Losses disallowed where S corp. not indebted to shareholder

Editor: Kevin D. Anderson, CPA, J.D.

In Hargis, T.C. Memo. 2016-232, the Tax Court held that an S corporation shareholder could not claim losses from several wholly owned S corporations due to insufficient basis. The shareholder’s participation as a co-maker or guarantor of his S corporations’ borrowings did not increase his basis because the indebtedness didn’t run directly to him.

Background

Sec. 1366(d)(1) provides that the amount of losses and deductions an S corporation shareholder may deduct in any tax year may not exceed the sum of the shareholder’s adjusted basis in the stock of the S corporation plus the adjusted basis of “any indebtedness of the S corporation to the shareholder.” Losses not allowed due to insufficient basis may be carried forward indefinitely (Sec. 1366(d)(2)).

Basis is increased where S corporation shareholders make a direct loan to an S corporation using their own funds or funds for which they are directly liable, including their borrowings from a related party, so long as a genuine indebtedness is created (see, e.g., Oren, T.C. Memo. 2002-172, aff’d, 357 F.3d 854 (8th Cir. 2004), and Yates, T.C. Memo. 2001-280).

Basis is not established where shareholders are only contingently liable by way of their status as a co-borrower, co-maker, or guarantor of an S corporation’s debt to a third party (see, e.g., Estate of Leavitt, 90 T.C. 206 (1988), aff’d, 875 F.2d 420 (4th Cir. 1989)). In Leavitt, the Tax Court disagreed with a decision by the Eleventh Circuit in Selfe, 778 F.2d 769 (11th Cir. 1985).

The Eleventh Circuit in Selfe reversed a district court decision (Selfe, No. CV 84-P-0952-S (N.D. Ala. 11/27/84)) that had granted summary judgment for the IRS by relying primarily on Brown, 706 F.2d 755 (6th Cir. 1983), which held that S corporation shareholders could increase their basis as guarantors only when they are called upon to pay the corporation’s debt.

In Selfe, the taxpayer had pledged personal assets to induce a bank to advance her personal loans that she in turn loaned to her S corporation. At the bank’s request, her personal loans were subsequently converted to corporate loans. In connection with the loan conversion, the taxpayer executed a loan guaranty to the bank. Despite the taxpayer’s being only a guarantor of the S corporation’s debts to the bank, the court accepted her argument based upon Plantation Patterns, Inc., 462 F.2d 712 (5th Cir.), cert. denied, 409 U.S. 1076 (1972), that the loan from the bank should be viewed, in substance, as a loan from her, allowing her to deduct losses from the S corporation. Interestingly, the IRS had successfully argued in a C corporation setting in Plantation Patterns that “substance and not form determines proper tax treatment for a transaction” and that “the guarantee was in reality a contribution to capital”—the polar opposite of its argument inSelfe.

Regulations issued in 2014, subsequent to the tax years under consideration in Hargis, specifically provide that shareholders do not establish basis in an S corporation by merely guaranteeing a loan of an S corporation or otherwise acting as a surety for the loan. Only when shareholders make a payment toward a genuine debt of the S corporation for which they have acted as a guarantor is their basis increased, and then only to the extent of that payment (Regs. Sec. 1.1366-2(a)(2)(ii)).

Hargis

Although the Tax Court addressed several issues in the Hargis case, this item focuses on whether the taxpayer had established basis to enable him to deduct losses from his several S corporations.

For 2007 through 2010, Bobby Hargis was the sole shareholder of several S corporations that operated nursing homes. Hargis and certain affiliated entities employed a business strategy of acquiring distressed nursing homes and restoring them to profitability. During those four years, several of the S corporations reported losses that Hargis deducted on his personal income tax returns. To fund the operating losses, the companies borrowed funds from various sources including several limited liability companies (LLCs) in which his wife held an interest, other operating companies Hargis owned, and banks and other commercial lenders. For all of the LLC and intercompany loans and some of the commercial loans, Hargis signed as a co-borrower or guarantor in his individual capacity.

The lenders advanced the loan proceeds directly to the respective operating companies. As payments became due, the operating companies made them to the lenders. Hargis, although being a co-maker on the indebtedness of the corporations, never incurred any personal outlays to satisfy the corporate debt.

Upon examination, the IRS determined that Hargis’s status as a co-borrower or guarantor of the S corporations’ debt did not constitute basis to permit deducting the losses for 2007 and 2008.

Hargis argued that under Arkansas state law, a co-borrower is considered “directly liable” and has the same liability “as if the loan were made to the borrower individually.” Consequently, he argued, his status as a co-borrower should be viewed as an indebtedness of the operating companies to him since he put his own funds at risk, albeit a contingent risk. The court did not agree, citing several of its earlier decisions, each of which was affirmed by a circuit court on appeal, and held that a shareholder’s potential for liability absent an economic outlay was insufficient to establish basis (Estate of Leavitt, 90 T.C. 206 (1988), aff’d, 875 F.2d 420 (4th Cir. 1989); Underwood, 63 T.C. 468 (1975), aff’d, 535 F.2d 309 (5th Cir. 1976); Perry, 47 T.C. 159 (1966), aff’d, 392 F.2d 458 (8th Cir 1968); and Estate of Bean, T.C. Memo. 2000-355, aff’d, 268 F.3d 553 (8th Cir. 2001)).

Lastly, Hargis argued that his facts and circumstances were akin to those of the taxpayer in Selfe, who prevailed in her argument that a co-maker or guarantor of a corporation’s loan from a third party should be treated as a basis-increasing investment by an S corporation shareholder in situations where “the lender looks to the shareholder as the primary obligor.”

Unfortunately for Hargis, the court was not persuaded, noting that he had not pledged any of his personal assets to the lender and had presented no evidence that any of the lenders looked to him as the primary obligor on the various corporate obligations. Further, unlike the facts presented in Selfe, the lenders did not advance any of the loan proceeds borrowed by the operating companies to Hargis individually.

In holding against Hargis, the court concluded that the case was distinguishable from Selfe’s “narrow exception to the general rule that the indebtedness of the S corporation must run directly to the shareholder” to increase the shareholder’s basis (emphasis in original). The court noted that the lending transactions could have been structured as back-to-back loans had the lenders wanted Hargis to be the primary obligor. Although penalties were not discussed in the opinion, the Tax Court has upheld the imposition of accuracy-related penalties in some similar cases where the court found that loans did not create shareholder basis in an S corporation for a taxpayer so the taxpayer had insufficient basis to deduct losses passed through from the S corporation (see, e.g., Suisman, T.C. Memo. 1989-629).

Expected losses call for careful basis tracking

For S corporations anticipating taxable losses, planning is required to ensure that the shareholders have adequate basis in their stock or through direct shareholder-to-S corporation loans. An S corporation loan from a third party for which a shareholder is merely a co-maker, co-borrower, or guarantor is not viewed as the equivalent of a qualifying direct shareholder loan, thus risking disallowance of losses and potentially subjecting the shareholder to Sec. 6662 accuracy-related penalties.

EditorNotes

Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.