Category: Corporations
Subject: S Corporation
Title: S Corporation Back-to-Back Loan
IRC Sections: 1362
Filename: 1257.html
Date Produced: 08/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Taxpayer (TP) is an S corporation in need of funds. SH, a majority (or sole) shareholder of TP, plans to borrow the funds from a bank and re-lend them to TP. The loan will be secured by TP's assets.

Issue
Does the transaction described above increase SH's basis in TP?

Answer
Although the conclusion is not clear, arguably the transaction does not increase basis. Using corporate assets as security for the loan dilutes the appearance of the loan to SH as an independent economic event. In other words, use of corporate security increases the risk that SH will be viewed as a nonsubstantive intermediary for the funds. In addition, SH will have used corporate assets for a shareholder purpose, a source of additional problems.

Discussion
The transaction described above is referred to as a back-to-back loan. It is clear the IRS does not care for such arrangements and has shown a predisposition to attack them where possible. TAM 9403003. In addition, the IRS has fought back-to-back loans in the international tax area for many years and finally won an important case, Aiken Industries v. Comr., 56 TC 925. (1971), which disregarded a pair of back-to-back loans because they had exactly the same terms. Section 7701(l) also gives Treasury the right to draft regulations for disregarding back-to-back loans deemed to be for tax avoidance purposes. To date, regulations proposed under this section limit its application to various international tax issues. It seems to me, however, that this is a potential source of additional risk, albeit an apparently remote source at the moment.

There is no bright-line test or safe harbor for such transactions. Whether or not a back-to-back loan passes muster is essentially a question of fact turning on whether all the facts and circumstances indicate that there is an actual economic outlay of funds by the shareholder.

It is my personal view (and I have not seen this anywhere else) that the last word has not been spoken on this issue. A back-to-back loan carries with it some measure of risk. I believe that attention to detail in arranging such transactions can mean the difference between success and failure.

While this matter can never be free from doubt, here are some things to increase the chances of having back-to-back loans honored.

1. Do not use corporate assets as security for the loan. Obviously, this complicates the issue for the client because a lender would prefer a security interest in hard assets over intangibles such as stock or notes.

2. Try to get the lender to accept a security interest in corporate stock or some other asset in SH's possession.

3. Two commentators suggest having the bank lend directly to SH. SH would in turn lend to TP, and the bank would get a security interest in SH's note from TP. If TP uses the funds to buy hard assets, SH should have a security interest in the assets which will be pledged along with the note as security for SH's loan to the bank.

4. Eustice and Kuntz, a well respected authority, suggests that all the steps in Item 3, above, can happen at a single closing. That makes me very nervous.

5. Absolutely under no circumstances should any money flow directly from the bank to TP. Viewed both from the standpoint of all the documents created with respect to this transaction as well as the actual checks drawn, it must be very clear that money goes first to SH and then independently to TP.

6. If the bank will allow it, separate the loan to SH from the loan to TP by a day or so.

7. The loans should carry different terms insofar as possible. SH should charge a small spread on the interest rate. The repayment terms should be such that SH has control of the repayment monies for a period of days. For example, suppose the bank loan calls for monthly payments due on the 15th of each month. The loan between TP and SH should call for monthly payments due on the 1st or perhaps the 7th of each month. If the bank loan calls for repayment over 60 months, SH should be repaid over some slightly shorter period, say 54 months.

8. Again, absolutely under no circumstances should any money flow directly from TP back to the bank when the loan payments are made.