Current developments.

• Author: Karlinsky, Stewart S.
• Position: Part 2 - S corporations

EXECUTIVE SUMMARY

* Salem upheld the concept that an S shareholder must have the equivalent of an economic outlay to generate Sec. 1366 basis for loss.

* In Peracchi, the Ninth Circuit held that a self-executed note transferred to an S corporation, along with real estate with a mortgage that exceeded its basis, avoided Sec. 357(c) gain recognition.

* Nelson held that COD income is not a flowthrough item, nor a tax-exempt item, and therefore does not increase basis under Sec. 1366.

This two-port update on S corporation developments reviews and analyzes recent rulings and decisions. Part II of this article addresses S operational issues, including passive activity loss use, cancellation of debt income and back-to-back loans.

Part I of this two-part article, in the October 1998 issue, examined S rulings from July 16, 1997 to July 15, 1998 in the areas of eligibility, elections and terminations. Part II, below, focuses on S operational issues.

Operations

Loss Limits

One of the common motivations for choosing S status is the ability to flow-through entity-level losses to shareholders. There are several hurdles that a shareholder must clear before it can deduct losses. Recent court cases and rulings addressed basis for loss purposes (Sec. 1366), passive activity loss (PAL) rules (Sec. 469) and at-risk rules (Sec. 465).

Secs. 1366 and 465 limits: If a taxpayer does not have sufficient adjusted basis in stock or debt, passthrough losses are suspended until the shareholder's basis is increased. The courts have consistently held that a shareholder must have the equivalent of an economic outlay to generate Sec. 1366 basis for loss. In Salem,(59) S shareholders argued that their guarantees and signatures as co-makers on bank loans to their S corporation gave them additional basis for Sec. 1366 loss purposes. Salem was appealable to the Eleventh Circuit, which decided in Selfe(60) that an S shareholder's guarantee of loans to an S corporation created basis. Selfe was distinguished because the shareholder originally pledged her self-employment assets as repayment for the loan; only after her business was later incorporated did the loan become a corporate liability. In Salem, on the other hand, the bank made the loan directly to the S corporation, no property was pledged and the bank looked primarily toward the corporation for repayment.

Similarly, in Spencer,(61) a former accountant transferred some business property he acquired from his C corporation to a new S corporation. The bank that financed the transaction originally was going to make a loan to the shareholder, but when it discovered the property was to be transferred to an S corporation, it requested the loan be made directly to the entity, and received a guarantee from the shareholder. This did not give rise to shareholder basis for loss purposes.

In Eli E. Sleiman, Jr.,(62) an S shareholder had guaranteed a loan to the corporation. Because the debt did not increase basis under Sec. 1366, distributions to the shareholder exceeded his stock basis and gave rise to a capital gain.

In Letter Rulings 9811017-9,(63) the taxpayers substituted personal notes for the corporation's debt with the bank; the corporation issued a note directly to the shareholders. Relying on Gilday,(64) and Rev. Rul. 75-144,(65) the IRS held that this arrangement allowed an increase in their adjusted stock bases for Sec. 1366(d) loss purposes. The rulings went on to hold that Sec. 465 did not...