S shareholder loan basis.

• Author: Schwartzman, Randy

The deductibility of S corporation losses hinges on whether a shareholder has basis under Sec. 1366 and whether he or she is "at risk" under Sec. 465. Under Sec. 1363(a), an S corporation is generally a passthrough entity, not taxable for Federal income tax purposes; thus, its shareholders are usually subject to only one level of tax on earnings. In general, under Sec. 1366(a)(1), all S items of income, loss, deduction and credit pass through the corporation and ale taxed directly to its shareholders in proportion to their ownership interests.

Background

For an S shareholder to deduct iris or her pro-rata share of S losses under Sec. 1366(a), he or she must have sufficient basis in S stock or debt under the Sec. 1366(d) basis limitation rules. According to Sec. 1366(d)(1), the total amount of losses and deductions that the S shareholder takes into account for any tax year cannot exceed the sum of:

1. The adjusted basis of the shareholder's S stock; and

2. The shareholder's adjusted basis of any debt of the S corporation to the shareholder.

   Although, according to Sec. 1366(d)(1)(B), a shareholder can deduct his or her proportionate share of the S losses and deductions to the extent of the shareholder's adjusted basis in S debt, the section does not specifically define "indebtedness of the S corporation to the shareholder." The cases and rulings interpreting Sec. 1366(d)(1)(B) have established two requirements for an S shareholder to be entitled to increase his or her basis for the S corporation's debt:

1. The indebtedness must run directly from the S corporation to the shareholder; and

2. The shareholder must have made an "actual economic outlay."

   Although the IRS and the courts generally have been consistent in applying the requirement that a loan run directly from a shareholder to the S corporation, they have been inconsistent in a requiring the S shareholder to make an actual economic outlay.

   Cases

   Oren: The Eighth Circuit recently ruled, in Donald G. Oren, (2/12/04), aff'g TC Memo 2002-172, that loans husband-and-wife taxpayers made to two of their S corporations from funds lent to them by their third S corporation, to which the two corporations, in turn, made loans of the same amount, were not actual economic outlays. Thus, these loans did not allow the taxpayers to increase their basis in the borrower corporations, so as to enable them to deduct those corporations' losses.

   In addition, the Eighth Circuit ruled that the Tax Court was...