Companies should pay their own bills. That is probably the real lesson to be learned from the Eleventh Circuit upholding of the Tax Court decision in the case of developer Homero Meruelo.  The stakes were pretty high, a deficiency over $2.6 million. The controversy was about the scintillating topic of S corporation stock basis.  We’ll start with a brief primer which the professionals may want to skip.

About Basis

Basis is a fundamental tax and accounting concept.  When you sell something you are taxed not on gross receipts but on your gain which is the amount received less basis.  And if you are entitled to a deduction because something becomes worthless, your loss will usually be your basis.

The simplest situation is when you obtain something by paying money for it.  Your basis, at least to start off will be the amount of money you pay for it.  That is the case with S corporation stock that you buy.  If you are a founder, your basis will be your initial capital contribution.   From there it starts getting complicated.

S Corporations

S corporations generally don’t pay tax on their income. The income is passed through to the shareholders increasing stock basis.  Additional capital contributions will also increase basis.  Losses that flow through will decrease basis as will distributions.

Here we have another complication and the problem that Meruelo ran into.  Basis in S corporation stock never goes below zero.  A loss that would run basis below zero is suspended. Meruelo was a 49% shareholder of  Merco of the Palm Beaches, Inc (Merco).  In 2008, Merco had a loss of nearly $27 million.  That loss wiped out Meruelo’s income from other S corporations and created a carryback to 2005.

The IRS is only allowing about $5 million of the $13 million loss, because that is what they determined Meruelo’s basis in the Merco stock to be, but there’s more.  A flow-through loss from an S corporation can also reduce the basis in the corporation’s indebtedness to the shareholder and according to Meruelo’s accountant Merco owed enough to Meruelo to absorb the loss.

The problem was that there was not a straightforward transfer of cash from Meurelo to Merco, supported by a promissory note from the corporation to the shareholder.

A Complicated Schedule

It turns out that Merco was one of a family of companies that Meurelo had an interest in.  And despite the disparate ownership, the companies supported one another when it came time to pay the bills.

From 2004 to 2008, Merco entered into hundreds of transactions with various partnerships, S corporations, and limited liability companies in which Meruelo held an interest. These Merco affiliates often paid expenses, such as payroll costs, for each other or for Merco to simplify accounting and enhance liquidity. The payor company recorded these payments to its affiliates as accounts receivable, and the payee company recorded them as accounts payable.

The accountant who prepared all the returns then went through a process that only another accountant could love.  There was a line of credit promissory note from Meruelo for $10,000,000 at 6% interest.  A schedule was prepared showing his share of each of the intercompany balances effectively treating the transactions as if the advancing entities had loaned the money to Meruelo who then loaned to Merco thereby giving him indebtedness basis to prevent the loss from being suspended.

The Arguments

There are two theories under which this sort of thing might work.  One is “back-to-back loans” and the other is “incorporated pocket-book”.

“Back-to-back loans” fails, because the taxpayer is stuck with the form of the transaction, which the taxpayer controls.  And the form of the transaction was transfers among the companies not transfers to the shareholder who then transferred to the company.

Because the transactions were contemporaneously classified as transactions between the affiliates and Merco, the designation Meruelo’s accountant gave them at the end of the year does not govern.

The “incorporated pocket-book” theory did not work, because there were multiple companies making advances and Meruelo did not own 100% of all of them.

Meruelo failed to establish that the Merco affiliates constituted his incorporated pocketbook. Unlike the shareholders in Yates and Culnen —who used a single, wholly owned entity to pay third parties on the shareholder’s behalf—Meruelo seeks to treat eleven distinct Merco affiliates, many of which he only partially owned, as his incorporated pocketbook.

The Lesson

The lesson is a discouraging one for accountants.  I went digging in PACER and found the schedule that Meruelo’s accountant prepared and they are really good work. A good bit of effort must have gone into them.  But they end up meaning nothing.

Those of us who think in double entry might believe that Meruelo should have gotten his basis and been allowed the loss.  Throughout most of my career, I would have thought there was no problem.  But years of reading decisions like this have caused me to conclude that the only people impressed by an accountant’s entries are other accountants .

Reilly’s Fourth Law of Tax Planning – Execution isn’t everything, but it’s a lot. Here we have an exception.  Execution actually was everything.  If the money that Meruelo purportedly loaned to Merco had actually passed through his hands and been recorded as a loan or a distribution to him, he would have had his basis and his loss.