It is a basic principle of federal tax law that a taxpayer cannot, for purposes of determining the taxpayer’s taxable income, claim a loss with respect to an investment in excess of the taxpayer’s unrecovered economic cost for such investment. If the taxpayer invested $X to acquire a non-depreciable asset – for example, a capital contribution in exchange for shares of stock in a C corporation, or a loan to a corporation in exchange for an interest-bearing note – the amount of loss realized by the taxpayer upon the disposition or worthlessness of the asset will be based upon the amount invested by the taxpayer in acquiring the asset. Where the asset is depreciable by the taxpayer, the loss realized is determined by reference to the taxpayer’s cost basis, reduced by the depreciation deductions claimed by the taxpayer (which represent a recovery of the taxpayer’s cost), i.e., the taxpayer’s adjusted basis.
Application to S-Corps
In the case of an S corporation, a shareholder’s ability to utilize his pro rata share of any deductions or losses realized by the S corporation is limited in accordance with this principle; specifically, for any taxable year, the aggregate amount of losses and deductions that may be taken into account by a shareholder cannot exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation, and the shareholder’s adjusted basis for any bona fide loans made by the shareholder to the S corporation.
Because an S corporation is treated as a pass-through for tax purposes, its income is generally not subject to corporate-level tax; rather, it is taxed to its shareholders (whether or not it is distributed to them).
In order to preserve this single level of tax, a shareholder’s initial basis for his shares of S corporation stock – which may be the amount he paid to acquire the shares from another shareholder or the adjusted basis of any property he contributed to the corporation in a tax-free exchange for such shares – is adjusted upward by the amount of income that is allocated and taxed to the shareholder; in this way, the already-taxed income may later be distributed to the shareholder without causing him to realize a gain (as where the amount distributed exceeds the stock basis).
By the same token, where already-taxed income has not been distributed to the shareholder, it remains subject to the risks of the business, and the shareholder is effectively treated as having made an “economic outlay” which may be lost in the operation of the business; this is reflected in his stock basis.
In general, a shareholder’s basis for a cash loan from the shareholder to the corporation is equal to the face amount of the loan.
If the corporation’s indebtedness to the shareholder arose out of a transfer of property by the shareholder to the corporation – basically, a sale of the property in exchange for the corporation’s obligation to pay the purchase price some time in the future – the basis is equal to the face amount of the obligation less the amount of the deferred gain.
As the corporate indebtedness is satisfied, and the amount at economic risk is reduced, the shareholder’s basis in the debt is reduced.
“Necessity” as the Mother of Invention?
Because of this basis-limitation rule, S corporation shareholders, over the years, have proffered many arguments to support their ability to claim their share of S corporation losses – i.e., to increase their stock or debt basis – without having made an economic outlay. A recent decision by the U.S. Tax Court illustrates one such argument.
The Personal Guarantee
The sole issue in this case was whether Taxpayer had a sufficient basis in S-Corp., on account of his obligation with respect to S-Corp’s debt to a third party, to permit Taxpayer to deduct $X, which represented a portion of his distributive share of the corporation’s flow-through losses, on his personal income tax return.
Taxpayer was the sole shareholder of S-Corp. S-Corp. borrowed $Y from Bank, and Taxpayer personally guaranteed the loan. S-Corp. was later liquidated. At the time of liquidation, S-Corp. still owed Bank $X. S-Corp. filed its Form 1120S, U.S. Income Tax Return for an S corporation, on which it reported an ordinary business loss of $X. Taxpayer had no stock or debt basis in S-Corp. when it was liquidated.
According to the record before the Court, after S-Corp. was liquidated, the operations of the business somehow continued under its former name, S-Corp.’s loan with Bank was somehow renewed, and S-Corp. remained the named borrower of the renewed loan. Taxpayer signed the renewal note as president of S-Corp. and was the guarantor of the loan.
Also according to the record, Taxpayer made all loan payments following the liquidation of S-Corp., but the record did not indicate whether he made the payments from his personal funds or merely signed checks drawn on the account of S-Corp.
The IRS examined Taxpayer’s tax return and disallowed the $X loss deduction related to S-Corp., explaining that, because Taxpayer’s share of S-Corp.’s loss was limited to the extent of his adjusted basis for his stock, the amount of loss in excess of such basis was disallowed and was not was not currently deductible.
The Court’s Analysis
The Court began by explaining that an S corporation shareholder may take into account his or her pro rata share of the corporation’s losses, deductions, or credits. It then explained how the Code limits the aggregate amount of losses and deductions the shareholder may take into account to the sum of (A) the adjusted basis of the shareholder’s stock in the S corporation, and (B) the shareholder’s adjusted basis in any indebtedness of the S corporation
Taxpayer conceded that he had no stock or debt basis in S-Corp. at the time of its liquidation. However, he contended 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 effectively a contribution to capital, allowing him to deduct the amount of S-Corp.’s losses. Further, he asserted that, following S-Corp.’s liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate basis for Taxpayer in S-Corp.
The Court rejected Taxpayer’s arguments. Merely guaranteeing an S corporation’s debt, it stated, was not sufficient to generate basis. The Court pointed out that, on many prior occasions, it had held that no form of indirect borrowing, be it by guaranty, surety or otherwise, gives rise to indebtedness from an S corporation to its shareholders until and unless the shareholders pay part or all of the obligation. “Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.” The Court also stated that a shareholder may obtain an increase in basis in an S corporation only if there was an economic outlay on the part of the shareholder that leaves the shareholder “poorer in a material sense.” In other words, the shareholder must make an actual “investment” in the corporation.
The Court recognized, however, that a shareholder who has guaranteed a loan to an S corporation may increase his or her basis where, in substance, the shareholder has borrowed funds and subsequently advanced them to the corporation. Although, as a general rule, an economic outlay is required before a shareholder in an S corporation may increase his or her basis, this rule does not require a shareholder, in all cases, to “absolve a corporation’s debt before [he or she] may recognize an increased basis as a guarantor of a loan to a corporation.” Observing that “where the nature of a taxpayer’s interest in a corporation is in issue, courts may look beyond the form of the interest and investigate the substance of the transaction.” The Court indicated that a shareholder’s 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.”
This determination, the Court stated, was an “inquiry focused on highly complex issues of fact and that similar inquiries must be carefully evaluated on their own facts.” (For example, the testimony of a loan officer stating that the lender-bank looked primarily to the taxpayer, and not the corporation, for repayment of the loan, as well as evidence that the S corporation was thinly capitalized.)
The Court then turned to the facts in the case to determine whether Taxpayer had established that the Bank looked to Taxpayer for repayment and Taxpayer had made economic outlays in making those payments.
The Court found that Taxpayer presented no evidence to support a finding that the Bank looked primarily to him, as opposed to S-Corp., for repayment of the loan, especially given the fact that, even after the corporate liquidation, S-Corp. remained an ongoing business enterprise.
It acknowledged that, according to the stipulation of facts, “[t]he [Taxpayer] continues to make payments on the loan”, but there was no indication, it pointed out, that the loan payments were made from Taxpayer’s personal funds rather than S-Corp.’s funds with Taxpayer signing payment checks as president. Moreover, under the terms of the renewal note, the renewed loan was to S-Corp. and Taxpayer’s obligation was that of a guarantor, not the maker of the loan.
The Court next considered Taxpayer’s assertion that the renewal of the loan to S-Corp. did not affect his position that he became the primary obligor of the loan upon S-Corp.’s liquidation. Taxpayer posited that he assumed the debt at the time of S-Corp.’s liquidation and that “his status as the sole remaining obligor”, for tax purposes, caused the repayments of the loan to be treated as contributions to the capital of S-Corp. The IRS disagreed, arguing that “upon the corporation’s liquidation, the debt remained undisturbed: the corporation did not default on the debt, the terms of the debt were not altered, and payments on the debt continued.”
The Court determined that there was insufficient evidence in the record to support a finding that the loan was made to Taxpayer personally, as opposed to S-Corp., and that Taxpayer, as the borrower, advanced the loan proceeds to S-Corp. Because Taxpayer failed to establish that the Bank looked primarily to Taxpayer to satisfy the debt obligation or that Taxpayer made an economic outlay with respect to the loan, Taxpayer failed to prove he had a basis in S-Corp. sufficient for him to deduct the reported business losses.
Advice to S Corporation Shareholders
What is an S corporation shareholder to do when corporate losses have been allocated to him, but he has no basis in his shares, and he either has no outstanding loan to the corporation or at least not one in which he has any basis? What happens to these excess losses, and how can they be utilized?
The excess losses allocated to a shareholder for a tax year cannot be used by the shareholder to offset ordinary income reported on the shareholder’s tax return for that year. That being said, the shareholder must realize that the excess losses are not lost (sorry for the pun) – they are merely suspended until such time as the shareholder has sufficient basis in his stock, or in a loan made by him to the corporation, to allow the losses to flow through to him. (Even then, however, the losses have to pass muster under the “at risk” and “passive loss” rules before the shareholder can realize their full benefit.)
So, how can a shareholder facilitate or expedite the use of his suspended losses? There are some options to consider:
- Make a capital contribution to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; paying off a corporate debt)
- Forego distributions by the corporation in profitable years (loan the distributed funds back to the corporation)
- Accelerate the recognition of income by the corporation
- Defer the deduction of corporate expenses
- Make a loan to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; substituting the shareholder’s note for the corporation’s)
Each of these options presents its own risks and issues. For example, what if the shareholder does not receive additional stock in the corporation in exchange for his capital contribution? Has he made a gift to the other shareholders? He has certainly put more of his money at risk.
Of course, the shareholder can wait until the corporation sells its business. The gain from the sale may generate sufficient basis so as to allow the use of the suspended losses for the year of the sale (though the shareholder will thereby likely realize more gain on a subsequent liquidation of his shares).
However, if the disposition of the business is effected through a sale of stock by the shareholders (without an election to treat it as an asset sale), the suspended losses will disappear. They will also be lost if all of the shares are gifted to another (other than the shareholder’s spouse or to a grantor trust) prior to any sale. The suspended losses will also be lost if the shareholder dies before having used the losses – the step-up in basis for the stock that occurs at death does not benefit the deceased shareholder.
Thus, it may behoove the shareholder to find a way to “consume” the suspended losses before it is too late, provided as always, of course, that the means chosen makes sense from a business perspective.