The petitioners appeal a decision of the United States Tax Court (Stephen J. Swift, Judge) finding that capital contributions they made to two S corporations could not be treated as "tax-exempt income" to the corporations for the purpose of increasing, pursuant to 26 U.S.C. § 1367(b)(2)(B), the petitioners' bases in loans they made to the corporations. The Tax Court also found that the petitioners could not deduct their capital contributions as ordinary losses incurred in a trade or business pursuant to 26 U.S.C. § 165(c)(1) or incurred in a transaction entered into for profit pursuant to § 165(c)(2). We affirm.
The opinion of the court was delivered by: John G. Koeltl, District Judge
Before: KATZMANN and RAGGI, Circuit Judges, and KOELTL, District Judge.*fn1
The petitioners, Ira and Tracy Nathel and Sheldon and Ann M. Nathel, appeal a decision of the United States Tax Court (Stephen J. Swift, Judge) upholding tax deficiencies assessed by the Commissioner of Internal Revenue (the "Commissioner"). On appeal, the petitioners argue that certain capital contributions they made to two S corporations, of which they were shareholders, should be treated as items of "tax-exempt income" to the corporations for the purpose of restoring, pursuant to 26 U.S.C. § 1367(b)(2)(B), the petitioners' previously reduced bases in loans they made to the corporations. The petitioners contend that as a result of their restored bases, they received no ordinary income when the S corporations repaid the petitioners' loans. Alternatively, the petitioners argue that because they made the capital contributions to obtain releases from personal loan guarantees made to one of the corporations, the capital contributions should be deductible as ordinary losses incurred in a transaction entered into for profit pursuant to 26 U.S.C. § 165(c)(2).
We conclude that the petitioners' capital contributions do not constitute "tax-exempt income" to the S corporations and, therefore, that the petitioners are not entitled to increase their bases in their loans. We also conclude that because the petitioners have not met their burden of showing that the primary purpose of their capital contributions was to obtain releases from their loan guarantees, the petitioners are not entitled to deductions from ordinary income pursuant to § 165(c)(2). Therefore, we affirm the Tax Court's decision.
The following facts are based on stipulated facts that the parties submitted to the Tax Court.
Ira and Sheldon Nathel*fn2 (the "Nathels") are brothers who, along with Gary Wishnatzki, organized three corporations that elected to be taxed under Subchapter S of the Internal Revenue Code (the "Code"), 26 U.S.C. §§ 1361–1379. "Subchapter S allows shareholders of qualified corporations to elect a 'pass-through' taxation system under which income is subjected to only one level of taxation." Gitlitz v. Comm'r, 531 U.S. 206, 209 (2001) (citing Bufferd v. Comm'r, 506 U.S. 523, 525 (1993)). S corporation profits are not taxed on the corporate level; instead, they are passed through as taxable income to shareholders on a pro rata basis. 26 U.S.C. § 1366(a)(1)(A); see also Gitlitz, 531 U.S. at 209.
In addition to profits, an S corporation shareholder is also taxed on any gain from the shareholder's sale of S corporation stock, which gain is calculated as the amount realized from the sale in excess of the shareholder's basis in the stock. See 26 U.S.C. § 1001(a); Craven v. United States, 215 F.3d 1201, 1204 (11th Cir. 2000). A shareholder's basis in stock is generally the price paid for the stock if purchased from a third party or the amount of the shareholder's capital contributions if the stock is received in exchange for capital contributions. 26 U.S.C. § 1012; Treas. Reg. § 1.118–1 (1960).
Because S corporation profits are passed on to shareholders to be taxed at the individual level, to avoid the double taxation of a corporation's profits, the Code permits shareholders to increase their bases in a corporation's stock when the corporation receives certain "items of income described" in § 1366(a)(1)(A). § 1367(a)(1)(A); Gitlitz, 531 U.S. at 209. Similarly, any losses or deductions that are passed through from an S corporation to shareholders reduce the shareholders' bases in stock in order to prevent the double deduction of those items. § 1367(a)(2)(B); Gitlitz, 531 U.S. at 209. If the deductions passed through by the corporation to a shareholder exceed a given shareholder's remaining basis in stock in any tax year, the excess deductions are applied to reduce the shareholder's basis in any indebtedness owed by the S corporation to the shareholder.*fn3 § 1367(b)(2)(A). If the shareholder's basis in indebtedness was so reduced, any net increase in basis in a subsequent tax year, as determined pursuant to §§ 1367(a)(1)(A) and 1366(a)(1)(A), is first applied to restore the shareholder's basis in indebtedness before it is applied to restore the shareholder's basis in stock. § 1367(b)(2)(B).
The three S corporations in this case, Wishnatzki & Nathel, Inc. ("W & N New York"), G & D Farms, Inc. ("G & D Farms"), and Wishnatzki & Nathel of California, Inc. ("W & N California"), were organized to operate food distribution businesses in New York, Florida, and California. The Nathels each owned twenty-five percent of the corporations and Mr. Wishnatzki owned fifty percent.
In June 1999, the Nathels and Mr. Wishnatzki personally guaranteed $2.5 million in loans made by two banks to G & D Farms. In December 2000, Ira and Sheldon Nathel each made personal loans in the amount of $649,775 to G & D Farms. As of December 31, 2000, the Nathels each had a zero basis in their G & D Farms and W & N California stock. They each had a basis of $112,547 in loans they made to G & D Farms and a basis of $3,603 in loans made to W & N California.
In February 2001, G & D Farms repaid the Nathels' December 2000 personal loans in the full amount of $649,775 each. In August 2001, the Nathels and Mr. Wishnatzki agreed to a plan to liquidate W & N California and to convey full ownership of G & D Farms to Mr. Wishnatzki and full ownership of W & N New York to the Nathels. Prior to its liquidation, W & N California repaid outstanding loans to the Nathels in the amount of $161,250 each. The Nathels then made capital contributions to W & N California in the amount of $181,396 each. The Nathels also made capital contributions to G & D Farms in the amount of $537,228 each. In the parties' stipulation before the Tax Court, they indicated that the capital contributions to G & D Farms "were made by the Nathels to secure the release of their respective guarantees of [G & D Farms'] debts to the Banks and to obtain [Mr. Wishnatzki's] agreement to the release of the Nathels from their guarantees and to the reorganization plan." (Stipulation of Facts ("Stip.") ¶ 34.) The parties also stipulated that "[a]s a condition for releasing Sheldon and Ira from their guarantees of [G & D Farms'] debt, the Banks and [Mr. Wishnatzki] required Sheldon and Ira to each contribute to [G & D Farms] additional capital in the amount of $537,228.00." (Stip. ¶ 26.) In sum, in 2001, the Nathels received a combined $1,622,050 in loan repayments from the two corporations and made a combined total of $1,437,248 in capital contributions. In calculating their 2001 taxes, the Nathels treated their capital contributions to G & D Farms and W & N California as constituting "tax-exempt income" to the corporations for the purposes of § 1366(a)(1)(A). Therefore, because the Nathels' bases in their stock previously had been reduced to zero and because their bases in the loans they made to the corporations were also reduced, the Nathels used their capital contributions to restore their bases in the loans pursuant to § 1367(b)(2)(B). Without such an increase in their bases, the petitioners would have been taxed on the ordinary income that would have resulted from the corporations' repayment of the petitioners' loans in amounts above the petitioners' previously reduced bases.
The Commissioner rejected the Nathels' treatment of the capital contributions. The Commissioner determined that the Nathels' capital contributions could not be used to offset the ordinary income that resulted from the amount of the corporations' repayment of the Nathels' loans above the Nathels' then-existing bases in the loans. Instead, the Commissioner determined that the capital contributions increased the petitioners' bases in their G & D Farms and W & N California stock. Because the petitioners redeemed their stock as part of the reorganization plan, the Commissioner determined that they were entitled to a long-term capital loss in light of their now-increased bases in the stock. The net effect of the Commissioner's calculation was an increase in the tax owed by the Nathels in 2001.
The Commissioner mailed a notice of deficiency dated June 21, 2006, to Ira and Tracy Nathel, indicating that they owed an additional $279,847 in income taxes for 2001. The Commissioner also mailed a notice of deficiency dated June 21, 2006, to Sheldon and Ann M. Nathel, indicating that they owed an additional $279,722. Both couples filed a timely petition in the Tax Court for a redetermination of the deficiencies. The Tax Court granted the parties' joint motion to consolidate the cases. In an opinion dated December 17, 2008, the Tax Court rejected the petitioners' challenges to the deficiencies determined by the Commissioner.*fn4 Nathel v. Comm'r, 131 T.C. 262 (2008).