S Shareholders Not Entitled to Increase Bases by Guarantee of Corporate Debt.

• Author: Fiore, Nicholas J.

In July 1991, E entered into an agreement to buy land, build a video rental store and lease it. The lease provided that, if the property was environmentally contaminated, the lessee could terminate it.

E then formed S corporation R, and assigned all his rights under the lease to R. R subsequently purchased the property and owned no other assets. The land was contaminated, but the state of Florida agreed to cover the costs of environmental remediation.

Because of the contamination and R's lack of assets, it experienced some difficulty in getting a construction loan. R eventually obtained a one-year loan. To secure the loan, R pledged the property and its improvements; in addition, E personally guaranteed both the mortgage and R's commitment to indemnify the bank for any environmental liability.

In 1992, E received distributions from R, which he did not report as taxable capital gains, claiming that his adjusted basis in R included the loans he had personally guaranteed.

The IRS disagreed and issued a deficiency notice. In a memorandum opinion, the Tax Court held for the Service, ruling that E could not treat his personal guarantee of R's bank loan as a capital contribution that increased his basis in R. The' Court of Appeals (opinion Kravitch, J.) affirms.

Operating a small business as an S corporation has certain tax consequences. The corporation is not subject to the corporate income tax; instead, its profits and losses "pass through" to its shareholders' personal income tax returns. When an S corporation with no accumulated earnings or profits makes a distribution to a shareholder, the shareholder must recognize capital gain only on that portion of the distribution that exceeds his adjusted basis in the shares of the S corporation's stock. The shareholder's adjusted basis in the stock is increased by amounts the shareholder contributes to the S corporation's capital. The more money a shareholder puts into the S corporation, the higher his adjusted basis. The higher his adjusted basis, the less capital gain he realizes if the S corporation makes a distribution to him; the less capital gain he realizes, the lower his potential tax liability.

A shareholder in an S corporation who personally guarantees a debt of the corporation may increase basis in the corporation by the amount of the debt when the facts demonstrate that, in substance, the shareholder has borrowed funds and subsequently advanced them to the corporation. In general, an...