively, under the incorporated pocketbook rule. Meruelo v. Comm'r, 2019 PTC 179 (11th Cir. 2019).

Homero Meruelo is a south Florida real estate developer who owns interests in several S corporations, partnerships, and LLCs. One of these entities was Merco of the Palm Beaches, Inc. (Merco), an S corporation incorporated in 2004. Meruelo held 49 percent of Merco's stock. Meruelo incorporated Merco to purchase a condominium complex in a bankruptcy sale. To raise funds for his share of the purchase, Meruelo obtained a personal loan of $4.9 million and transferred the loan proceeds to Merco Group of Akoya (Akoya), an S corporation in which he and his mother each held a 50 percent interest. Akoya transferred the proceeds it received from Meruelo to Merco's escrow account.

From 2004 to 2008, Merco entered into hundreds of transactions with various entities in which Meruelo held an interest. These Merco affiliates often paid expenses, such as payroll costs, for each other or for Merco to simplify accounting and enhance liquidity. The payors recorded these payments as accounts receivable and the payees recorded them as accounts payable. Between 2004 and 2008, Merco affiliates made more than $15 million in payments to, or on behalf of, Merco. Merco repaid its affiliates less than $6 million of these payments. On December 31 of each year, Merco's books and records showed substantial net accounts payable to the affiliates.

Luis Carreras, a CPA, prepared the tax returns filed by Meruelo, Merco, and the Merco affiliates. When preparing Merco's tax return for a given year, Carreras would net Merco's accounts payable to its affiliates, as shown on the books as of the preceding December 31, against Merco's accounts receivable from its affiliates. If Merco had net accounts payable, Carreras reported that amount as a "shareholder loan" on Merco's tax return. Carreras then allocated a percentage of this debt to Meruelo based on Meruelo's ownership interests in the various affiliates that had transferred funds to Merco. In March 2004, Carreras drafted a promissory note for Meruelo purportedly to make a $10 million unsecured line of credit available to Merco at a 6 percent interest rate. When preparing Meruelo's and Merco's tax returns for tax years 2004 to 2008, Carreras made an annual charge to Merco's line of credit for Meruelo's share of Merco's net accounts payable to its affiliates for the preceding year.

In 2008, Merco incurred a loss of $26.6 million when banks foreclosed on the condominium complex it purchased in 2004. Merco reported the loss on its income tax return, and Merco allocated 49 percent of the loss to Meruelo. On his 2008 return, Meruelo claimed an ordinary loss deduction of $11.7 million, reflecting a $13 million flow-through loss from Merco (49 percent of Merco's $26.6 million loss on the foreclosure). After an examination of Meruelo's returns, the IRS determined that his basis in Merco was limited to the $4.9 million loan he contributed to Merco through Akoya. It disallowed, for lack of sufficient basis, $8 million of Meruelo's $13 million flow-through loss for 2008, resulting in a tax deficiency of $2.6 million. Meruelo petitioned the Tax Court for determination of the deficiency, but the Tax Court agreed with the IRS and upheld the deficiency. Meruelo appealed to the Eleventh Circuit.

Reg. Sec. 1.1366-2(a)(2) limits an S shareholder's debt basis to bona fide indebtedness of the S corporation that runs directly to the shareholder. Meruelo contended that Merco's debt ran directly to him under a back-to-back loan theory. Meruelo cited Reg. Sec. 1.1366-2(a)(2)(iii), Example 2, which describes a transaction in which an affiliated entity loans the shareholder funds that he then loans directly to the S corporation and states that a genuine back-to-back loan can establish bona fide indebtedness running directly to the shareholder. Meruelo's other argument was that the debt ran directly to him under an incorporated-pocketbook theory. That theory holds that a taxpayer can obtain debt basis in an S corporation through payments made by a wholly owned corporate entity if that entity functions as the shareholder's incorporated pocketbook, meaning that the taxpayer has a habitual practice of having the wholly-owned corporation pay money to third parties on the shareholder's behalf.

The Eleventh Circuit rejected both of Meruelo's theories. The court found that taxpayers are ordinarily bound by the form of their transactions and may not argue that the substance triggers different tax consequences. Only an unusual set of facts can warrant judging a transaction based on its substance rather than its form, the court explained, and this case hardly presented such an unusual set of facts. The court also found that Carreras's year-end reclassification of the intercompany transfers, as reflected on Meruelo's tax returns and on the annual adjustments to the line of credit from the 2004 note, were insufficient to establish that the transactions amounted to shareholder loans. In the court's view, because the transactions were contemporaneously classified as transactions between the affiliates and Merco, the designation Carreras gave them at the end of the year did not govern. The Eleventh Circuit agreed with the Tax Court that Carreras's adjustments to a notional line of credit, uniformly made after the close of each relevant tax year, did not suffice to create indebtedness to Meruelo where none in fact existed.

The Eleventh Circuit also held that Meruelo failed to establish that the Merco affiliates constituted his incorporated pocketbook. The court explained that in cases where the incorporated pocketbook rule applied, the shareholders habitually used a single, wholly owned entity to pay third parties on the shareholder's behalf. The court said that in this case, Meruelo sought to treat eleven distinct Merco affiliates, many of which he only partially owned, as his incorporated pocketbook, even though these affiliates acted more like ordinary business entities by both disbursing and receiving funds for business expenses from Merco. The court also found that Meruelo failed to establish that he habitually paid third parties through the supposed incorporated-pocketbook companies.

For a discussion of a shareholder's basis in S corporation debt, see Parker Tax ¶32,840.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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