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In Estate of Thomas H. Fry et al. v. Commissioner (T.C. Memo. 2024-8, released January 23, 2024), the Tax Court held that an S corporation owner could claim losses from his waste processing business. In reaching that conclusion, the court reasoned that the undocumented cash transfers from the owner' profitable business to his unprofitable business were properly considered equity, not debt, which increased his basis in the business and allowed him to claim losses.

Background

Thomas H. Fry was the sole shareholder of two S corporations, Crown Disposal, Inc. (Crown) and CR Maintenance Services, Inc. (CR Maintenance), which engaged in waste collection and waste processing, respectively. The management of both companies was extremely integrated, and they shared common facilities in Sun Valley, California. Beginning in 2010, CR Maintenance was not profitable and required regular cash infusions to stay in operation, which were provided by Crown at the direction of Mr. Fry and totaled approximately $36.25 million by the end of 2013 (the Transfers and Payments).

Crown and CR Maintenance executed no promissory notes for any of the transfers, and there was no written due date for return of the money. No security interest was requested by Crown or granted by CR Maintenance. Furthermore, CR Maintenance did not make, or promise to make, interest payments related to the Transfers and the Payments. The payments were characterized on CR Maintenance's balance sheet and tax returns from 2010 to 2019 as liabilities to Crown and not additional capital contributions from Mr. Fry. The Tax Court found that, from 2010 through 2020, "CR Maintenance reported the Transfers and the Payments as a balance due to Crown on its tax returns and characterized them as debts."

For the 2013 tax year, CR Maintenance showed an approximately $5.65 million ordinary loss, of which the Frys claimed a $4.7 million flow-through loss on their individual tax return. In September 2020, the IRS issued the Frys a notice of deficiency disallowing approximately $3.46 million of the 2013 flow-through loss, saying the Frys lacked sufficient basis in CR Maintenance because the transfers from Crown were debt and not equity.

The Frys claimed in their petition to the Tax Court that the payments were constructive distributions from Crown, followed by equity contributions to CR Maintenance, regardless of how they were characterized on the balance sheets and tax returns of the two companies. The IRS in turn claimed that IRC Section 385(c), the duty of consistency, and the doctrine of election prohibited the Frys from recharacterizing the payments as equity when they previously characterized them as debt.

Court decision

The court first addressed the IRS's contention that IRC Section 385(c) bound the Frys to their characterization of the Transfers and Payments as debt at the time of filing their return for the 2013 tax year. IRC Section 385(c)(1) provides that "[t]he characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary)." The court held that the IRC Section 385(c) requirement binding a taxpayer to its characterization of an instrument as debt or equity at issuance did not apply where an instrument was not formally issued.

In response to the Frys' secondary argument that IRC Section 385(c) does not apply to S corporations, the court noted in a footnote that no court decision had ever bound any taxpayer (S corporation or otherwise) to its initial characterization of an interest under IRC Section 385(c)(1). As a result, the court declined to apply IRC Section 385(c)(1), noting that "the ultimate test" is "not necessarily the original intent of the parties." Rather, the court stated, the determination should be made annually based on all facts and circumstances, as opposed to an initial characterization on the issuer's tax return.

After establishing that IRS Section 385(c) did not apply, the court analyzed the transactions under Hardman v. United States, 827 F.2d 1409 (9th Cir. 1987) and other cases listing debt-equity factors to determine whether the transfers from Crown could be considered constructive distributions to Mr. Fry, followed by capital contributions to CR Maintenance.

Of the 11 Hardman factors, the court found four neutral and only one favoring classification of the transactions as debt, specifically that the parties originally intended for the transfers to create indebtedness.

The court found six of the 11 Hardman factors favored the creations of an equity interest, particularly that:

• Repayment depended on CR Maintenance's future success
• Crown never obtained a security interest
• Crown's right to repayment was subordinate to any other creditors
• The interests of the two businesses were significantly intertwined
• Interest payments were not expected
• CR Maintenance could not obtain loans from outside lenders

The court also found that the transfers satisfied both prongs of the constructive dividend test under Ninth Circuit case law1 because the expenditure did not give rise to a deduction on behalf of Crown and, more critically, resulted in an economic benefit for Mr. Fry. According to the opinion, there was no discernable business reason for Crown to make the transfers and payments at issue and no true expectation of timely repayment or interest other than for Mr. Fry's benefit in keeping CR Maintenance afloat.

The court also held that the duty of consistency and the doctrine of election did not prevent the Frys from treating the payments as equity. Regarding the former, the IRS was unable to prove that it would be harmed by the change. Regarding the latter, the court did not view the debt-equity determination as a free choice or an election, but rather a determination based on the various factors that indicate the true economic substance of a transaction.

Implications

As the court noted, only one court has ever cited IRC Section 385(c) and only in passing. In contrast, the IRS has issued several forms of informal advice on the provision, some of which consider tax return treatment relevant to the characterization for IRC Section 385(c) purposes in the absence of a legal instrument (see e.g., FSA 200004011). Thus, the court's determination that there was no "characterization" for purposes of IRC section 385(c) in the instant case because there was no legal issuance of an instrument is noteworthy.

Further, the court gave little weight to the parties' original intent for purposes of characterizing the interest (even where the taxpayer was the one arguing against characterization consistent with the original intent) and suggested performing the debt-equity test annually based on all facts and circumstances. The court's comment suggests an instrument's characterization may transform from debt to equity (or vice versa) depending on the facts and circumstances, which should be evaluated annually. Absent egregious circumstances, courts have not retested an instrument's characterization as debt or equity on an annual basis. See NA General Partnership & Subsidiaries v. Commissioner, T.C. Memo 2012-172.