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									AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
                              Comments on
  S Corporation Shareholder Basis in Indebtedness and Back-to-Back Loans



                            Developed by the

                      Back-to-Back-Loan Task Force

                           Stewart Karlinsky
                             Horacio Sobol
                            Sydney Traum
                             Kevin Walsh
                   Marc A. Hyman, Technical Manager



                             Approved by the


             S Corporation Taxation Technical Resource Panel

                                 and the

                        Tax Executive Committee




                              Submitted to

                   The U.S. Department of the Treasury
                      The Internal Revenue Service


                              May 29, 2009
          AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

            Pre-Release Comments on S Corporations and Back-to-Back Loans

                                          May 29, 2009

I.     Introduction

These comments include a brief review of the ―back-to-back‖ loan issue, the relevant statutory
and regulatory law, selected and brief case analysis, and a suggested regulatory framework
including a recommended safe harbor in this area.

We are pleased that personnel from the Internal Revenue Service requested comments from us
on the debt basis implications of back-to-back loans. The current economic recession is broad
and deep in terms of damage to business owners. Very few industries or geographic areas are
exempt. Consequently, many businesses operating as S corporations are requiring additional
funds to "stop the bleeding." These funds will often be received as loans from the shareholder to
the S corporation and thus it is particularly appropriate that the Service should seek to provide
guidance in this area as we have entered a period in which the number of back-to-back loan
transactions is increasing.

Case law in this area has resulted in inconsistent, even opposite determinations as to whether a
shareholder receives debt basis with respect to very similar fact patterns. This makes it difficult
for the government, tax preparers and taxpayers to determine whether a particular loan
transaction will result in such a basis increase. This uncertainty represents primarily a challenge
to those charged with fair administration of the tax law, but also an opportunity. The challenge is
to provide a fair, consistent and true-to-the-statute application of the law. The opportunity is to
use the available regulatory power to provide practical and comprehensive explanations of how
common transactions are covered by statutory law. Well-drafted regulations enable taxpayers to
more clearly understand and apply complex tax laws to the transactions that come up in
commerce. The clarity provided by such regulations can and should reduce both the number of
cases tried in the subject area as well as the diversity of opinions stemming from these cases.

We recommend the establishment of safe harbor criteria to provide the necessary clarity. Our
discussion concerns only written obligations and does not apply to open account indebtedness.
Besides our recommended safe harbor criteria, we present some examples of fact patterns which
demonstrate the application of the safe harbor and could be included in the proposed and final
regulations. There are also numerous fact patterns outside the safe harbor that may result in basis
for shareholder indebtedness.

II.    Statutory & Regulatory Framework

Section 1366(d)(1) provides that deductions and losses flowing through to S corporation
shareholders are limited to the shareholders combined total of the basis in their stock and the
basis of ―any indebtedness of the S corporation to the shareholder.‖ The legislative history of



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this subsection refers to the need for an investment in stock or debt in the entity.1 Section
1366(d)(1)(B) and reg. section 1.1366-2(a)(1)(ii) provide that debt considered for loss purposes
is ―the adjusted basis of any indebtedness of the corporation to the shareholder…‖ There is no
particular definition of ―indebtedness of the S corporation to the shareholder‖ found in any other
section of Subchapter S or the related regulations.

III.     Understanding “Indebtedness of the S Corporation to the Shareholder”

Section 1366(d)(1)(B) Is Not Ambiguous and Indebtedness Basis Should be Created Where the Terms of an
Arrangement Between the S corporation and Its Shareholders Results in “Debt” for Federal Income Tax
Purposes

Normal rules of statutory construction would dictate that the words or phrases of the statute be
given their common everyday meaning. The Supreme Court has, in general, noted that
―[b]ecause [the statute] is not ambiguous, this Court need not examine other interpretative tools,
including legislative history.‖2 ―Indebtedness of the S corporation to the shareholder‖ is, in our
opinion, unambiguous.

The clear and common use of this term is at odds with court decisions in this area, which inject a
vague and subjective level of analysis not required or warranted given that the statute is
unambiguous. With no statutory basis for doing so, numerous court decisions consider the source
of the funds used by the shareholder to make a loan to the S corporation as determinative of
whether the shareholder loan is included in basis under section 1366(d). If a shareholder has used
funds borrowed from another source to make a loan to an S corporation, the two loans involved
are referred to as ―back-to-back‖ loans.

The courts have, with one exception, adopted an ‗economic outlay‘ test. 3 Interestingly, many of
these court decisions discuss the fact that the economic outlay theory is based on the concept that
the shareholder is ―poorer in a material sense.‖4 The irony of this economic outlay doctrine is, as
can be demonstrated by simple balance sheet analysis, that when a loan is made to the S
corporation entity, the shareholder is not ‗poorer‘ since the cash previously held is replaced with
a note receivable, and net worth of the shareholder is unchanged immediately after the exchange.

The loan from the shareholder to the corporation creates an asset. The source of funds for this
asset can either be from another asset, from an increase in liabilities or from an increase in
equity. In none of these instances is a shareholder ―poorer in a material sense.‖ The shareholder
may be less liquid but never ―poorer in a material sense.‖ The corporation becomes more liquid
and has additional debt but the equity balance remains the same; the corporation is not richer (or
poorer) in a material sense. Non-recognition of an S corporation debt to the shareholder under


1
  S. Rept. 1983, 85th Cong., 2d Sess. (1958), 1958-3 C.B. 922, 1141
2
  Exxon Mobil Corp. v. Allapattah Services, Inc. (04-70) 545 U.S. 546 (2005)
No. 04—70, 333 F.3d 1248
3
  See Raynor 50 TC 762 (1968), Estate of Leavitt 90 TC 206 (1988), William H. Perry 47 TC 159 (1966; aff‘d 68-1 USTC 9297
CA-8), and its progeny such as Lawrence Uri Jr. 56 TCM 1217 (1989) aff‘d 91-2 USTC 50,556 (CA-10), Grojean TC Memo
1999-425, Maloof (6th Circuit, 2006) and the latest which is Marvin S. Kerzner v. Commr. TC Memo 2009-76; but see Selfe 86-1
USTC 9115, CA-11 for an exception.
4
  See Oren, Perry and Underwood cases cited throughout the footnotes for this phrase.

                                                             2
this economic outlay theory, therefore, violates the clear, unambiguous language of the statute
because the S corporation is, in fact, indebted to the shareholder.

Accordingly, the AICPA believes the economic outlay doctrine as defined as a shareholder who
is ‗poorer in a material sense‘ is not the appropriate test for establishing bona-fide indebtedness
between a shareholder and an S corporation. Bona-fide indebtedness (and thus basis) should be
created if the terms of the arrangement between the S corporation and its shareholder(s) arise to
"debt" status for federal income tax purposes.

A back-to-back loan (in terms of its form, mutual legal rights of the parties, and the economic
substance of the transaction) generally works as follows: a person or entity (either related or
unrelated to the S corporation or the shareholder) lends money to the shareholder and the
shareholder in turn lends money to the S corporation. This transactional structure has been held
to give the shareholder basis for loss in multiple court decisions and administrative rulings.5
Where the first loan from a third party is a direct loan to the shareholder, there is broad
agreement that debt basis is permitted to the shareholder.

Difficulties arise where the loan from the third party, often a bank or other financial institution, is
not made directly to the shareholder. One approach financial institutions take is to lend directly
to the S corporation while obtaining the guarantee of the shareholder and collateral from the
borrowing corporation. Unlike the partnership rules where a guarantee, recourse debt or even
non-recourse debt at the entity level may give the partner basis for loss, it is well settled under
case law that S corporation shareholders are not permitted this benefit. Thus, lending directly to
the corporation by a person other than a shareholder will not provide guaranteeing shareholders
basis for loss until they actually fulfill the guarantee.6

A second approach is for the first loan to be made to the shareholder while obtaining collateral
such as: (1) a note between the shareholder and the corporation, (2) S corporation stock, (3)
assets of the S corporation (if previously pledged as collateral on a loan from the shareholder), or
(4) other assets owned by the shareholder. In either case, the loan between parties should include
commercially reasonable rates and terms, collateral, guarantees, and/or documents supporting the
legal rights between the parties.

IV.      General Recommendation

Regulations Should Include a Safe Harbor and Examples That Will Address Unrelated and Related Party
Back-To-Back Loans

The AICPA urges Treasury and the IRS to include in the proposed and final regulations under
section 1366(d)(1)(B) both a safe harbor rule and clear examples that cover a spectrum of

5
 See Sid Paul Ruckriegel TC Memo 2006-78, Timothy Miller TC Memo 2006-125 as well as Revenue Ruling 75-144 1975-1 CB
277, PLR 8747013, Seven Sixty Ranch Co. v. Kennedy 66-1 USTC 9293 (DC-Wyo), and Raynor 50 TC 762 (1968).

6
 Sleiman v. Comm., 84 AFTR 2d 99-5987 (187 F.3d 1352), 09/10/1999, Donald L. Russell, et ux., et al. v. Commissioner, TC
Memo 2008-246




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common back-to-back lending situations encountered in practice that show when an S
corporation shareholder will and will not create debt basis both inside and outside of the safe
harbor. Taxpayers and their advisers need this guidance as does the government to avoid
unnecessary litigation. To that end, please find below our recommended criteria for such a safe
harbor rule as well as a few suggested examples. We hope you agree that such a regulatory
approach will provide clarity in this very important S corporation area.

V.       Safe Harbor Rationale

In arriving at our suggested safe harbor criteria, we considered many of the significant cases in
this area and, of course, considered the types of transactions both approved and not approved
bythe courts. Below we discuss the aspects of these cases that have been incorporated into our
recommended safe harbor.

According to the Sid Paul Ruckriegel case,7 there is nothing inherently wrong or abusive about a
related party lending money. The judge points out that it is neither unusual to conduct business
with nor lend between a multitude of related entities. Thus, it follows that, as long as the terms of
related party indebtedness are reasonably equivalent to a commercial loan and the transactions
have legal significance, Treasury and the IRS would agree that related party transactions should
be included in the safe harbor test.

In addition, the courts have allowed an ‗incorporated pocketbook‘8 to lend directly to the S
corporation and treat it as a loan from the shareholder and thus have basis for loss under section
1366(d)(1)9. Nevertheless, because this situation is fact specific and would not always yield the
results of Culnen and Yates, we have not included the incorporated pocketbook transaction in the
safe harbor test.

Further, courts have distinguished the incorporated pocketbook fact pattern from situations
where either no money changed hands or where money was lent directly from one related entity
to the loss entity but bookkeeping entries or adjusting journal entries were made after the fact.10
We have also omitted these transactions from our recommended safe harbor as their treatment
would be case specific.

Finally, we have included transactions within our safe harbor test whereby cash movement is
circular as indicated in the Oren, Bergman and Kaplan cases.11 However, if all steps in these
transactions are done in the same time frame (doesn‘t pass step transaction muster), are
uncollateralized, and have produced few, if any legal documents, it is highly unlikely this
transaction would pass our safe harbor. As noted in the Ruckriegel case cited previously,
taxpayers involved in related party transactions ―bear a heavy burden of demonstrating that the
substance of the transactions differs from their form.‖

7
  TC Memo 2006-78
8
   The Ruckrielgel court defined the term ―incorporated pocketbook‖ as ―the taxpayer‘s habitual practice of having his wholly–
owned corporation pay money to third parties on his behalf.‖
9
  Culnen Tax Court Memo 2000-139 and Yates Tax Court Memo 2001-280
10
    See Ruckrielgel; also Thomas v. Commissioner 92 AFTR 2d 2003-5301 and Kerzner v. Commissioner TC Memo 2009-541
11
   Oren TCM 2002-172 aff‘d (2004, CA-8) 93 AFTR 2d 2004-858; Larry Bergman 83 AFTR 2d 99-1882 (CA-8) and Kaplan TC
Memo 2005-218

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Please note that a transaction qualifying for debt basis by falling within our safe harbor does not
automatically allow the taxpayer a deduction. The at-risk rules of section 465 and the passive
activity loss rules of section 469 still represent significant barriers to deduction. The AICPA
believes that the section 465 and 469 enforcement tools adequately protect the interests of the
government so that a safe harbor, such as the one we are recommending, can be crafted to be of
significant aid to both taxpayers and the government.

VI.        Safe Harbor Test

A safe harbor test must provide clear guidance to taxpayers to enable them to structure the vast
majority of transactions in a manner that is incontrovertibly within such safe harbor. To work
efficiently, each condition must be straight forward and unequivocal in both meaning and
application. We believe that such seven-point criteria below achieves these goals, but are happy
to work with Treasury and the IRS to modify the criteria if modifications are believed necessary.

A shareholder note would be treated as debt qualified to permit the S corporation shareholder to
increase its basis in indebtedness from the corporation and, assuming at-risk and passive activity
loss limitations are met, to deduct losses under section 1366(d) only if it has all of the following
characteristics:

       1. The note is a written12 unconditional promise by the corporation to pay the
          shareholder, on demand or on a specified date, a sum certain in money.

       2. The interest rate specified in the instrument meets, at a minimum, the published
          applicable federal rate for the type of loan and for the time the loan is made.

       3. Interest payment dates are specified in the instrument.

       4. The instrument is legally enforceable under state law. That is, a transferee, under a
          voluntary or involuntary transfer, receiving the note would have the right to
          proceed against the corporation to enforce the terms of the note.

       5. The S corporation is not an obligor or co-obligor on the note issued by the
          shareholder to the primary lender in a back-to-back situation. A guarantee or
          pledge of corporate assets is not to be considered as making the company an obligor
          with respect to the shareholder’s loan from the primary lender.

       6. Interest and principal payments are made pursuant to the agreement, i.e. the
          company pays the shareholder and the shareholder pays the primary lender (if
          mistakes are made and direct payment is made, the books and records are adjusted
          and appropriate information reporting forms are filed). A doctrine of substantial
          compliance as opposed to strict compliance would apply. Routine use of offsetting
          accounting entries without actual payment would not be considered within the safe
          harbor.
12
     These safe harbor criteria do not address open account debt which, by definition, is not written.

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   7. Loans are reported appropriately on tax returns and year-end financial statements,
      if any, of the company and shareholder.

We note that these criteria are more extensive than those of the straight debt safe harbor of
section 1361(c)(5)(B) which are intended solely to ensure that debt does not create a second class
of S corporation stock. Given that the sole purpose of this new debt safe harbor is to ensure a
shareholder‘s debt basis increase, it clearly cannot cover all situations. Factual situations outside
of the safe harbor would be judged on facts and circumstances under statute, regulation and case
law. We encourage Treasury and the IRS to approve of back-to-back transactions, for example,
in which the primary lender is not related (as defined in sections 267(b) or 707(b)) to the
shareholders.

Below, we provide three sets of examples: one for unrelated party back-to-back loans, another
for related party back-to-back loans and one for substituted or subrogated debt.

VII.   Suggested Examples

Back-to-Back Loans Involving Unrelated Third Party Lenders

Example 1: Bank lends $100,000 to Individual A at commercially reasonable rates and terms
(the "X Bank Loan"). Individual A immediately lends the funds to Corporation L, an S
corporation, in the form of debt for use as working capital. The terms of the loan from A to L are
also commercially reasonable. The payments of the X Bank Loan to A are made by A according
to the terms.

If the shareholder debt otherwise meets all requirements of the safe harbor, Individual A would
have an increase in adjusted basis in debt of $100,000 under section 1366(d)(1).

Example 2: Bank lends $200,000 to Individual A at commercially reasonable rates and terms
including A‘s pledging of publicly traded stocks and bonds he owns. Individual A immediately
lends the funds to Corporation L, an S corporation in the form of debt to purchase equipment.
The note between A and L is collateralized by assets purchased with the loan proceeds. Because
of the size of the loan between Bank and A, Bank requires the note between A and L as
additional collateral. Payments are made from L to A and from A to Bank under an automatic
withdrawal system that Bank maintains. Proper book keeping adjustments are made on L's
books.

If the shareholder debt otherwise meets all requirements of the safe harbor, Individual A would
have an increase in adjusted basis in debt of $200,000 under section 1366(d)(1).

Example 3: Bank lends $350,000 to Individual A at commercially reasonable rates and terms,
and collateralized by A‘s pledging of publicly traded stocks and bonds he owns as well as a
second mortgage on A‘s home. Individual A immediately lends the funds to Corporation L, an S
corporation in the form of debt to fund an acquisition. Because of the size of the loan between
Bank and A, Bank requires the note between A and L as additional collateral as well as a

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guarantee by the S corporation. The payments are often made from L to A and from A to Bank,
but periodically, L pays Bank directly on behalf of A. Proper book keeping adjustments are made
on L's books.

If the shareholder debt otherwise meets all requirements of the safe harbor, Individual A would
have an increase in adjusted basis in debt of $350,000 under section 1366(d)(1).

Back-to-Back Loans Involving Related Parties

Example 4: Individual B wholly owns PR, a C corporation and M, a loss S corporation. M
needs working capital funds so B borrows $50,000 from PR and contemporaneously records a
receivable on PR's books and a payable on his books. B then lends the $50,000 to M at
commercially reasonable rates and terms including taking as collateral some tangible and
intangible assets. The principal and interest payments are paid from M to B and from B to PR;
appropriate information reporting forms are filed in connection with the loans.

If the shareholder debt otherwise meets all requirements of the safe harbor, Individual B would
have an increase in adjusted basis in debt of $50,000 under section 1366(d)(1).

Example 5: Individual B wholly owns M, an S corporation and 50% of Partnership PP. M needs
working capital funds so PP distributes $150,000 excess cash to B. B then lends the $150,000 to
M at commercially reasonable rates and terms including taking as collateral some tangible and
intangible assets. M uses some of the loan proceeds to pay the rent on its premises to a trust set
up by B‘s family.

If the shareholder debt otherwise meets all requirements of the safe harbor, Individual B would
have an increase in adjusted basis in debt of $150,000 under section 1366(d)(1).

Example 6: Individual B wholly owns M, an S corporation and 50% of Partnership PP. M rents
a building from PP with annual rental of $20,000 (determined in arm's length negotiations).
Partnership PP borrows $250,000 from Bank at commercially reasonable rates and terms. M
guarantees the loan between PP & Bank. M needs working capital funds so B withdraws
$300,000 cash from PP, including proceeds from PP‘s borrowing from Bank. B then lends the
$300,000 to M at commercially reasonable rates and terms including taking as collateral some
tangible and intangible assets. M uses $20,000 of the loan proceeds to pay the rent to Partnership
PP.

If the shareholder debt otherwise meets all requirements of the safe harbor, Individual B would
have an increase in adjusted basis in debt of $300,000 under section 1366(d)(1).

Substituted or Subrogated Debt

Example 7: A, an S corporation, is owned by shareholders B and C. A has borrowed $500,000
from Bank. Subsequently, shareholders B and C substitute personal notes with the bank for A‘s




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corporate note with the bank such that the corporation now owes B and C $500,000 and B and C
owe the bank. The bank fully extinguishes the indebtedness of the corporation to the bank.13

If the shareholder debt otherwise meets all requirements of the safe harbor, the new shareholder
loans should give rise to combined B and C debt basis of $500,000.

Example 8: Individual D owns stock in X, a C corporation. Individual D also owns stock in Y,
an S corporation. D has no basis in the Y stock. X lends money directly to Y. Journal entries are
made contemporaneously to reflect the intent of the parties to create a back-to-back loan
situation, interest is paid from D to X. Also, Y pays D interest on the loan and eventually pays
off the loan. Forms 1099-INT are issued by the appropriate parties.

The lack of a legally enforceable instrument documenting the debt from shareholder D to S
Corporation Y would prevent this loan from qualifying under the safe harbor.

VIII. Conclusion

We believe that given the litigious history of this subject, and especially in light of the deep
economic recession through which S corporations and their shareholders are currently struggling
to survive, it is critical that Treasury and the IRS provide regulatory clarity in the area of debt
basis and back-to-back loans. Corporations, shareholders and their advisors must react quickly to
the changing times or risk economic extinction as a consequence. They need to be able to put in
place loan arrangements which will satisfy the critical needs of the business while, at the same
time, have a high degree of certainty as to the tax treatment of the transaction. We believe our
proposed safe harbor and examples are well within statutory law and that the proposed safe
harbor will cover a very large percentage of these types of transactions. We believe it would be
appropriate for Treasury and the IRS to also offer additional examples of transactions that would
and would not produce debt basis both inside and outside of any safe harbor rule. We would be
happy to work with the Administration to develop these additional examples.




13
     Gilday TC Memo 1982-242 & Rev. Rul. 75-144

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