S corporations vs. C corporations.

• Author: Orbach, Kenneth N.

A major advantage of conducting business as an S corporation, rather than as a C corporation, is that S losses flow through to the shareholders, who may deduct them on their individual returns. However, Se. 1366(d)(1) limits the amount of a shareholder's pro rata share of corporate losses that currently may be deducted to the sum of the basis in the stock plus the "adjusted basis of any indebtedness of the S corporation to the shareholder." To provide basis for this purpose, the debt must run directly to the shareholder; the creditor may not be a person related to the shareholder (see Frankel, 61 TC 343 (1973)).

To qualify as "indebtedness," a shareholder generally must have acquired the debt through an actual economic outlay, viz.," there must have occurred some transaction which when fully consummated left the taxpayer poorer in a material sense" (Perry, 54 TC 1293 (1970)).

Corporate debt from a third-party lender does not create indebtedness from the corporation to the shareholder even if the shareholder guarantees the debt. Only when the guaranteeing shareholder makes payments on the debt does corporate indebtedness to the shareholder arise under the economic outlay doctrine. (See, e.g., Est. of Leavitt, 90 TC 206 (1988), aff'd, 875 F2d 420 (4th Cir. 1989).)

Even Selfe, 778 F2nd 769 (11th Cir. 1985) (widely regarded as the most pro-taxpayer decision in this area), "reaffirms that economic outlay is required before a stockholder in a Subchapter S corporation may increase her basis." However, Selfe did not require actual payment in order to meet the economic outlay test; a shareholder/guarantor who has pledged stock in another corporation to secure a loan may have experienced an economic outlay. (Of course, more was needed here to acquire basis. The Eleventh Circuit also looked to the debt-equity principles of Plantation Patterns, Inc. 462 F2nd 712 (5th Cir. 1972), to ascertain whether in substance the shareholder had borrowed funds and subsequently advanced them to her corporation.)

The IRS has approved another form of economic outlay (other than immediate payment on the guarantee). In Rev. Rul. 75-144, a shareholder/guarantor executed his own promissory note for the full amount of the corporation's liability to a third-party bank. The bank in turn accepted the note in satisfaction of the guarantee and relieved the corporation of its liability. Assuming subrogation, the Service concluded that the shareholder's note to the bank was an...