Pass-Through Losses Disallowed For Developer with Insufficient Debt Basis
in S Corporation (Parker Tax Publishing: September 22, 2013)

Because a cellular network developer lacked sufficient debt basis in his S corporation, his deductions for its pass-through losses were properly disallowed; business expense and amortization deductions claimed for his other business entities were also properly disallowed, since the entities were never engaged in any active trade or business. Broz v. Comm'r, 2013 PTC 257 (6th Cir. 8/23/13).

Robert Broz invested in the development of cellular networks in rural statistical areas (RSAs) in the 1990s. He organized RFB Cellular, Inc. (RFB), a wholly owned S corporation, and purchased an RSA license for Northern Michigan in 1991. He later expanded his cellular telephone business by organizing additional entities. Alpine PCS, Inc., an S corporation, was created to construct and operate digital networks servicing new licensing areas. Several Alpine license-holding entities were also formed to hold and lease additional RSA licenses that Robert acquired. RFB operated the only on-air networks and used Alpine PCS's licenses on a limited basis. Only two Alpine license-holding entities reported income of approximately $68,000 from RFB's use of its licenses in 2001. Alpine did not report income during any of the other years in issue but claimed depreciation deductions, interest deduction on debt owed to the FCC, and interest deductions on debt owed to RFB, although Alpine never made any interest payments. Alpine also amortized and deducted expenses for startup costs. However, Alpine had not made a formal election under Code Sec. 195(b) to expense the startup costs. Alpine and the license holding entities stopped all business activities by the end of 2002.

CoBank was the main commercial lender to RFB and the Alpine entities during the years at issue. RFB used CoBank loan proceeds to expand its existing business through Alpine and the related entities. RFB advanced the CoBank loan proceeds to Alpine PCS. Using year-end accounting adjustments and post-dated promissory notes, Robert recharacterized the transaction so that it appeared that the loan proceeds were advanced from RFB to Robert and then loaned by Robert to Alpine PCS. The loan was secured by the assets of the Alpine license holding entities. Robert pledged his RFB stock as additional security but he never personally guaranteed the CoBank loan.

The IRS assessed an $18 million deficiency in Robert's federal income tax returns for 1996, 1998, 1999, 2000 and 2001. The IRS determined that Robert had insufficient debt basis in Alpine to claim pass-through losses and that he was not at risk with respect to his investments in the Alpine entities. Therefore, he was not entitled to claim the pass-through losses on his individual income tax return. The IRS also determined that the Alpine companies were not entitled to interest, depreciation, and startup expense deductions because they were not engaged in an active trade or business during the years at issue. Finally, the IRS disallowed the Alpine license holding entities amortization deductions for the FCC licenses because they were not engaged in an active trade or business at the relevant time. The Tax Court ruled in favor of the IRS and Robert appealed.

Code Sec. 1366(d) provides that the amount of pass-through loss deductions that an individual shareholder may claim cannot exceed the shareholder's basis in stock and debt. The debt-basis limitation is determined by examining the shareholder's adjusted basis in any indebtedness of the S corporation to the shareholder. An S corporation's indebtedness to another entity does not increase the amount of pass-through deductions the shareholder can claim.

Robert claimed that he was at risk and had sufficient debt basis in Alpine PCS to deduct its pass-through losses, business expense and amortization deductions.

The Sixth Circuit affirmed the Tax Court and held that purported back-to-back loan arrangement between FRB, Robert and Alpine did not establish a bona fide indebtedness between Robert and Alpine and Robert's pass-through loss deductions on his debt basis were properly disallowed. Robert was a mere conduit for the loans from RFB to Alpine PCS, and Alpine was never directly indebted to Robert. Robert's use of journal entries and promissory notes to guarantee the debt that already existed from Alpine to RFB and his pledge of stock did not establish indebtedness from the S corporation to the shareholder. Because Robert lacked sufficient debt basis in Alpine to allow him to deduct the pass-through losses under Code Sec. 1366(d), the at-risk rules under Code Sec. 465(c) did not apply.

The court also determined that the Alpine entities were not carrying on a trade or business during the years in issue, and Robert's claimed business expense deductions were properly disallowed. The court looked to case law in Bennett Paper Corp. v. Comm'r, 78 T.C. 458 (1983), which held that each entity must be evaluated individually and not in connection with any other entity. The court rejected Robert's argument that the Alpine entities were merely a business expansion and not a new business. Viewed individually, no Alpine entity was performing activity consistent with a business purpose.

Further, the FCC licenses were amortizable only upon the active beginning of a trade or business. The Alpine license-holding entities were formed solely to acquire and lease FCC licenses for use in Robert's cellular telephone business. Since the entities never leased the licenses for such use, the licenses were never held in connection with a trade or business that was being conducted. Thus, the court concluded that the licenses did not qualify as amortizable intangibles under Code Sec. 197 and were ineligible for amortization deductions.

For a discussion of calculating S corporation stock and debt basis, see Parker Tax ¶32,800.

Parker Tax Publishing Staff Writers

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