Monday, September 12, 2011

Danger With Brother-Sister S Corporations

Let’s talk about the Broz case. This case involves brother-sister S corporations and claiming tax losses. It does have a fact pattern which seems to repeat in practice, so the case is worth going over.

Robert Broz (Broz) worked in the cell phone industry. He was president of Cellular Information Systems (CIS), a cellular company, during the 1980s. He decided to invest personally in the development of cell networks in rural statistical areas (RSAs) during the 1990s. The FCC began offering RSA licenses by lottery to encourage development of cellular networks in rural areas.

Broz participated in approximately 400 lotteries. He won and purchased an RSA license for Northern Michigan (the Michigan 4 license) in 1991. He organized RFB Cellular, Inc. (RFB), an S
corporation, in 1991, the year he acquired the license.

RFB entered into a purchase agreement to acquire the Michigan 2 license and related equipment in 1994. The acquisition however was stalled for two years, primarily because of a lawsuit Broz’s former employer, CIS, filed against him.

Broz wanted to expand RFB’s existing business. RFB’s lenders agreed but required that Broz form a new entity (Alpine) to isolate the liabilities. Enter the brother-sister.

CoBank was Broz’s main bank during the years at issue. Broz pledged his RFB stock as additional security but he never personally guaranteed the CoBank loan. Broz would borrow money through RFB and then ship it out to Alpine.

RFB accounted for this as “advances” to Alpine. Alpine recorded the same advances as “notes payable.” At year-end, the accountant would come in and change the entries to show Broz as borrowing the monies from RFB and in turn loaning the money to Alpine. There was enough forethought to create notes between all the parties. There was not enough forethought to charge an interest rate different from the bank or to write Alpine checks to Broz and require him to write personal checks to CoBank. RFB did not help its case by noting in its financial statements that it would not demand repayment of the loans.

The IRS challenged that Broz had basis in Alpine. There are some routine things that the IRS wanted to see. First, a shareholder must make an economic outlay for the transaction to work. An example would be Broz signing the bank loan. Second, the debt must run directly from the S to the shareholder. An example here would be Broz writing the check to Alpine that started the loan cycle. Third, Broz handed the IRS yet another argument against his cause. He had RFB borrow the money, then “lend” it to him so he could “relend” it to Alpine. This roundabout raises the stakes, because now Broz must prove RFB was acting on his behalf and that Broz was the actual lender to Alpine. Broz just handed the IRS the argument that Broz was just a conduit, and whatever transaction occurred took place at the entity-to-entity (RFB – Alpine) level.

Here comes the Tax Court, and it did not like certain facts:

(1)    Accrued interest was added to the outstanding loan and not paid.
(2)    In fact, no loan payments were ever made.
(3)    Broz signed the notes on behalf of all the companies, making it unlikely that anybody would demand payment.
(4)    Monies that RFB moved to Alpine from the CoBank loan were characterized as advances to Alpine rather than distributions to Broz (ouch!).
(5)    These were recharacterized as loans only through year-end journal entries.

So the Tax Court said this was a loan from RFB to Alpine. Broz had no basis in Alpine to claim tax losses.

I have seen any number of variations of this fact pattern over the years. It involves brother-sister S corporations and is very often bank-driven. The bank wants access to the corporate assets as collateral, and it does not want a personal loan to the shareholder. The shareholder in turn wants the loan and does not press the issue. The way we have worked with this is four-fold: (1) we never receive and disburse the loan on the same day; (2) we never use the same interest rate; (3) we never use the same maturity date; (4) we always require cash payments respecting the form of the transaction. I would still prefer to borrow personally, if at all possible. We have at times made the shareholder a co-maker of the note, although that too carries its tax risk.

Another way is to use a holding company. In this case, RFB and Alpine would be subsidiaries (Q-Subs, more specifically) of a “parent,” and the basis calculations and issues would take place at the parent level. Broz would have had to establish basis only at one level - the parent.

The morale? This is an area of tax law with more sunken ships than the Bermuda triangle. The IRS demands you respect form and procedure when establishing basis in your S corporation(s). The law wants you to invest or loan money directly. Do so.

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