Restructuring debt basis in light of the "economic outlay" doctrine.

• Author: Porcaro, Gregory A.

EXECUTIVE SUMMARY

* An S stockholder's basis determines use of corporate losses; it may be comprised of both stock and debt, and changes constantly.

* Economic outlay is a prerequisite for a shareholder taking basis in S debt.

* Culnen, a taxpayer-friendly case, provides a structure that allows the creation of shareholder basis for S debt.

An S corporation shareholder seeks to have as high a basis as possible to be able to use passthrough losses. This has led shareholders to creative methods of restructuring S debt in an attempt to boost basis, but the courts have required an actual shareholder economic outlay. This article examines cases addressing this issue and offers planning strategies.

S corporations have been a part of the practitioner's repertoire of available entity structures for over 40 years. Although they have evolved significantly over that time, one area of subchapter S continues to require careful monitoring and planning--stockholder basis. An S stockholder's basis may be comprised of both stock and debt; it changes constantly due to corporate profits, losses, distributions, loans and loan payments. This article focuses on the effect of basis in stockholder debt on the use of an S corporation's losses by its stockholders.

Sec. 1366(d)(1) limits deductibility of S losses to a stockholder's basis in stock and debt. If the corporation's current-year's loss exceeds such basis, Sec. 1366(d)(2) provides that it may be carried forward indefinitely (a suspended loss). Generally, this statutory structure provides some relief from a temporary lack of basis, but planning opportunities and pitfalls exist, particularly when one or more individuals own stock in multiple S corporations with varying degrees of profitability and basis. This is not uncommon; however, if not properly monitored, it can lead to taxation of profits from one S corporation and suspended losses from another (due to lack of basis).

Can shareholder action avoid this result? The answer depends on the facts and circumstances; however, two criteria are not specifically defined by Sec. 1366, 1367 or the regulations--economic outlay and direct debt.

Economic Outlay

The economic outlay doctrine was first developed in Perry,(1) which involved an S shareholder's failed attempt to create basis through the issuance of notes between him and the corporation. The court interpreted the economic outlay doctrine to require an actual cash investment by the shareholder in the corporation. Rev. Rul. 81-187(2) applied the concept to deny a basis increase for the exchange of a sole shareholder's note for stock. In Underwood,(3) the Tax Court concluded (and the Fifth Circuit affirmed) that no basis is created when a shareholder exchanges demand notes with his wholly owned corporations. The court considered the lack of an actual advance of funds by the shareholder and questioned his intent to demand repayment.

Example 1: X owns 100% of each of C corporation A and S corporation B. A loaned money to B. X gave A his demand note as a substitute for A's note from B. Although a debtor/creditor relationship was established, X created no basis in B's debt, because he made no economic outlay.

In Underwood, one stockholder controlled both entities; perhaps the result would have been different had the stockholder not been in control.

Example 2: The facts are the same as in Example 1, except that X owns only 45% of A. An economic outlay may have occurred, because X cannot control how A deals with the X demand note.

A shareholder can create basis by substituting his note for the corporation's note to an unrelated third-party lender, if the corporation is thereby released from liability (a "back-to-back" loan).(4)

Example 3: S corporation Z has a $250,000 bank loan guaranteed by Y, its sole shareholder. The loan guarantee structure does not create basis.(5) Y substitutes his personal note for Z's note to...