In Phillips v. Commissioner, No. 17-14439 (11th Cir. 2018), the court concluded that a judgment against the owner of an S corporation for guaranteeing the business debts does not increase the owners tax basis in the S corporation. This is one area where a little advance planning can go a long way to avoiding a tax dispute.
Facts & Procedural History
The taxpayers owned a real estate development business. The business operated as an S corporation.
The taxpayers guaranteed loans made by third parties to the corporation. The business defaulted on the loans, lawsuits ensued, and the business and taxpayers were found to be jointly liable for the loans.
At the S corporation level, the business reported a loss for the judgment against it. This loss was limited to the taxpayers basis in the S corporation. The taxpayers took the position that their basis in the S corporation was increased by the judgment. Thus, they deducted the flow through losses from the S corporation.
The IRS took the position that the S corporation loss was limited for the taxpayers as they were not entitled to increase their basis in the S corporation until payments were made on the judgment. The IRS’s position was upheld by the U.S. Tax Court, which the taxpayers appealed.
S Corporation Losses Limited by Tax Basis
The law allows S corporation owners to deduct losses incurred by the business. The losses are limited to the owners tax basis in the S corporation. These rules are fundamental for the taxation of S corporations. These rules are clear.
But the owners increase in tax basis in the S corporation is not as clear. This is particularly true where the owner becomes liable for a debt for the businesses and, in effect, the owner becomes a creditor owed money by the business.
It would make sense that the owner is entitled to increased tax basis in the business if they are personally liable for the business debts. This would be the same result as if the owner borrowed the funds from a third party and then contributed those funds to their business. The owner would increase their basis in the business.
In a closer fact pattern, it would also be the same result as if the owner guaranteed the business’ debt and the lender agreed to only look to the owner for repayment. That the lender looked to the owner for repayment would seem to mean that the owner can increase his basis in the S corporation. There are prior court cases that say just that (see, e.g., Tinsley).
But the court decided the case on the facts. The court reasoned that the owners were not materially worse off by being liable for a business debt to a third party; they would only be materially worse off if they paid the debt. As such, it concluded that the owners had to actually pay the judgment before they could get an increase in tax basis.
The result is that the taxpayers basis in the business was not increased by the judgement and the flow through losses were limited by the lack of basis in the business.
Increasing S Corporation Basis
As in Tinsley, this case highlights the importance of structuring loans by S corporation owners and, if appropriate, documenting that the lender would look only to the owner for repayment. This is particularly true for loans that are merely guaranteed by the owners.