The IRS utilizes a variety of equitable doctrines to recast transactions for tax purposes, including step transaction, substance over form, economic substance, and sham transaction, and they are quite effective for unwinding efforts to escape tax. State and local tax authorities utilize these doctrines as well. While taxpayers may think that turnabout is fair play, the doctrines don’t work that way, as was illustrated by the Tax Court last week. See Messina v. Comm’r, Nos. 25510-15 & 25567-15, T.C. Memo 2017-213, 2017 Tax Ct. Mem. LEXIS 214 (Oct. 30, 2017).
Messina involved two taxpayers, Mr. Messina and Mr. Kirkland, who each owned a 40% interest in an S corporation. Under the Internal Revenue Code, an S corporation is a pass-through vehicle; for any particular tax year, each shareholder’s gross income includes “the shareholder’s pro rata share of the corporation’s—(A) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and (B) nonseparately computed income or loss.” I.R.C. § 1366(a)(1). While losses sustained by an S corporation pass through to its owners, there is a limit: A shareholder can only deduct a loss associated with an ownership interest in an S corporation to the extent she has basis in her stock or in “any indebtedness of the S corporation to the shareholder.” I.R.C. § 1366(d)(1)(A), (B).
The S corporation was known as Club One, and in early 2008, it acquired a corporation that operated a casino. 2017 Tax Ct. Mem. LEXIS 214, **2, **7-**8. The casino operator became a qualified subchapter S subsidiary or “Qsub” of Club One. While a Qsub retains its separate legal identity for a variety of purposes, it is disregarded for tax purposes, and its assets, liabilities and tax items are treated as assets, liabilities and tax items of its parent. I.R.C. § 1361(b)(3)(A)(ii).
Club One financed the acquisition of the casino operator with a loan from a partnership affiliated with D. B. Zwirn & Co., a hedge fund, and after the acquisition was complete, the Qsub became the borrower under the loan. Messina, 2017 Tax Ct. Mem. LEXIS 214, **9. Subsequently, the partnership holding the Qsub’s loan was taken over by Fortress Investment Group, another investment management firm. Id. at **11-**12.
In early 2010, Messina and Kirkland began to seek investors who would either acquire or refinance the Qsub’s loan from Fortress. Id. at **12. At or about the same time, Messina informed Fortress that the Qsub was likely to violate one of its loan covenants, which required it to maintain a certain minimum level of cash flow measured on the basis of its earnings before interest, taxes, depreciation, and amortization. Id. at **12-**13. In an effort to resolve this problem, in early 2011, Messina and Kirkland formed a California corporation, KMGI, to either refinance or acquire the Qsub’s loan. Id. KMGI elected to be treated as an S corporation. Unable to find outside investors, Messina and Kirkland loaned KMGI the funds to acquire the loan from Fortress. Id. at **15. Their decision to proceed in this fashion, rather than lending the funds to Club One or its Qsub, would have significant consequences.
The KMGI completed the acquisition of the loan from Fortress in early 2012 in return for a payment of approximately $14.475 million. The Qsub made a loan payment to KMGI in May of 2011, the bulk of which was disbursed to Messina and Kirkland. Id. at **19. At that point, KMGI still owed Messina and Kirkland slightly more than $14 million, and each of them treated one-half of this amount as their basis in Club One indebtedness, rather than as their basis in KMGI stock. Id. at **20.
For 2012, Club One reported an operating loss of $1,425,709; Messina and Kirkland each claimed $570,284 of that loss. Id. at **2. They each also claimed charitable deductions of over $15,000 that flowed through to them from Club One. Id. The claim for the loss and the charitable deduction was dependent upon the position that Messina and Kirkland each had a basis in Club One indebtedness of over $7 million. Id. at **3. The IRS did not accept that treatment, and it reduced the amount of the loss that Messina and Kirkland could claim and assessed them with additional tax. Id. at **4-**6.
After summarizing the posture of the case, the Tax Court commenced its analysis by focusing on the limitation of losses under section 1361(d)(1), which permits a shareholder to deduct losses only to the extent of basis in either S corporation stock or indebtedness of the S corporation to the shareholder. The government argued that basis in an S corporation could be acquired either by a capital contribution or by a direct loan. Id. at **28. For their part, Messina and Kirkland conceded that the case law called for a direct loan, but argued that the court should focus not merely on the form of the transaction but on its substance. Id. at **29-**30. While this was a clever approach, it was not a successful one.
First, the taxpayers argued that KMGI was nothing more than an incorporated pocketbook, invoking caselaw suggesting that the use of a corporate entity to make payments to an S corporation on behalf of a shareholder can be treated as a direct payment from the shareholder to the S corporation. The Tax Court rejected this argument because the relevant case law involved habitual payments, not a single payment. Id. at **32-**34.
Next, the taxpayers argued that KMGI had acted as their agent in acquiring the loan from Fortress. To test this thesis, the Tax Court applied a nine-factor test derived from Commissioner v. Bollinger, 485 U.S. 340 (1988) and National Carbide Corp. v. Commissioner, 336 U.S. 422 (1949), and the court concluded that KMGI was not the taxpayers’ agent. 2017 Tax Ct. Mem. LEXIS 214 at **38. The only evidence providing any support for an agency relationship was the fact that KMGI had promptly distributed its receipts to Messina and Kirkland. Since it was under no legal obligation to do so, the Tax Court viewed this factor as neutral at best. Id. at **39.
The taxpayers then argued that KMGI had not made an actual economic outlay to purchase the loan from Fortress because they loaned it the money to do so. The Tax Court viewed this contention as merely rehashing prior arguments it had already rejected. Id. at **45. And the taxpayers were not helped by the fact that KMGI had reclassified their loans as additional paid-in capital. Id.
Finally, Messina and Kirkland argued that the step transaction doctrine should apply, permitting the court to ignore the fact that KMGI was technically the holder of the loan. The Tax Court, however, rejected the effort, noting that this was “yet another permutation of their other theories of which we have disposed.” Id. at **47. The court also observed that “taxpayers are bound by the form of their transaction and may not argue that the substance triggers different tax consequences.” Id. at **48 (citations omitted). As the court explained, “[t]axpayers have the benefit of forethought and strategic planning in structuring their transactions, whereas the Government can only retrospectively enforce its revenue laws.” Id. at **48-**49 (citing Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465 (1935)).
Having planned badly, Messina and Kirkland were saddled with the tax consequences of the transaction they created. The broader lesson is that absent very unusual circumstances, taxpayers should not rely on equitable doctrines to sustain their tax position.