Or, Sometimes the Tax Tail Wags the Business Dog

Dana D. Messina and Kyle R. Kirkland (hereinafter respectively “DD” and “KK”) were corporate wheeler-dealers who bought the sub S stock of a regulated CA card room corporation, heavily leveraged the buy with a loan from a hedge fund, and when the business climate went south tried to buy out the hedgefunder via a Sub S they created and funded.

DD and KK wanted to argue that the buyout sub S was really just an incorporated pocketbook or an agent, or should just be collapsed, so that their basis in the buyout sub S stock really should be treated as basis in the card room sub S.

Judge Laro has this one, and you can find it as 2017 T. C. Memo. 213, filed 10/30/17.

The card room S corp had great losses, which DD and KK wanted to grab. But they needed basis in the card room sub S stock to take the losses. If they simply bought the hedgefunders’ loan and had the card room S Corp treat that as a capital contribution although keeping the loan alive, they were concerned that they would thereby subordinate that loan to the notes they gave when they bought the card room in the first place.  Given that their sellers had signed an agreement subordinating their notes to the hedgefunders’ loan, and that in the middle of everything else they were suing each other, this was not an unreasonable concern. The word “novation” does come readily to the mind of every subordinated party.

So rather than buy the hedgefunders’ loan themselves or lend the card room sub S the money to do so itself, DD and KK formed another sub S, lent it the money, and had that sub S buy the loan. And release DD and KK from their personal guarantees on the loan.

Problem: to increase your basis in an S corp, you need to contribute capital to the S corp (stock basis) or incur debt on behalf of the S corp (debt basis), and the latter must be real economic debt and the stockholder directly on the hook . DD and KK had their loans to the debtholding sub S recharacterized on the books as capital contributions, but that only built basis in the debtholding sub S, not the card room sub S.

So is the debtholding sub S real, or just an agent?  “The Supreme Court has set forth several factors to consider when evaluating whether a corporation is another’s agent:  (1) whether it operates in the name and for the account of the principal, (2) whether it binds the principal by its actions, (3) whether it transmits money received to the principal, (4) whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal, (5) whether its relations with the principal depend upon the principal’s ownership of it, and (6) whether its business purpose is the carrying on of an agent’s normal duties.  Nat’l Carbide Corp. v. Commissioner, 336 U.S. 422, 437 (1949). “ 2017 T. C. Memo. 213, at p 36.

Well, it acquired the hedgefunders’ debt in its own name and was never designated as an agent in writing, or held out as an agent. It’s true that its only assets were a few bucks DD and KK fed it, and the debt, and it did pay every cent of debt service it got from the card room S corp to KK and DD. But that’s not enough to make it an agent, says Judge Laro. The debtholding sub S was a blocker, to keep the hedgefunders’ debt from being subordinated to the suing sellers’ notes.

And the debtholding sub S wasn’t an “incorporated pocketbook.” That’s a corporation which habitually uses its funds to pay the stockholders’ personal debts, or the debts of another entity related to the stockholders. But the debtholding sub S did neither.

It’s true DD and KK made an actual economic outlay. But that only builds their basis in the debtholding sub S.

Finally, collapsing the transaction and disregarding the debtholding sub S flunks the Alfalfa test. While DD and KK could structure their business deals how they wanted, they cannot restructure them to get a better tax result after the fact.

Takeaway- Sometimes the tax tail does wag the business dog. The sellers’ notes were way less than the hedgefunders’ loan. If the tax breaks are worth more than the risk of subordination, when the business was in trouble and in default of said loan, don’t sweat the small stuff. Sometimes the insurance just isn’t worth the premium.

Edited to add, 2/28/20: 9 Cir., in a Memorandum that dare not speak its name, affirmed Tax Court 12/27/19.