Tax Court restricts S corporation shareholder's basis for loss deductions.

• Author: Barton, Peter C.

In a case of first impression, the Tax Court recently held in Hitchins, 103 TC No. 40 (1994), that a shareholder's basis in an S corporation does not include third-party debt payable to the shareholder assumed by the corporation.

Sec. 1366(a) allows S shareholders to deduct on their individual returns their pro rata share of the corporation's losses and deductions. However, Sec. 1366(d)(1) specifies that the deduction on the shareholder's return cannot exceed the sum of the shareholder's adjusted basis in his S stock plus the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder. Any corporate losses or deductions not deductible on the shareholder's return due to lack of basis can be carried forward indefinitely and are deductible by the shareholder when he has sufficient basis (Sec. 1366(d)(2)).

Previous cases have established certain rules as to the meaning of "any indebtedness of the S corporation to the shareholder." First, there must be an "actual economic outlay" by the shareholder. Four appellate courts have rejected mere loan guarantees of an S corporation's debt by a shareholder as constituting an actual economic outlay for shareholder basis purposes when the shareholder makes no payment on the loan (e.g., see Uri, Jr., 949 F2d 371 (10th Cir. 1991)). Second, the S corporation debt must run directly to the shareholder. For example, a shareholder who also is a partner in a partnership cannot increase his basis in the S corporation as a result of a loan from the partnership to the S corporation (Frankel, 61 TC 343 (1973)).

In Hitchins, the taxpayer founded Champaign Computer Company (CCC), a C corporation, which developed a database for various chemicals in 1985 and 1986. CCC was to be reimbursed for this software development, and ownership of the software would be transferred to another company (yet to be formed). In 1986, Hitchins personally loaned CCC $34,000, which CCC treated as a "loan from shareholder." Later in 1986, Hitchins and two other people formed ChemMulti-Base Company, Inc. (CMB) as an S corporation. Hitchins owned 50% of CMB.

On Oct. 1, 1986, CCC billed CMB for expenses incurred by CCC to develop the database. CMB issued a note payable to CCC for this amount. Later, CMB paid part of the note and agreed to repay CCC's debt to Hitchins in consideration of the remainder CMB's debt to CCC. CMB made a journal entry debiting its liability to CCC and crediting a liability to Hitchins...