By: Ralph Levy
Two recent Tax Court cases are reminders that shareholder guarantees of loans to an S corporation do not generally create basis that can be used by the shareholder to deduct losses. Under Internal Revenue Code §§1366(d)(1)(A) and 1366(d)(1)(B), an S corporation shareholder can only deduct a prorata share of deductions and losses of an S corporation to the extent of the shareholder’s adjusted basis in stock in the S corporation and the adjusted basis in any debt payable by the S corporation to the shareholder. Under regulations promulgated under that Code section, a guarantee of debt of the S corporation does not create basis unless the shareholder actually makes a payment on such indebtedness and then only to the extent of such payment. Reg. §1.1366-2(a)(2)(ii). Because of these rules, practitioners generally discourage the use of S corporations to own real estate or any business in which the shareholders anticipate the need to borrow money to finance operations (particularly in the startup phase of any business in which tax losses are anticipated).
In Franklin, TC Memo 2016-2017, the Tax Court found that where the assets of a sole shareholder of an S corporation who had personally guaranteed debt of the corporation were seized and sold by a creditor of the corporation after the corporation had defaulted on the debt, the shareholder was entitled to include in basis that could support losses of the corporation the amount the creditor received from the sale of the seized assets. However, no basis could be claimed for the remaining unsatisfied debt of the corporation after sale of the assets. Philip J. Franklin, the taxpayer, had guaranteed indebtedness that was owed by FDI, his wholly owned S corporation, to a third party, ACRO. After FDI’s default in repayment of this debt, which was originally in excess of $1.7 Million, ACRO seized and sold Mr. Franklin’s assets for $496,000, leaving a remaining balance of $500,000 on the guaranteed loan. In concluding that $496,000 in cost basis was created by virtue of the sale but that the taxpayer had no basis in the remaining $500,000 of the loan, the Tax Court gave the taxpayer credit for the $496,000 since by virtue of the levy and sale, he had in essence paid that portion of the guaranteed debt. However, the taxpayer had not made any payments on the remaining $500,000 of FDI’s debt to ACRO. Thus, the taxpayer could deduct up to $496,000 in FDI losses in the year of seizure and sale of the assets.
In another case, Tinsley, TC Summary Opinion 2017-9, the Tax Court rejected the taxpayer’s argument that the rule of “no basis in guaranteed debt of S corp until paid” should not apply to debt of an S corporation owed to a bank that was renewed in the name of the S corporation after the corporation had dissolved and liquidated and was no longer in existence under corporate state law. The taxpayer had argued that in Selfe, 57 AFTR 2d 86-464 (11th Cir. 1985), the Eleventh Circuit found that a guaranty of a loan to an S corporation “may be treated for tax purposes as an equity investment in the corporation where the lender looks to the shareholder as the primary obligor (emphasis added).” The Tax Court in Tinsley found that the taxpayer had failed to establish that the bank looked primarily to the taxpayer and not to the S corporation borrower or that the taxpayer had made direct payments to satisfy the loan (as the Tax Court in Franklinhad found took place as discussed above). Even though after the liquidation of the corporation, the loan was renewed in the name of the (then defunct) corporation and payments were made to service the loan after its renewal, the taxpayer had not submitted sufficient proof that he had made the payments personally. For that reason, the Tax Court found that the taxpayer did not have sufficient basis to deduct the reported business losses.
These two cases remind us that in structuring debt used to finance an S corporation, shareholders cannot use personally guaranteed entity level debt to support losses generated by the S corporation. One alternative would be to finance the S corporation through a so-called “back to back” loan, i.e., a loan by a bank or other third party lender to the shareholder, who then reloans the monies to the S corporation. Loans of this type will create cost basis that can be used by the business owner to support the deductibility of tax losses of the S corporation.
For more information, please contact Ralph Z. Levy Jr. in the Nashville, TN office at 615-620-1733.