When can losses be deducted against S corporation basis?

• Jurisdiction: United States
• Author: Selvia, Jack
• Date: 01 May 1997

It is an article of faith among many tax planners that, absent any other restriction (like the passive activity loss limitation), an S shareholder should be able to deduct S losses to the extent chat he has tax basis in S stock and debt. When it appears that losses will exceed basis, planners frequently advise clients to increase their investment in S corporation debt, to secure basis sufficient to permit the deductibility of passthrough losses.

These practices are based on the plain language of Sec. 1366(d)(1) and are sanctioned by Rev. Rul. 75-144, which held that a taxpayer could deduct S passthrough losses when he had substituted his own note for that of the S corporation to a third party lender (a "back-to-back" loan). This rule has sometimes been described as the "economic outlay doctrine."

This doctrine arose in cases tried in the Tax Court soon after S corporations were created by the Technical Amendments Act of 1958 (1958Act). Following enactment of the new law, in a flurry of litigation, taxpayers claimed basis in S debt as guarantors and sureties for S debt to third parties. In some cases, taxpayers exchanged notes with their S corporations...