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Indirect Loans Did Not Increase Shareholders' Bases in S Corporation's Debts

(Parker Tax Publishing November 2017)

The Tax Court held that two shareholders of an S corporation that operated a casino could not increase their bases in that corporation by the amount they lent to a separate S corporation formed to acquire a loan made by a third party to the first S corporation. The Tax Court held that the debt did not run directly from the first S corporation to the shareholders and that the independent corporate existence of the second S corporation had to be respected. Messina v. Comm'r, T.C. Memo. 2017-213.


Dana Messina and Kyle Kirkland are business partners and co-owners of an investment advisory firm. In 2008, they acquired a California casino called Club One Casino, Inc. (Casino) for $27 million. Casino was owned by George Sarantos and Elaine Long and taxed as an S corporation. To acquire Casino, Messina and Kirkland formed Club One Acquisition Corp. (Club One), also an S corporation. Messina and Kirkland each owned 40 percent of Club One. After Casino was acquired by Club One, Casino elected to become a qualified S corporation subsidiary (QSub). As a QSub, all of Casino's debts were treated as the debts of Club One.

The purchase of Casino was financed by several loans that became the debts of Casino on the closing of the sale. Specifically, Casino became the obligor of two $2.5 million promissory notes to the sellers, Sarantos and Long, and a loan of approximately $21.8 million from D.B. Zwirn Special Opportunities Fund, L.P. (Zwirn). The Zwirn loan, which was secured in part by the personal guarantees of Messina and Kirkland, required quarterly interest and principal payments until February 2012, when the remaining balance would become due. Sarantos and Long agreed to subordinate their notes to the Zwirn loan. In 2009, Zwirn was converted into Fortress Value Recovery Funds I LLC (Fortress Fund).

In 2010, with 18 months left until the balance of the Zwirn loan became due, Messina and Kirkland began looking for other investors or lenders. They were unsuccessful, and in 2011 they formed KMGI, Inc., an S corporation, to either refinance or acquire the Zwirn loan from the Fortress Fund. Messina and Kirkland did not have the money to acquire the full amount of the loan, and Fortress Fund was not willing to sell the loan piecemeal, so Messina and Kirkland liquidated some investments in order to obtain the necessary funds.

Messina and Kirkland each agreed to acquire half of KMGI's stock and to lend it the funds to purchase the Zwirn loan. They believed that if they lent the funds directly to Casino, the loan would lose its superiority to the promissory notes from Sarantos and Long. Similarly, if they contributed funds to Club One intending that the funds be lent to Casino to pay the loan, consent from the other shareholders of Club One would be required. Messina and Kirkland believed that by lending the money to KMGI to purchase and hold the Zwirn loan, repayment of the funds lent to KMGI would be senior to the Sarantos and Long promissory notes, which remained subordinated to the note backing the Zwirn loan.

The Zwirn loan became payable in full in February 2012. In April, Kirkland and Messina each transferred approximately $7 million to KMGI. Kirkland then transferred an additional $227,000. The transfers were recorded as shareholder loans. As of April 2012, Casino owed the Fortress Fund approximately $14.5 million. KMGI paid that amount and became the holder of the loan, and Messina and Kirkland were released from their personal guarantees.

KMGI's address was the same address as Kirkland and Messina used for their investment advisory firm. KMGI's sole asset was initially the cash contributed or lent by Messina and Kirkland for the purchase of the Zwirn loan. After April 2012, KMGI's only assets were the Zwirn loan and a small amount of cash used to pay nominal expenses. As of the end of 2012, the loan from Messina and Kirkland to KMGI had an unpaid principal balance of approximately $14 million. KMGI's bookkeeper reclassified the entire loan balance from shareholder loans to additional capital contributions in May 2012.

Club One had an ordinary business loss of $1.4 million for 2012. Because Club One was an S corporation, Messina's and Kirkland's ability to take this loss into account was limited by their basis in Club One stock and any debt it owed to them. In preparing their tax returns for that year, Messina and Kirkland each treated half of the $14 million they loaned to KMGI as a loan directly to Club One, and thus an increase in their bases in Club One by that amount.

The IRS sent notices of deficiency for 2012 to Messina and Kirkland in 2015, disallowing their debt bases in Club One and reducing the available losses. The IRS said that the Zwirn loan did not run directly from Messina and Kirkland to Club One and therefore could not be considered in computing their bases in Club One's debt. The adjustments resulted in deficiencies of $161,000 for Messina and $182,000 for Kirkland. Each petitioned the Tax Court for redeterminations of the deficiencies and their cases were consolidated for trial.

Taxpayers' and IRS's Arguments

Messina and Kirkland argued that KMGI should be disregarded and that the Zwirn loan to Club One's QSub, Casino, should be treated as running directly from Club One to them because the Zwirn loan was indirectly held by them through their wholly owned S corporation, KMGI,. They further argued that case law allows an intermediary such as KMGI to be disregarded where it (1) is acting as the taxpayer's incorporated pocketbook, (2) is a mere conduit or agent of the taxpayer, or (3) has failed to make an actual economic outlay to the loss S corporation that has made the intermediary poorer in a material sense as a result of the loan. They said that, because KMGI had no business activities other than holding the loan, it was nothing more than their incorporated pocketbook or their conduit or agent. Messina and Kirkland acknowledged that an actual economic outlay is required in order to obtain basis in S corporation debt, but asserted that they, and not KMGI, made such an outlay because they fully owned KMGI and were released from their personal guaranties when KMGI acquired the Zwirn loan. They also argued that the formation of KMGI should be ignored under the step transaction doctrine.

The IRS argued that the Zwirn loan ran to Club One and Casino from KMGI, not from Messina and Kirkland. All the evidence indicated to the IRS that the debt did not run directly from the shareholders to Club One and Casino and so could not be considered in computing the bases of any indebtedness of Club One to Messina and Kirkland. The IRS also noted that a corporation is an incorporated pocketbook only where it makes frequent and habitual payments on its owners' behalf, and KMGI did not qualify because it made only a one-time transfer. The IRS also contended that KMGI was not a conduit or a shell corporation because it was formed with the independent business purpose of maintaining the seniority of the Zwirn loan in relation to the promissory notes. According to the IRS, KMGI was not an agent because no third party was aware of its agent status, there was no agency agreement, and Messina and Kirkland were released from their personal guaranties when KMGI acquired the loan. Finally, the IRS said that the step transaction should not be applied because Messina and Kirkland intentionally chose the form of the transaction and should not be able to argue against their own form in order to achieve a more favorable tax result.

Tax Court's Decision

The Tax Court held that Messina and Kirkland could not use their contributions to KMGI to increase their bases in the debt of Club One and offset their losses. The court found that KMGI could not be disregarded as an incorporated pocketbook because it was not used habitually to pay Casino's or the shareholders' expenses. The court agreed with the IRS that the one time transfer from Messina and Kirkland to KMGI, followed by a single payment to acquire the Zwirn loan, was insufficient to establish a habitual practice of the entity paying on the owners' behalf as required under the applicable case law.

The Tax Court also found that KMGI could not be ignored for tax purposes as the agent of Messina and Kirkland. It applied a nine factor test to determine if the agent-principal relationship was genuine and found that the weight of the factors showed KMGI to be a distinct corporate entity. The only factor that slightly favored treating KMGI as an agent was that it promptly transmitted to Messina and Kirkland substantially all of the funds it received in connection with the Zwirn loan. The Tax Court found that this factor was either neutral or at best slightly favorable to Messina and Kirkland.

The argument that Messina and Kirkland, and not KMGI, made an actual economic outlay in acquiring the loan was also rejected. The Tax Court found that Messina and Kirkland made actual economic outlays to KMGI, not to Club One, in the form of loans that were later reclassified as capital contributions. These contributions increased their bases in the stock of KMGI, and could not be used again to increase their debt bases in Club One.

Finally, the shareholders' step transaction argument was rejected. The Tax Court found this argument to be another permutation of the shareholders' other theories. The court concluded that KMGI had clearly been organized as a separate, distinct corporation, and that Messina and Kirkland could not argue against the form of their transaction to obtain different tax consequences.

For a discussion of a shareholder's basis in the debt of an S corporation, 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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