When can losses be deducted against S corporation basis?

• Author: Selvia, Jack

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 and claimed passthrough deductions on the strength of a corporate note received in exchange for a personal note.

In Perry, 54 TC 1293 (1970), relying on language found in the Senate Finance Committee Report accompanying the 1958 Act, the Tax Court held that no such deductions were allowable. Quoting the Finance Committee Report, the Tax Court emphasized that the Committee contemplated that shareholders would be allocated losses up to the amount of their basis in an "investment" in S stock and debt. Denying the Perrys' claim for passthrough losses supported by corporate notes received in exchange for personal notes, the court held that no deduction is allowable when shareholder debt does not arise out of an "investment" in an S corporation.

The line of judicial decisions embodying this economic outlay doctrine predates the Sec. 465 at-risk rules. While the doctrine originally appeared to serve the purpose of applying"at risk-like" principles to S shareholder debt basis issues, over the years the economic outlay doctrine has grown more restrictive than the rules under Sec 465.

In Wilson, TC Memo 1991-544, a profitable S corporation lent funds to unprofitable S corporations owned by the same parties. The profitable corporation distributed the debt of the unprofitable corporations to shareholders...