Substance over Form: No Friend of the Taxpayer

In the recent Messina1 case, the Ninth Circuit Court of Appeals affirmed the decision of the Tax Court denying S corporation shareholders losses as a result of lack of basis, particularly in this case, debt basis. In rendering their opinions, the Ninth Circuit and Tax Court discussed a taxpayer’s ability to argue substance over form principals to reclassify transactions differently than the form chosen by the taxpayer.

Summary of Facts

The taxpayers, Messina and Kirkland, were 80% shareholders of Club One Acquisition Corp. (“Club One”), an S corporation. In 2008, Club One acquired 100% of the interests in Club One Casino, Inc. (“Casino”), also an S corporation, after which Casino elected to be a disregarded entity as a qualified subchapter S subsidiary. The acquisition was financed primarily through two sources. Club One incurred third-party debt to finance approximately 81% of the acquisition, personally guaranteed by Messina and Kirkland. The remaining acquisition costs were funded by seller-financed promissory notes subordinated to the third-party debt.

At least as of the beginning of 2010, Club One was failing to meet certain covenants applicable to the third-party senior debt. In order to avoid negative effects of default, Messina and Kirkland sought to find investors to purchase the third-party debt. To raise this capital, they formed KMGI, Inc. (“KMGI”), another S corporation. Failing to find other investors, Messina and Kirkland funded KMGI through capital contributions and loans allowing KMGI to purchase the third-party debt. At that time, the personal guarantees of Messina and Kirkland were released.

Importantly, Messina and Kirkland intentionally, and with the advice of counsel, purchased the debt through KMGI rather than individually or through Club One. A significant reason for this structure was to allow the purchased debt to remain senior to the seller-financed promissory notes. Pursuant to the terms of a subordination agreement entered into when Club One acquired Casino, these other alternative forms of acquiring the debt would have caused the acquired debt to lose its senior status. Additionally, state casino regulatory approval was required for the transactions which also was a planning reason for the use of KMGI to acquire Club One’s debt.

For the 2012 tax year, Messina and Kirkland reported losses from Club One in excess of the basis in their S corporation shares of Club One. On a variety of theories discussed below, they argued that the debt owed by Club One to KMGI gave them personal basis against which to use the flow-through losses.

Tax Court Legal Analysis

As a starting point, an S corporation shareholder’s flow-through loss deductions cannot exceed the shareholder’s stock basis in the S corporation plus “adjusted basis of any indebtedness of the S corporation to the shareholder.”2 The Tax Court noted that “indebtedness of the S corporation to the shareholder” is not defined in the Internal Revenue Code. However, based on legislative history and case law authority, it relates to a shareholder’s investment in the corporation resulting from an economic outlay of the shareholder. Thus, the question of whether a shareholder obtains basis for corporate debt turns on whether the shareholder made an economic outlay to the corporation.

Messina and Kirkland argued the form of their transactions should be ignored. Rather, the substance of the transactions should control. Ultimately, as the sole shareholders of KMGI, funded entirely by them, the debt of Club One to KMGI was a debt of Club One to them. They argued that KMGI should be disregarded: (1) as an “incorporated pocketbook”; (2) a mere conduit or agent of the taxpayer; or (3) failing to make an actual economic outlay making it poorer in a material sense. They also argued that the step transaction doctrine should apply finding them to be the true lenders.

Incorporated Pocketbook

An entity is generally an “incorporated pocketbook” when it has the habitual practice of paying money to third parties on the taxpayer’s behalf, such as for personal expenses. While Messina and Kirkland admitted KMGI did not pay personal expenses on their behalf, they argued the lack of any other activity supported disregarding the entity as their “incorporated pocketbook.”

The IRS argued first that Messina and Kirkland chose to use KMGI rather than purchase the Club One debt individually. Citing to numerous authorities, the IRS believed this should bind them to the form – tax effect should be based on “what actually occurred and not …what might of occurred”3; “taxpayers are bound by the form of the transaction they have chosen; taxpayers may not in hindsight recast the transaction as one that they might have made in order to obtain tax advantages.”4 In order to overcome these challenges, a taxpayer bears “a heavy burden of demonstrating that the substance of the transactions differs from their form.”5 Ultimately, the Tax Court agreed with the IRS finding that Messina and Kirkland did not use KMGI to pay their expenses or the expenses of Casino (habitually or otherwise). As such, KMGI could not be disregarded on the “incorporated pocketbook” theory.

Conduit or Agent

Next, Messina and Kirkland argued that KMGI served as a conduit, acting as their agent. The U.S. Supreme Court has held that, in such cases, a corporation may be ignored.6 After some discussion, the Tax Court ultimately cited to nine factors laid out by the U.S. Supreme Court in evaluating whether a corporation is another’s agent:

  • Whether it operates in the name and for the account of the principal;
  • Whether it binds the principal by its actions;
  • Whether it transmits money received to the principal;
  • Whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal;
  • Whether its relations with the principal depend upon the principal’s ownership of it;
  • Whether its business purpose is carrying on of an agent’s normal duties;7
  • Whether there was a written agreement setting forth that the corporation was acting as agent for its shareholders with respect to a particular asset;
  • Whether it functioned as agent and not principal with respect to the asset for all purposes; and
  • Whether it was held out as agent and not principal in all dealings with third parties relating to the asset.8

After a step-by-step review of all nine factors, the only factor the Tax Court found which supported the taxpayers’ (“at best favoring them weakly”) was that KMGI promptly made distributions to Messina and Kirkland upon receipt of loan payments from Club One. The Tax Court went on to describe the actual need for Messina and Kirkland to argue the opposite of an agency relationship. A primary reason for using KMGI to fund the Club One debt was to avoid them personally acquiring the debt and losing priority to the seller-financed notes under the subordination agreement. As such, they “had every incentive to place as much separation between themselves and KMGI as they could.” Based on this analysis, Messina and Kirkland lose on this argument.

Actual Economic Outlay

Messina and Kirkland pointed to the fact that all KMGI funds came directly from them. They personally provided the funds to acquire the Club One debt. Further, KMGI was a shell corporation with no other activity beyond holding the debt. It served merely as a conduit with money flowing back and forth between Messina/Kirkland and Club One. KMGI only retained nominal funds.

The IRS pointed that the KMGI books showed Messina and Kirkland funds as constituting loans, then paid-in capital. For that, they received an increase in the basis of their KMGI stock for funds they contributed to KMGI. These facts along with the taxpayers’ significant business purpose of using KMGI make any “economic outlay” to have been made by KMGI, not Messina and Kirkland.

Ultimately, the Tax Court felt the taxpayers’ argument on this point was a rehashing of other arguments the court already had resolved against them. KMGI held a substantial asset, the Club One debt, and had a significant business purpose. Messina and Kirkland chose to form KMGI, classify their contributions as paid-in capital, and to have KMGI purchase the Club One debt. They are bound by the form they chose. While there was an “economic outlay,” it was made by KMGI.

Step Transaction

The Tax Court quickly dispensed with this argument, recognizing it is not a “one-way ratchet,” but rather can, in certain circumstances, benefit a taxpayer. However, as with all of the other arguments raised by Messina and Kirkland, KMGI was not an agent, mere conduit, incorporated pocketbook, etc. Rather, it was formed with real business purposes which operated in conformity with that business purpose. Messina and Kirkland cannot avoid the tax consequences of the form they chose – the Tax Court stating “long has the rule been recognized by the courts that taxpayers are bound by the form of their transaction and may not argue that the substance triggers different tax consequences.” Beyond these reasons, the Tax Court also felt there could not even hypothetically be a step transaction. There simply was no “interrelated yet formally distinct steps in an integrated transaction” here. Rather, there were two steps: (1) the taxpayers’ funding of KMGI; and (2) KMGI’s purchase of Club One debt. These are separate, distinct steps that should not be consolidated under the step transaction theory, a part of the substance over form doctrine.

Ninth Circuit Court of Appeals Analysis

The Ninth Circuit made relatively quick work of the matter. While the Ninth Circuit recognized it reviews Tax Court determinations de novo, that did not help Messina and Kirkland. At the outset, the Ninth Circuit addressed the “substance over form” argument:

We have not held that the “substance over form” doctrine is available to a taxpayer as well as the government. Indeed, we have previously rejected the notion that the taxpayer can “escape the tax consequences of a business arrangement which he made upon the asserted ground that the arrangement was fictional.”

Based on this view of a taxpayers’ ability to use substance over form in their own favor, it is clear Messina and Kirkland were dead on arrival. Nonetheless, the Court reviewed whether Messina and Kirkland could prevail assuming, arguendo, that the doctrine would be available to taxpayers in the Ninth Circuit. In determining whether the form of the transaction should be respected as corresponding to its substance the Court said:

KMGI’s purchase of the third-party loan directly, rather than through Kirkland and Messina, was motivated by a number of non-tax business and regulatory considerations. In all circumstances except their tax returns, Taxpayers treated KMGI as an independent entity that was to acquire the third-party loan and serve as Club One’s creditor. They reaped several benefits from doing so, including avoidance of a foreclosure on the casino that they co-own through Club One and a call on the personal guaranties that they signed in connection with the third-party loan. In addition, KMGI served business functions, including: being able to apply for the Gambling Commission’s permission to acquire the loan; purchasing the loan from the third party potentially to maintain the loan’s seniority to Club One’s other obligations; receiving loan payments from Club One; and returning capital contributions to Kirkland and Messina. Thus, even if the “substance over form” doctrine were available to Taxpayers, it does not alter the outcome here.

The Ninth Circuit seemed pretty clear that it would not offer taxpayers the opportunity to alter the form of a transaction they chose to achieve a better tax result. Further, even were they to offer Messina and Kirkland that opportunity, the substantial non-tax business purposes for which KMGI was formed and used negate their arguments. It should be respected, leaving Messina and Kirkland without basis in Club One stock against which to take S corporation flow-through losses.


Messina is the second case from a U.S. Circuit Court of Appeals in a seven-month period to address these issues. In Meruelo9, the Eleventh Circuit Court of Appeals recently affirmed the Tax Court in another case involving many of the same questions. A full discussion of the Meruelo case is beyond the scope of this writing. However, while many of the facts in Meruelo were different than Messina, both cases involved an S corporation shareholder seeking stock basis for funds advanced to the S corporation by an affiliated entity. In both cases, the taxpayer argued substance over form and related concepts. Both courts rejected a taxpayer’s attempt to reclassify the form of transactions they chose.

The Eleventh Circuit, in Meruelo, said that “Meruelo’s argument for substance over form is a nonstarter.”10 Citing to the U.S. Supreme Court, the Court further stated that “a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.”11 The Eleventh Circuit mentions only one, single case where it has allowed a taxpayer to prevail on a substance over form argument.12 As in Messina, the taxpayer in Meruelo could not prevail when seeking to disregard the form he chose.


Clearly, when a taxpayer finds themselves pushing a substance over form argument in any tax dispute, they are in a bad place. As cited above, a taxpayer is under a “heavy burden” to undermine the form they intentionally chose. The IRS, on the other hand, was not a part of that process. Therefore, understanding taxpayers will often attempt to paint a different picture than what in substance is occurring, courts are much more accepting of the IRS’ arguments that the substance of a transaction differs from its form.

These cases can be seen merely as lessons in what not to do, i.e. do not claim S corp. basis for funds advanced by another taxpayer, whether as a loan or contribution to capital, to the S corp. and rely on substance over form to save the day. Likewise, they can be seen as warnings for taxpayers arguing that the form of the transaction they choose should be disregarded to obtain better tax results.

In addition to showing us what not to do, we can view these cases as what we should be doing. In Messina and Meruelo, the courts gave a detailed analysis of the legal standards applicable to various substance over form theories – incorporated pocketbook, mere conduit/agent, step transaction, etc. We can use these cases to illustrate how substance over form will be analyzed by courts. In doing so, we can affirmatively structure transactions to avoid those theories being used against our clients by the IRS. Therefore, while certainly showing what not to do, these cases also provide us guidance as to what we should be doing to support the transactions we develop against arguments they should be viewed as something other than what we intend.

An interesting coda is that Messina and Kirkland, while losing the tax benefits they sought in litigation with the IRS, also lost their priority status versus Club One’s seller-financed notes from acquiring Casino. A dispute with the sellers was submitted to binding arbitration, which ended in favor of sellers. Afterwards, the arbitration award was entered with the local court in Fresno County, California. Then, Club One filed action in the Supreme Court of New York County, New York seeking a determination that the arbitration award was subordinate to the Club One debt purchased by KMGI. In 2014, the court found that, while the promissory notes were subordinate, the arbitration award was not. As a result, Club One filed for Chapter 11 bankruptcy protection. In the end, Messina and Kirkland suffered negative tax consequences from transactions structured to gain priority over the seller-financed promissory notes which they lost anyway.


  1. Messina v. Commissioner, 2019 WL 7209828 (9th Cir. 2019), affirming Messina, T.C. Memo 2017-213.
  2. IRC §1366(d).
  3. Don E. Williams Co. v. Commissioner, 429 U.S. 569, 579-580 (1977).
  4. Harris v. U.S., 902 F.2d 439, 443 (5th Cir. 1990).
  5. Ruckriegel v. Commissioner, T.C. Memo 2006-78.
  6. Commissioner v. Bollinger, 485 U.S. 340 (1988).
  7. The foregoing factors are set fort in Nat’l Carbide Corp. v. Commissioner, 336 U.S. 422, 437 (1949).
  8. These additional factors are set forth in Bollinger, 485 U.S. at 349-350.
  9. Meruelo v. Commissioner, 923 F.3d 938 (11th Cir. 2019), affirming Meruelo, T.C. Memo 2018-16. For descriptions of the case, see Tianhang (Helena) Liu, Payment of S Corp.’s Expenses by Affiliated Companies Did Not Increase Shareholder’s Basis, The Tax Advisor, November 1, 2019, (last visited January 12, 2020); and Peter J. Reilly, Don’t Try to Create Tax Basis with Journal Entries, Forbes, May 21, 2019, (last visited January 12, 2020).
  10. Id. at 944.
  11. Id. at 945; citing Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974).
  12. See Selfe v. U.S., 778 F.2d 769 (11th Cir. 1985).


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