Thomas B. Wells
MEMORANDUM OPINION
WELLS, Judge: Respondent determined deficiencies in Federal income taxes for petitioners Fleming G. Brooks and Sherry H. Brooks in the case at docket No. 8981-03 as follows 1:
| Addition to tax |
| Year | Deficiency | Sec. 6662(a) |
| 1999 | $207,552 | $997.60 |
| 2000 | 190,105 | 1,027.60 |
Respondent determined deficiencies in Federal income taxes and additions to tax for the Estate of Fleming S. Brooks and Merle R. Brooks in the case at docket No. 8983-03 as follows:
| Year | Deficiency |
| 1999 | $ 157,207 |
| 2000 | 163,910 |
After concessions, the issue to be decided is whether the advances of open account debt by petitioners to their closely held S corporation in 1999 and 2000 provided petitioners with basis to offset repayments of open account debt made by the company in 1999 and 2000, prior to each respective advance. 2
Background
The parties submitted the instant case fully stipulated, without trial, pursuant to Rule 122. The parties' stipulations of fact are incorporated herein by reference and are found as facts in the instant case.
Petitioners Fleming G. Brooks and Sherry H. Brooks are husband and wife. At the time of filing the petition, they resided in Samson, Alabama. During the years in issue, Fleming S. Brooks and Merle R. Brooks were husband and wife. Fleming S. Brooks died on March 30, 2001. At the time of filing the petition, Merle R. Brooks resided in Samson, Alabama. Fleming G. Brooks and Fleming S. Brooks (Messrs. Brooks) and their respective spouses were calendar year taxpayers.
At all relevant times, Fleming S. Brooks owned 51 percent of the stock of Brooks AG Company, Inc., (the company), and Fleming G. Brooks owned 49 percent. The company was an S corporation with a calendar year tax year, and Messrs. Brooks each had a zero basis in their stock in the company during all relevant times.
Before and during the years in issue, Messrs. Brooks advanced money to the company on open account on three occasions. The open account transactions and related computations of Messrs. Brooks are described in detail in the Appendix to this opinion. The first such advance occurred during 1997, when Messrs. Brooks each advanced $ 500,000 to the company on open account (referred to collectively as the $ 1 million advance). The second advance occurred on December 31, 1999, when Messrs. Brooks each advanced $ 800,000 to the company on open account (referred to collectively as the $ 1.6 million advance). The third advance occurred on December 29, 2000, when Messrs. Brooks each advanced $ 1.1 million to the company on open account (referred to collectively as the $ 2.2 million advance). On January 5, 1999, the company made a $ 500,000 repayment to each of Messrs. Brooks (referred to collectively as the $ 1 million repayment). On January 3, 2000, the company made a $ 800,000 repayment to each of Messrs. Brooks (referred to collectively as the $ 1.6 million repayment).
As of the close of 1998, the outstanding balance of open account debt owed by the company to Messrs. Brooks equaled the amount advanced to the company during 1997; i.e., $ 1 million. However, pro rata company losses during 1997 and 1998 had reduced Messrs. Brooks's basis in the open account debt to zero.
When Messrs. Brooks made the $ 1.6 million advance at the close of 1999, it was an amount sufficient, in Messrs. Brooks's view, to (1) provide a basis offset for the $ 1 million repayment and (2) allow for the recognition by Messrs. Brooks of their pro rata share of company losses incurred during 1999. 3
When Messrs. Brooks made the $ 2.2 million advance at the close of 2000, it was an amount sufficient, in Messrs. Brooks's view, to (1) provide a basis offset for the $ 1.6 million repayment and (2) allow for the recognition by Messrs. Brooks of their pro rata share of company losses during 2000. 4
Respondent concedes that Messrs. Brooks's advances to the company and the company's repayments of the advances constituted open account debt and does not contend that any of the advances constituted separate indebtedness. Other than the advances described above, Messrs. Brooks advanced no money to the company from 1997 to December 31, 2000.
Discussion
We must decide whether the $ 1.6 million advance provided sufficient basis to offset the $ 1 million repayment on January 5, 1999, in addition to allowing recognition of Messrs. Brooks's pro rata share of company losses for 1999, and whether the $ 2.2 million advance provided sufficient basis to offset the $ 1.6 million repayment on January 3, 2000, in addition to allowing recognition of Messrs. Brooks's pro rata share of losses for 2000.
A lender recognizes income to the extent that repayment of the debt exceeds the lender's basis in the debt. See sec. 1001(a), (c). Because a lender generally takes a basis equal to the face amount of the debt, a repayment generally does not generate taxable income to the lender. See secs. 1001(a), 1011(a), 1012. However, taxable income may result from the repayment of a debt if the lender's basis in the debt is reduced from the face amount. See sec. 1001(a). If a shareholder advances money to an S corporation and the shareholder's pro rata share of S corporation losses exceeds the shareholder's basis in the stock of the S corporation, a reduction in the basis of a debt may occur. See sec. 1367(b)(2)(A); sec. 1.1367-2(b), Income Tax Regs.
A shareholder of an S corporation must take into account the shareholder's pro rata share of the S corporation's items of income, loss, deduction, and credit. 5Sec. 1366(a)(1). Items of income increase the shareholder's basis in stock of the S corporation (stock basis), and items of loss decrease the shareholder's stock basis. Sec. 1367(a). In the instant case, Messrs. Brooks each had a zero basis in their stock in the company at all relevant times.
Although a shareholder may not reduce stock basis below zero, a shareholder with a zero stock basis may recognize further losses to the extent of the shareholder's debt basis, including the shareholder's advances to the S corporation. See sec. 1366(d)(1). Section 1367(b)(2)(A) and section 1.1367-2(b), Income Tax Regs., provide that a shareholder must reduce debt basis (but not below zero) to the extent that the shareholder's pro rata share of losses exceeds the shareholder's stock basis, after taking into account any income items for the tax year. 6 In a year subsequent to such a reduction in debt basis, if the shareholder's pro rata share of income exceeds the pro rata share of losses, section 1367(b)(2)(B) and section 1.1367-2(c), Income Tax Regs., provide that the excess income shall first restore the shareholder's debt basis and then restore the shareholder's stock basis. 7 The reduction of debt basis pursuant to section 1367(b)(2)(A) and section 1.1367-2(b), Income Tax Regs., and the restoration of debt basis pursuant to section 1367(b)(2)(B) and section 1.1367-2(c), Income Tax Regs. , are hereinafter collectively referred to as debt basis adjustments.
In the instant case, the record reveals that the amount of the company's losses in 1997, 1998, 1999, and 2000, exceeded the amount of the company's income in each respective tax year. Consequently, pursuant to section 1.1367-2(b), Income Tax Regs., the losses reduced Messrs. Brooks's respective open account debt bases at each respective year end. Respondent does not challenge petitioners' recognition of such losses. 8
For the purpose of determining taxable income upon an S corporation's repayment of shareholder advances, a separate transaction involving an advance and repayment of indebtedness is generally treated separately. See sec. 1.1367-2(a), (b)(3), (c)(2), Income Tax Regs. Shareholders may not offset the repayment of a shareholder advance with the basis of another separate shareholder advance. Cornelius v. Commissioner, 58 T.C. 417 (1972) (discussed further below), affd. 494 F.2d 465 (5th Cir. 1974). However, multiple shareholder advances and repayments that constitute open account indebtedness are treated as a single indebtedness rather than separate indebtedness. See Cornelius v. Commissioner, 494 F.2d 465, 471 (5th Cir. 1974); sec. 1.1367-2(a), Income Tax Regs.9
Petitioners contend that the basis of a shareholder's open account debt is properly determined at the close of the S corporation's tax year by first netting advances and repayments of open account debt during the tax year and then making any necessary debt basis adjustments. Respondent relies on Cornelius v. Commissioner, 494 F.2d 465 (5th Cir. 1974), for the proposition that Messrs. Brooks must recognize income on the repayment of their advances to the extent that the repayments exceed their basis in the advance on the date of repayment, without regard to the basis of subsequent advances in the year of repayment.
We believe that respondent's reliance in the instant case on Cornelius v. Commissioner, supra, is misplaced. In Cornelius, the Fifth Circuit Court of Appeals affirmed the finding of this Court that the advances by the taxpayers to their S corporation and the repayments of those advances constituted separate and complete transactions as opposed to open account debt. 10Cornelius v. Commissioner, 494 F.2d at 471. The Court of Appeals stated:
The real question to be decided is whether each advance to the
corporation by the shareholders and its corresponding repayment
constitute a separate and complete transaction or whether the
indebtedness should be considered as an "open account" whose
fluctuations are to be measured for tax purposes at the end of
each taxable year. ** * The Tax Court properly determined that
"the 1966 loans and the [1967] repayments thereof constituted a
completed transaction, and the loans occurring later in 1967
were separate and apart from such transaction." * * *
[Id.; citation omitted.]
Based on the Tax Court's finding in Cornelius that the loans were separate transactions and not open account indebtedness, the taxpayers were required to recognize as taxable income the amount of the repayment in excess of the taxpayers' basis in the advance at the time of repayment, without regard to the basis of a subsequent advance in the year of repayment. Cornelius v. Commissioner, 58 T.C. at 423. It may be inferred that a netting of advances and repayments during the year would have been proper if the loans had been open account indebtedness rather than separate transactions.11Cornelius v. Commissioner, 494 F.2d at 471. In contrast to Cornelius, the parties in the instant case have stipulated that the advances in issue constitute open account debt. Respondent has made no contention that any advance and repayment constitutes a separate indebtedness or closed transaction.
Based on the parties' stipulations that the advances were open account debt and respondent's failure to contend that any advance and repayment composed a separate transaction, we hold that the basis of the open account indebtedness is properly computed by netting at the close of the year advances of open account debt during the year and repayments of open account debt during the year. Cf. Cornelius v. Commissioner, 494 F.2d 465 (5th Cir. 1974). Consequently, the advances in 1999 and 2000 shielded petitioners from the realization of gain upon the repayments during those years.
We have considered all contentions that the parties have raised. 12 To the extent not addressed herein, those contentions are without merit or unnecessary to reach.
To reflect the foregoing and concessions by the parties,
Decisions will be entered under Rule 155.
Appendix
I. Computation of Debt BasesA. RespondentWith respect to the 1999 tax year, respondent's position results in (1) a debt basis of $ 358,707 for petitioners in docket No. 8981-03 at the close of 1999, reflecting a reduction of basis in the $ 800,000 advance only by an allowable loss of $ 441,293, and (2) a debt basis of $ 386,056 for petitioners in docket No. 8983-03 at the close of 1999, reflecting a reduction of basis in the $ 800,000 advance only by an allowable loss of $ 413,944 for petitioners' 1999 tax year.
With respect to the 2000 tax year, respondent's position results in (1) a debt basis of $ 718,762 for petitioners in docket No. 8981-03 at the close of 2000, reflecting a reduction of basis in the $ 1,100,000 advance only by an allowable loss of $ 381,238, and (2) a debt basis of $ 703,202 for petitioners in docket No. 8981-03 at the close of 2000, reflecting a reduction of basis in the $ 1,100,000 advance only by an allowable loss of $ 396,798.
B. PetitionersWith respect to the 1999 tax year, petitioners contend that the basis of each $ 800,000 advance was first reduced by the $ 500,000 repayments on January 5, 1999, and then further reduced by $ 300,000 of pro rata company losses, resulting in a zero debt basis at the close of 1999.
With respect to the 2000 tax year, petitioners contend that the basis of each $ 1,100,000 advance was first reduced by the $ 800,000 repayments on January 3, 2000, and then further reduced by $ 300,000 of pro rata company losses, resulting in a zero debt basis at the close of 2000.
II. Computation of GainA. RespondentWith respect to the 1999 tax year, respondent determined that (1) petitioners in docket No. 8981-03 had a taxable gain of $ 500,000 related to the repayment of January 5, 1999 ($ 500,000 repayment less zero debt basis), and (2) petitioners in docket No. 8983-03 had a taxable gain of $ 500,000 related to the repayment of January 5, 1999 ($ 500,000 repayment less zero debt basis). 13
With respect to the 2000 tax year, respondent determined that petitioners in docket No. 8981-03 had a taxable gain of $ 441,293 related to the repayment of January 3, 2000 ($ 800,000 repayment less $ 358,707 debt basis), and that petitioners in docket No. 8983-03 had a taxable gain of $ 413,944 related to the repayment of January 3, 2000 ($ 800,000 repayment less $ 386,056 debt basis). 14
B. PetitionersWith respect to the 1999 tax year, petitioners contend that the $ 800,000 basis of each advance offset the $ 500,000 repayments on January 5, 1999, and also allowed for the recognition of $ 300,000 of the pro rata share of the company's losses.
With respect to the 2000 tax year, petitioners contend that the $ 1,100,000 basis of each advance offset the $ 800,000 repayments on January 3, 2000, and also permitted each petitioner to recognize $ 300,000 of the pro rata share of the company's losses.