S shareholder's personal guarantee did not allow for increased basis.

• Author: Fiore, Nicholas J.
• Position: S corporation's tax basis

For many years, B operated a trucking business, set up as Partnership P. In 1988, B formed S corporation C, which provided maintenance and parts for the P trucks. In 1990, B took a second mortgage on his home to secure a debt that C owed to the Bank.

In 1992, to obtain operating capital, the Bank extended a line of credit to C. B had to sign a personal guarantee to repay such funds and had to mortgage additional real estate. At approximately the same time, P transferred almost all its assets to C. C assumed all P's liabilities and took over its trucking business. No cash was involved; B treated the transaction as a sale of P's assets to C, with no gain to P.

For 1990 and 1991, C realized operating losses, which B deducted (through net operating loss carrybacks and carryovers).

The IRS denied these deductions, claiming that B lacked sufficient tax basis in his C investment. The Tax Court, in a memorandum opinion, held for the Service; B's personal guarantee of C's debt on the Bank loan did not entitle him to increase his basis in C.

Under Sec. 1366, S shareholders may deduct their pro rata shares of the corporation's losses to the extent the losses are supported by the shareholders' adjusted bases in the stock and in debt of the S corporation to the shareholders.

Unless the S shareholders incur an economic outlay on debt that the corporation owes to third parties, the shareholders are not entitled to increase their bases in their stock by the debt's amount. Accordingly, mere shareholder guarantees of corporate debt to third parties generally do not qualify as an economic outlay or as debt from the S corporation to the shareholder until (and unless) the shareholder pays part or all of the debt. Likewise, if corporate debt to third parties is merely secured by the shareholders' property, no economic outlay has occurred, no debt to the shareholders exists and shareholders are not entitled to increase their bases in the S corporation by the amount of the corporate debt that the shareholders secured.

B contends that he is entitled to increase his tax basis in C's debt to the Bank, to the extent he personally guaranteed and secured such debt.

In this case, the Bank extended funds directly to C, and C has made all payments on the debt. B could have structured the debt as debt to himself, but chose to avoid primary liability. B's secondary liability, as guarantor, may have been necessary for the Bank's approval of the debt. Until (or unless) B is...