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Tax Court Sides with Taxpayer: Transfers Between S Corps Were Not Debt Transactions

(Parker Tax Publishing February 2024)

The Tax Court held that transfers and payments made by one S corporation to another S corporation (both of which were wholly owned by a taxpayer) were constructive distributions rather than debt transactions, and thus the taxpayer had adequate basis in the S corporation that received the transfers and payments to claim flowthrough losses from it. The court agreed with the taxpayer that the transfers and payments were constructive distributions from the first S corporation to the taxpayer, followed by constructive contributions from the taxpayer to the second S corporation. Estate of Fry v. Comm'r, T.C. Memo. 2024-8.


Thomas Fry was the sole shareholder of two S corporations, Crown and CR Maintenance. Fry was also the president and treasurer of both companies. Crown's business operations included the collection of trash, recyclables, and other waste. CR Maintenance processed the trash, recyclables, and other waste collected by Crown into commodities such as alfalfa, olive oil, and wheat for sale to third parties. Despite being organized as separate businesses, the two companies conducted business operations in a highly integrated manner. Crown and CR Maintenance shared the same principal place of business and used the same maintenance, payroll, corporate officers, and accountant. Crown did not pay CR Maintenance for taking possession of the waste collected, nor did Crown share collection fees with CR Maintenance.

CR Maintenance was not profitable. Beginning in 2010 and through 2013, Crown provided financial support to CR Maintenance to allow it to continue operating. When CR Maintenance was unable to meet its obligations, Fry would instruct Crown to transfer funds directly to CR Maintenance (Transfers). Crown did not distribute cash to Fry, nor did Fry contribute cash to CR Maintenance. CR Maintenance used the Transfers to pay general business operating costs. Crown, on behalf of CR Maintenance, also made payments directly to CR Maintenance's vendors for various business expenses (Payments). At the end of 2013 the net total of the Transfers and the Payments was $36,255,141. CR Maintenance did not provide any promissory notes regarding the Transfers and the Payments and did not have any written due dates for a return of the money. No security interest was requested by Crown or granted by CR Maintenance. Furthermore, CR Maintenance did not make, nor promise to make, interest payments related to the Transfers and the Payments.

CR Maintenance accounted for each of the Transfers from Crown as a "Loan Payable" in its general ledger liability from 2010 through 2014. From 2006 through 2013 CR Maintenance accounted for the Payments made by Crown as "Due to Crown" in another general ledger liability account. From 2010 through 2017 CR Maintenance documented the Transfers and the Payments as liabilities between CR Maintenance and Crown. From 2006 through 2013 Crown accounted for the expenses it paid on CR Maintenance's behalf as "Due from CR [Maintenance]." Crown documented the Transfers and the Payments as liabilities between Crown and CR Maintenance from 2010 through 2017. CR Maintenance intended to repay Crown for the Transfers and the Payments if it was profitable.

From 2010 through 2020 CR Maintenance reported the Transfers and the Payments as a balance due to Crown on its tax returns and characterized them as debts. Likewise, Crown reported the Transfers and the Payments as a liability due from CR Maintenance on its tax returns for 2010 through 2020 and characterized these transactions as indebtedness.

On their joint income tax returns filed between 2008 and 2019, Fry and his wife did not report distributions from Crown. However, between 2008 and 2020, Crown did report distributions and repayment of shareholder loans on Fry's Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc. For 2013, CR Maintenance reported an ordinary loss of $5,650,651 on its tax return. On their joint return, the Frys claimed a flowthrough loss deduction of $4,733,675 from CR Maintenance.

In 2015 Crown and CR Maintenance received cash from their sale of most of their assets for about $70 million. Crown distributed all of its cash from the sale of its assets to Fry in 2015, 2016, and 2017. Fry received no further distributions from Crown. Following the distributions of the cash to Fry, Crown had insufficient assets for tax years 2017 through 2020 to make any further distributions to Fry. The "distributions" reported on Crown's tax returns were not actual distributions but accounting entries intended to balance Crown's balance sheet. The reductions of amounts described as "Due from" CR Maintenance by Crown were write-offs of the Transfers and the Payments as "bad debts" for 2017 through 2020.

In a notice of deficiency, the IRS disallowed the flowthrough loss from CR Maintenance because of Fry's lack of basis. The Frys took their case to the Tax Court. They argued that the Transfers and the Payments were not bona fide debt; rather, they were constructive equity contributions and distributions that gave Fry sufficient stock basis to deduct the flowthrough losses from CR Maintenance on the Frys' 2013 tax return.

The IRS asserted that Code 385(c), the duty of consistency, and the doctrine of election prohibited the recharacterization of the Transfers and the Payments from debt to equity. Under Code Sec. 385(c), "[t]he characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary)." Permitting the Frys to recharacterize the debt as equity would, in the IRS's view, result in prohibited flowthrough losses for them for tax years 2017 and 2018. These tax years were now closed for assessment since the period of limitations had expired. Furthermore, the IRS noted that the Frys had the prior opportunity to characterize the Transfers and the Payments as equity when filing their tax returns and preparing their financial documentation, but they elected to treat the Transfers and the Payments as loans.


The Tax Court held that Code Sec. 385(c) did not apply to the facts of this case as there was no formal issuance of any instrument evidencing the creation of an interest in stock or equity. The issuance of an interest in debt, the court found, is typically contained in a promissory note and an equity interest is typically contained in a stock certificate. No such issuance of a promissory note or a stock certificate occurred here. Thus, the court concluded that on the basis of a plain reading of the statute, Code Sec. 385(c) was inapplicable.

Next, the court found that it was more likely than not that the Transfers and Payments did not constitute true indebtedness. The court applied an 11-factor test set forth by the Ninth Circuit in Hardman v. U.S., 827 F.2d 1409 (9th Cir. 1987). The 11 factors are: (1) the names given to the certificates evidencing the debt; (2) the presence or absence of a fixed maturity date; (3) the source of the payments; (4) the right to enforce payments of principal and interest; (5) whether the advances increase participation in management; (6) whether the "lender" has a status equal or inferior to that of regular creditors; (7) objective indicators of the parties' intent; (8) whether the capital structure of the "borrower" is thin or adequate; (9) the extent to which the funds advanced are proportional to the shareholder's capital interest; (10) the extent to which interest payments come from "dividend" money; and (11) the ability of the "borrower" to obtain loans from outside lending institutions.

The court found that of the 11 Hardman factors, four were neutral, six favored equity, and one favored debt. The court said that the one factor weighing in favor of debt was that when the Transfers and the Payments were initially structured, it was likely that Fry, Crown, and CR Maintenance intended them to be debt. However, the court also found that CR Maintenance's repayments of the Transfers and Payments depended on the success of CR Maintenance and were not due at any fixed time. Fry never made a written request to demand payment from CR Maintenance on Crown's behalf and Crown never obtained a security interest. In addition, the court noted that there was no expectation that CR Maintenance would make interest payments to Crown, nor did Crown make such a demand.

The court agreed with the Frys that the Transfers and the Payments constituted constructive distributions from Crown to Fry, followed by constructive contributions from Fry to CR Maintenance. Under P.R. Farms, Inc. v. Comm'r, 820 F.2d 1084 (9th Cir. 1987), a constructive dividend occurs where a two-part test is met: (1) the expenditures do not give rise to a deduction on behalf of the distributing corporation and (2) the expenditures create an economic benefit to the shareholder. The court reasoned that the Transfers and the Payments primarily benefited Fry as there was no discernable business reason for Crown to make the Transfers and the Payments and they allowed his other business entity, CR Maintenance, to continue operations.

The court disagreed with the IRS's arguments that the Frys were required to treat the Transfers and Payments as debt under the duty of consistency and the doctrine of election. In the court's view, the duty of consistency did not apply because the Frys did not attempt after the expiration of the period of limitations to recharacterize the Transfers and Payments in such a way as to harm the IRS. The doctrine of election also did not apply, in the court's view, because the characterization of the Transfers and Payments as equity resulted from the application of factors indicating their. true economic substance, not from any election made by the Frys.

For a discussion of characterizing corporate instruments as debt or stock, see Parker Tax ¶45,310.

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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