Supreme Court Won't Review Case Denying Basis For Capital Contributions To S Corporations

Nathel, (CA 2 06/02/2010) 105 AFTR 2d 2010-2699 cert denied 04/25/2011

Last year, the Court of Appeals for the Second Circuit, affirming the Tax Court, held that shareholders' capital contributions to S corporations did not constitute income to the entities and did not restore or increase their tax basis in their loans to the S corporations. Subsequently, the shareholders asked the Supreme Court to review the case but it has now declined to do so.

Background. Generally, under Code Sec. 1367 a shareholder's tax basis in the stock in, and in the loans to, an S corporation are adjusted to reflect the shareholder's share of income, losses, deductions, and credits of the S corporation, as calculated under Code Sec. 1366(a)(1). Under Code Sec. 1367(a)(1), a shareholder's tax basis in his S corporation stock is increased by, among other things, the shareholder's share of the S corporation's income items (including tax-exempt income).

Under Code Sec. 1367(a)(2), a shareholder's tax basis in his S corporation stock is decreased (but not below zero) by, among other things, the shareholder's share of losses and deductions. If a shareholder's tax basis in his S corporation stock is reduced to zero by his share of the losses of the S corporation, any further share of the S corporation's losses decreases, but not below zero, the shareholder's tax basis in outstanding loans the shareholder has made to the S corporation. (Code Sec. 1367(b)(2)(A), Reg. §1.1367-2(b)(1)) If the shareholder's basis in debt was so reduced, any net increase in basis in a subsequent tax year is first applied to restore the shareholder's basis in debt before it is applied to restore the shareholder's basis in stock. (Code Sec. 1367(b)(2)(B))

Observation: As a result of these rules, a shareholder's tax basis in loans the shareholder has made to an S corporation may be lower than their face amount or zero because of downward adjustments in such basis caused by losses of the S corporation that are passed through to the shareholder.

Facts. In calculating ordinary income relating to $1,622,050 in loan payments received from two S corporations, for purposes of Code Sec. 1366(a)(1), shareholder brothers Ira and Sheldon Nathel treated $1,437,248 in capital contributions that they had made to the S corporations as income to the entities (excludable under Code Sec. 118) that under Code Sec. 1367(b)(2)(B) restored or increased their tax basis in the loans that they had previously made to the S corporations. The brothers then used the restored or increased tax basis in these loans to offset ordinary income that otherwise would have been reportable by them on their receipt from the S corporations of the $1,622,050 loan payments.

On audit, IRS determined that the $1,437,248 capital contributions couldn't be treated as restoring or increasing the brother's tax basis in their loans to the S corporations. Rather, the contributions increased their basis in their S stock, resulting in additional ordinary income being charged to them on receipt of the S corporation loan payments.

The Tax Court held that for purposes of Code Sec. 1366(a)(1), the $1,437,248 capital contributions to the S corporations did not constitute income to the S corporations and that under Code Sec. 1367(b)(2)(B), these capital contributions did not restore or increase the brother's tax basis in their loans to the S corporations. Reg. §1.118-1 specifically provides that capital contributions do not constitute income to an S corporation. Nor, the Court found, were the capital contributions tax exempt income.

The Court reasoned that by attempting to treat their capital contributions to the S corporations as income to the S corporations, Ira and Sheldon in effect sought to undermine three cardinal and longstanding principles of the tax law: (1) that a shareholder's contributions to the capital of a corporation increase the basis of the shareholder's stock in the corporation; (2) that equity (i.e., a shareholder's contribution to the capital of a corporation) and debt (i.e., a shareholder's loan to the corporation) are distinguishable and are treated differently by both the Code and the courts; and (3) that contributions to the capital of a corporation do not constitute income to the corporation.

Appeals Court decision. Before the Second Circuit, the brothers argued that capital contributions constitute “items of income (including tax-exempt income)” for purposes of Code Sec. 1366(a)(1)(A). The Court observed that they made this argument even though Code Sec. 118(a) provides that gross income does not include capital contributions. The Court said that it knew of no case that has decided whether capital contributions constitute income items under Code Sec. 1366(a)(1)(A). However, cases addressing the scope of income under Code Sec. 61(a) and the Sixteenth Amendment indicate that capital contributions traditionally have not been considered income. Therefore, the Court said, they should not be considered “items of income” under Code Sec. 1366(a)(1)(A).

The brothers argued that capital contributions should be regarded as items of tax-exempt income. According to them, there would be no reason to exclude capital contributions from gross income as Code Sec. 118(a) does if they were not already included in gross income under Code Sec. 61(a). The Court rejected this view. It stressed that capital contributions traditionally have not been included in gross income in the first instance. The fact that Code Sec. 118(a) explicitly excludes them does not transform them into “items of income” for purposes of Code Sec. 1366(a)(1)(A). The legislative history showed that Congress did not consider capital contributions to be generally includible in gross income when it created the exclusion. Accordingly, the Second Circuit affirmed the judgment of the Tax Court.

Case now over. The Supreme Court has now declined to review the case. Accordingly, the decision of the Second Circuit stands.

References: For how S corporation shareholders are taxed, see FTC 2d/FIN ¶D-1761 et seq.; United States Tax Reporter ¶13,664; TaxDesk ¶614,701; TG ¶4771.