Creation of S Corporation Basis Through Shareholder Guarantees
| Publication year | 1987 |
| Pages | 982 |
1987, June, Pg. 982. Creation of S Corporation Basis Through Shareholder Guarantees
In order to utilize Subchapter S corporation ("S corporation") losses and deductions, shareholders now must have basis in stock and indebtedness of the corporation at least equal to the current losses and deductions.(fn1) Despite the seemingly fundamental nature of this proposition, determination of shareholder basis in S corporation stock has given rise to substantial litigation. A recurring argument in this body of litigation has been the claim that shareholders should be allowed basis in their stock as a result of their guarantee of corporate debt.
This article reviews the development of principles governing shareholder guarantees. It also identifies circumstances under which shareholders may be able to argue successfully that shareholder guarantees create basis in S corporation stock.
An important benefit of an election by a corporation to be taxed as an S corporation is the pass-through of items of deduction and loss. This results in tax treatment for the S corporation similar to that received by partnerships. As noted, shareholders are able to receive a current benefit from corporate losses and deductions only to the extent of their basis in the S corporation.
Basis in an S corporation arises from two sources: the adjusted basis of the shareholder's stock in the S corporation and the adjusted basis of indebtedness of the corporation to the shareholder. Adjusted basis in stock of the S corporation is created by stock purchases, capital contributions and pass-through of items of corporate income. Basis in indebtedness of the corporation to the shareholder is created by shareholder loans to the corporation.
Lenders are often reluctant to make loans to small corporations. Shareholders of small corporations in need of credit frequently are faced with two alternatives: (1) successful shareholders can personally borrow needed amounts and contribute or loan the borrowed amounts to their corporation, or (2) shareholders can guarantee a loan to the corporation.
Ill-advised shareholders often choose the latter. Shareholders who are short on basis must then argue that their guarantee is equivalent to a loan or capital contribution to the corporation. This argument almost always has been rejected.(fn2) If the issue arises for the first time on audit, the result is certain disallowance of deductions and losses taken by the shareholders for previous tax years. However, a recent line of decisions provides a glimmer of hope for obtaining shareholder relief from this result.
Taxpayers repeatedly have argued that they should be allowed basis in their S corporation stock for the amount of corporate loans guaranteed by the shareholders. Until recently, courts uniformly have rejected the allowance of shareholder basis for guaranteed loans. Two principal reasons were usually given for this: a claimed absence of any economic outlay by the shareholder making the guarantee;(fn3) and a stated inability of taxpayers to utilize for their benefit the familiar "substance over form" argument, discussed further below.
The decisions have based the requirement of actual shareholder economic...
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