Basis Basics: A Lesson From the 8th Circuit

Apr 19, 2019 10:02:00 AM

basis

In an article by Professor Douglas A. Kahn published by the American Bar Association, Mr. Kahn contends that the increase in experiential learning in law schools is leading to a decrease in law student enrollment in core doctrinal classes, such as tax courses. According to Professor Kahn, only one-third of the students who recently graduated from Michigan Law School took a tax class, and less than 10% of those students took either partnership or corporate taxation.  Sadly, the situation at Michigan Law School is not unique.

What impact is the absence of tax education having on attorneys? Attorneys can certainly practice law without having studied tax, but in many areas of law (e.g., trusts & estates, real estate, business law), tax issues are pervasive. Without at least a basic understanding of tax concepts, attorneys may find that their business and estate planning strategies overlook key tax considerations. Lacking comprehension, some attorneys will refer more complicated cases to tax attorneys, CPAs, and other specialists, potentially forfeiting the client engagement altogether.

To combat these problems, attorneys can start by reading case law, as it’s a great way to learn tax law in a practical, fact-intensive context. Let’s take a look at a recent 8th Circuit case that explains a fundamental tax concept—basis—in very basic terms.

In Hargis vs. Koskinen, Bobby and Brenda Hargis bought and operated nursing homes. Bobby was the sole owner of S corporations that operated the homes (the “Operating Corporations”), while Brenda owned interests in limited liability companies—taxed as partnerships (the “Nursing Home LLCs”)—that bought and leased the nursing homes to the Operating Corporations. All the entities had net operating losses, which the Hargises deducted on their joint tax returns for 2009 and 2010. The IRS Commissioner issued the Hargises a notice of deficiency, disallowing their deduction of most of the nursing home losses, due to the Hargises’ insufficient basis in their companies. The Hargises owed $281,766.

The Tax Court ruled for the Commissioner, and the Eighth Circuit affirmed. The 8th Circuit held that the Tax Court correctly denied Bobby any basis in the indebtedness of the Operating Corporations, finding “no convincing evidence that any of the lenders looked to [Bobby] as the primary obligor on the loans.” The Commissioner properly calculated Brenda’s basis from the Nursing Home LLCs’ tax returns (Schedule K-1). Her deduction of their losses is limited to “the adjusted basis of [her] interest in the partnership.”

Why is Tax Basis Important?

An LLC member’s tax basis in his ownership interest impacts his personal tax liability since members are taxed on: (i) their share of a pass-through entity’s taxable income, and (ii) any distributions received from the entity in excess of the member’s basis in the entity. A member is entitled to deduct his share of the entity’s losses up to the amount of the member’s basis (subject to at-risk and passive activity rules). In other words, a high basis is good: Distributions from the LLC are only subject to tax when they exceed the member’s basis, and LLC losses are deductible by the member up to the amount of the member’s basis.

LLC vs. S Corporation Basis Rules

A key difference between S corporations and LLCs is found in the basis rules that apply to them.  Distributions from both S corporations and LLCs will be tax free to the extent of the owner’s basis. S corporation shareholders, however, do not get to increase their basis for all the S corporation’s debt but are limited to that debt which represents a direct loan by the shareholder to the S corporation. On the other hand, an LLC member can increase its basis for its allocable share of all the LLC’s debt.

In Hargis, the Operating Corporations’ debt, while guaranteed by Bobby Hargis, did not constitute a direct loan by Bobby Hargis, which would entitle him to basis. As Bobby Hargis learned the hard way, basis rules have real implications regarding the deductibility of losses and the taxation of distributions. Losses can only be deducted to the extent of the owner’s basis, and Bobby did not have enough basis. Since members of an LLC can include their share of the business liabilities in their basis, including loans that they guarantee but do not directly make, Bobby would have been able to increase his basis for the guaranteed loan had the Operating Corporations instead been LLCs taxed as partnerships.

Takeaways

If doctrinal coursework like federal taxation continues to be deemphasized by law schools in favor of experiential learning, then practitioners will continue to seek continuing legal education and other methods to learn the law and to better address tax issues that inevitably arise in client engagements. Case law is a practical and instructive resource, based in factual scenarios not unlike those your own clients face. Had Bobby and Brenda considered (with the help of a knowledgeable business lawyer) the projected early losses of their business, the need for financing, and the desire to deduct the resulting losses, the couple may have thought twice about the choice of entity, the method of financing, or both.


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1. Kahn, Douglas A., “The Downside of Requiring Additional Experiential Courses in Law School”, Probate & Property Magazine, Vol. 31, No. 02 (2017).
2. Prof. Kahn identified Temple University School of Law as having a higher percentage of law students taking a tax course before graduation, with only 29% of graduating students having taken no tax classes.
3.  No. 17-1694 (8th Cir. 2018)
4.  For example, members do not increase “at risk” basis for shares of non-recourse debt (unless “qualified non-recourse debt”), so members may not have enough “at risk” basis to deduct losses.

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