One of the benefits of Subchapter S corporations is the ability to have losses flow through from the business’ tax return to the individual shareholder’s tax return. These flow-through losses are limited by the shareholder’s tax basis in the S corporation stock. The court recently addressed this limitation in Tinsley v. Commissioner, T.C. Summary Opinion 2017-9. This case is timely given that this issue is the focus of the IRS’s new audit campaigns.
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The Facts & Procedural History
The taxpayer was the sole shareholder of an S corporation. The corporation had borrowed approximately $100,000 from a bank. After the S corporation dissolved under state law, it reported a loss on its Form 1120S tax return. The bank then renewed the loan, still listing the dissolved corporation as the borrower, but also had the taxpayer personally guarantee the loan. The taxpayer continued to operate the business under the old name and reported the loss on his personal tax returns. The IRS disallowed the flow-through loss.
The Taxpayers Basis in his S Corporation
The taxpayer did not have any tax basis in the S corporation stock due to capital contributions to the business. He argued that he had tax basis in the S corporation stock given his personal guarantee of the $100,000 bank loan:
he contends that upon the liquidation, he assumed the balance due on the note as guarantor, and because he was the sole remaining obligor, this assumption was a contribution to capital, allowing him to deduct the amount of Command Computers’ losses. Further, Mr. Tinsley asserts that following Command Computers’ liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate a basis for Mr. Tinsley in Command Computers.
The court did not agree. The court noted that merely guaranteeing an S corporation’s debt is not sufficient to generate a basis under Section 1366(d).
The court noted that a shareholder may obtain an increase in basis in an S corporation only if there is an economic outlay on the part of the shareholder that leaves him or her “poorer in a material sense.” The taxpayer has to have an economic outlay. This can come about if the lender looks primarily to the taxpayer to repay the loan.
Economic Outlay Requirement
Under Section 1366(d), a shareholder can only increase their basis in an S corporation if there is an economic outlay that leaves the shareholder “poorer in a material sense.” This means that the shareholder must actually incur an expense or make a payment that affects their financial position.
The courts have consistently held that a mere loan guarantee does not satisfy this requirement. The guarantee must result in an actual payment or a shift in liability from the corporation to the shareholder. Additionally, the lender must look primarily to the shareholder for repayment of the loan.
Basis Adjustments
According to Section 1367, a shareholder’s basis in their S corporation stock is adjusted annually to account for the pass-through income, losses, and distributions. A shareholder’s basis is increased by their share of the corporation’s income and decreased by their share of losses and distributions. To deduct pass-through losses, the shareholder must have sufficient basis in the stock.
Look to the Taxpayer for Repayment
This brings us back to the Tinsley case. In Tinsley, the court found no evidence that the lender looked primarily to the taxpayer to repay the loan. The court emphasized that the lender continued to list the dissolved corporation as the borrower, and there was no evidence of an economic outlay by the taxpayer. The court record did not show that the taxpayer had made any payments on the loan.
These Section 1366(d) basis rules are in addition to the at-risk rules under Section 465 and the passive activity loss rules under Section 469. It’s noteworthy that the same fact pattern could satisfy the at-risk rules under Section 465, as they do not require an economic outlay or that the taxpayer be the primary source of repayment.
The Takeaway
This case helps explain why it is important to document the basis rules for S corporation shareholders. Shareholders must have a genuine economic outlay to increase their tax basis in the corporation. Simply guaranteeing a loan is not enough. To avoid issues with Section 1366(d) tax basis, taxpayers should ensure that their financial contributions and the lender’s reliance on them for repayment are well-documented.
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