S Corp Shareholders Not Entitled to Basis for Guaranteeing Corporation Loans

Posted on Tue, Oct 29, 2013 ©2021 Drucker & Scaccetti

encyclopedia s corp BKT 544 resized 600There was a recent Tax Court Memorandum (T.C. Memo 2013-151) addressing S Corporation basis limitation (issue #2) of S-Corporation owners.

 

Tax basis of an S Corporation is computed by adding the stock basis of the S Corporation to the debt basis of S Corporation debt to the shareholder at the end of the year.  “Basis is generally the amount of your capital investment in a property for tax purposes.” (IRS Pub 703 – Basis of Assets).

 

Background

The husband and wife in this case were both shareholders in an S-Corporation that operated an active business.  In 2006, the S Corporation borrowed $1 million from a bank and the couple personally guaranteed the loan.  In 2008, the S Corporation defaulted on the loan and the husband and wife subsequently also defaulted.  Net operating losses were generated in the business in 2008.  In 2009, the bank obtained a judgment against the husband and wife for $425,000.

 

What Happened

The husband claimed that he should receive a basis increase of $425,000 (the amount of the judgment against him), as well as $105,000 for loans he personally made directly to the S Corporation.  The IRS agreed that the husband was entitled to a basis increase of $105,000 for the money directly loaned to the S Corporation, however, the Court ruled there was no debt between the S Corporation and the shareholder until the shareholder actually made payments to the bank under the guarantee.  Finally, the court distinguishes cases where the shareholder is the primary obligor on the loan, not the guarantor.

 

Because the husband and wife were denied an increase in their basis as a result of the judgment against them, they were limited in the amount of losses they could deduct on their individual income tax returns.

 

What Went Wrong

There are a couple of reasons why the husband’s claim did not succeed in Court.  First, the Court correctly asserted that when an S Corporation shareholder guarantees a loan by a bank to the S Corporation, no debt is created between the shareholder(s) and the S Corporation.  Second, if the husband or wife began making payments to the bank, they would then be entitled to basis for the amount of those payments, as S Corporation owners are only entitled to basis for direct loans to the corporation.

 

Tax Warrior Perspective

S Corporation basis computations can become very complex, especially when debt and loans/loan repayments to the corporation are involved.  Often shareholders don’t focus on basis calculations until they are preparing to sell their business or in years where they may have substantial losses they wish to deduct.  Basis should be maintained annually by your tax advisor.  

 

Key Point: If you haven’t had a tax basis study done recently or ever (yes…ever!), consider engaging someone to calculate your historical basis and then ensure it is maintained annually.  This will allow you and your advisors to analyze the tax impact of a proposed sale transaction or to see if a current year loss will be deductible quickly.  Most times, the ability to analyze these scenarios quickly can give you a competitive edge!

 

Contact The Tax  Warriors® at Drucker & Scaccetti if you have questions about the basis in your S Corporation.  We would be happy to discuss this or any tax situation with you.

Topics: Basis, Shareholders, S corporation, loans, court, tax basis study, Tax

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