The summary Tax Court opinion  in the Merrell, TC Summary Opinion 2020-5 ( ruled that the ten percent penalty on early withdrawal from an IRA applies when the withdrawal was on account of the disability of the spouse rather than the account holder himself.)

   The court point out that the disability exception to the 10% additional tax on certain IRA distributions only applies to the owner and no one else. This a tax trap for the unwary.

The Case Law…. In general, Code Sec. 72(t)(1) imposes an additional tax of 10% on IRA distributions.

Code Sec. 72(t)(2)(A)(iii) provides that the additional 10% tax does not apply to a distribution that is attributable to the employee’s being disabled. In the case of an IRA, the term “employee” is defined in Code Sec. 72(t)(5) as “the individual for whose benefit such plan was established.”

The Case Facts. In this case the taxpayer was Mr. Merrell, who was under the age of 59½ and was  not disabled. He  took a distribution from his IRA. He did not pay the 10% additional tax on the distribution because his felt that his wife who was disabled and filing joint with him would be shielded from the 10% additional tax penalty.  The IRS sent the couple a notice of deficiency, saying the IRA distribution should be subject to the 10% additional tax.

All parties agreed that Mr. Merrell was the individual for whose benefit the IRA was established, Mr. Merrell was not disabled, and no other exception to the 10% additional tax applied.

The Final Court Decision. The Tax Court held that, because Code Sec. 72(t)(2)(A)(iii) specifically requires that a distribution be attributable to the employee’s disability for the exception to the 10% additional tax to apply, the exception did not apply here because it was not the IRA owner that was disabled, but his wife.

A small point of misunderstanding cost the Merrell’s a needless penalty.

This points out the need for effective pre-planning when clients set up their individual IRA’s.

Sound Familiar…The Ninth Circuit Court of Appeals challenged S Corp shareholders basis on the grounds it had insufficient basis to deduct loss !!

The Ninth Circuit Court of Appeals has held that S corporation shareholders had insufficient basis to deduct their claimed loss in the Messina Case.

An ongoing theme with tax court cases this year seems to focus on whether our client had ‘sufficient basis ‘ to deduct losses on their personal tax returns. This case was decided at year end of 2019. It points out significant requirements that advisors must consider before they can claim a loss.

 The Key Element  An S corporation’s indebtedness to another entity, even one wholly owned by the shareholder, does not increase the basis that the shareholder can claim in the S corporation.

The Court summary……”In sum, absent a basis in Club One that equals or exceeds their claimed deductions, Taxpayers fail to satisfy their “burden of clearly showing” that they are entitled to those deductions, Stahl v. United States, 626 F.3d 520, 522 (9th Cir. 2010) (internal citation omitted); see also 26 U.S.C. § 1366(d)(1) (limiting passthrough deductions that shareholder may claim to “shareholder’s basis in stock and debt”).

Accordingly, the Tax Court correctly concluded that the deficiencies assessed by the Commissioner were proper.”…

The Tax Law  An S corporation shareholder takes into account, for the shareholder’s tax year in which the corporation’s tax year ends, his or her pro rata share of the corporation’s items of income, loss, deduction, or credit, as well as the corporation’s non-separately computed income or loss. (Code Sec. 1366(a)(1)) The character of the items passed through to the shareholders is preserved. (Code Sec. 1366(b))

The aggregate amount of losses and deductions considered by an S corporation shareholder is limited to the sum of

  1. The adjusted basis of the shareholder’s stock in the S corporation, and
  2. The shareholder’s adjusted basis of any “indebtedness of the S corporation to the shareholder.” (Code Sec. 1366(d)(1))

The Tax Code does not define “indebtedness of the S corporation to the shareholder.” The legislative history of the predecessor to Code Sec. 1366(d)(1)(B) states that losses are limited “to the adjusted basis of the shareholder’s investment in the corporation; that is, to the shareholder’s adjusted basis in corporation stock owned by the shareholder and the adjusted basis of any debt the corporation owes to the shareholder.”

A shareholder bears the burden of establishing his basis in an S corporation’s indebtedness to him (debt basis). (Broz, (2011) 137 TC 46)

The Case Facts  Dana Messina and Kyle Kirkland each owned 40% of the outstanding stock in Club One, an S corporation.

In 2008, Club One acquired 100% of the stock of Casino, which elected to be a QSub of Club One. The acquisition was funded in part by a third-party loan later acquired by KMGI, an S corporation organized by Messina and Kirkland. Messina and Kirkland each transferred over $7 million to KMGI to provide it with the necessary funds. The transferred funds were initially listed in KMGI’s books as “shareholder loans.”

During 2012, Club One had an ordinary business loss and Messina and Kirkland each received a pass-through loss of $570,284.

On their 2012 tax returns Kirkland and Messina each deducted the pass-through loss from Club One, each claiming he had a $7 million basis in Club One by treating their “shareholder loans” to KMGI as their respective bases in Club One. The IRS disallowed their loss deductions.

The Taxpayer position Messina and Kirkland argued that KMGI should be disregarded because it was acting as their agent. Therefore, the loans they made to KMGI should be deemed to be Club One’s indebtedness to them, thus allowing them to count their adjusted bases in the loan when calculating the amount of Club One’s pass-through losses they could deduct for the 2012 tax year.

However, the IRS argued that KMGI’s separate corporate existence should be respected because KMGI wasn’t a conduit or agent of Messina and Kirkland, and that the loan they made to KMGI to acquire the third party debt owed by Club One should not be treated as indebtedness of Club One to Messina and Kirkland. The IRS asserted that basis in an S corporation can be only acquired either by contributing capital or directly lending funds to the company. Accordingly, the IRS reasoned, KMGI’s loans to Club One did not create basis in Club One for Messina and Kirkland. Accordingly, the IRS reasoned, KMGI’s loans to Club One did not create basis in Club One for Messina and Kirkland.

The Tax Court’s holding. The Tax Court agreed with the IRS’s argument that KMGI’s separate corporate existence should be respected because KMGI was not a conduit or agent of Messina and Kirkland and, therefore, could not be disregarded as such.

The Tax Court noted that KMGI operated in its own name and for its own account, there was no agreement showing that KMGI was Messina and Kirkland’s agent, and it was never held out as their agent in dealings with third parties.

The Tax Court also found that Messina and Kirkland were bound to the form of the transaction they chose and that their investment in KMGI increased their basis in KMGI’s stock, not their stock in Club One. Accordingly, they lacked the basis in Club One to deduct their claimed losses. See Tax Court Rejects S corp shareholders’ attempt to deduct loss based on QSub loan (11/09/2017).

The Court of Appeals Position. According to the Ninth Circuit, the Tax Court correctly concluded that Code Sec. 1366(d)(1) limits the debt basis that a shareholder may claim in an S corporation to “any indebtedness of the corporation to the shareholder.”

Therefore, “an S corporation’s indebtedness to another entity, even one wholly owned by the shareholder, does not increase the amount of pass-through deductions the shareholder can claim.”

The Ninth Circuit also held that the Tax Court correctly determined that Kirkland and Messina improperly included the debt that Club One owed KMGI when calculating their bases in Club One because the Club One debt ran to KMGI —not to Messina and Kirkland—and, therefore, it did not increase their bases in Club One.

Careful planning and a thorough  yearend review of all the debt transactions is essential to prove  shareholder’s adjusted basis of any “indebtedness of the S corporation to the shareholder.” (Code Sec. 1366(d)(1))

 This case again signals that the IRS  will continue to challenge taxpayers to document their basis calculations.

Be careful !!


If your clients have installment agreements with the  IRS be aware that IRS is updating  their criteria   on which it provides answers to taxpayers with existing installment agreements. The suspension through July 15, 2020 of due dates under those agreements is being reviewed. Care should be taken in reviewing these agreements so that your clients are complying.

Code Sec. 6159(a) allows IRS to enter into written agreements with delinquent taxpayers under which such taxpayers may pay their taxes in installments (installment agreements).

The IRS initiated the  “People First Initiative” in the form of  IR 2020-59. This pronouncement  allowed taxpayers with an installment agreement, including a direct debit installment agreement, to suspend any installment payments due between April 1, 2020 and July 15, 2020 (“suspension period”).

It was clear that the IRS updated their internal directives on defaulted installment agreements. The suspension effected any taxpayers that did not default on any installment agreements for nonpayment between April 1, 2020 and July 15, 2020.

However, by law, interest continued to accrue on any unpaid balances. (IR 2020-59).

It would be productive to review the Frequently Asked Questions (FAQ) about suspended installment payments that were in place as of April 1, 2020.

In June, IRS provided answers to frequently asked questions (FAQs) about the suspended due dates, under the People First Initiative, for installment agreement payments.

 IRS has updated their website which included the following reminders:

Reminder regarding interest and penalties while installment agreement is in effect. Though interest and late-payment penalties continue to accrue on any unpaid taxes, the failure-to-pay-tax penalty rate is cut in half while an installment agreement is in effect. The usual penalty rate of 0.5% per month is reduced to 0.25%.

Where taxpayer is unable to meet his current installment agreement terms. If a taxpayer cannot meet their current installment agreement terms due to a COVID related hardship, they can revise the agreement on plan or call the customer service number on their IRS notice if they have a Direct Debit Installment Agreement.

IRS monthly payment vouchers. IRS did not mail monthly reminder payment vouchers during the suspension period due to IRS office closures caused by COVID-19. IRS will resume mailing reminder notices as IRS offices re-open.

Taxpayers must resume making payments with their first payment due on or after July 16, 2020 to avoid default, even if they do not receive their monthly reminder notice.