Structuring debt basis in an S corporation.

• Author: Packard, Pamela

Recent Tax Court rulings have dramatically changed the landscape for determining whether shareholders in commonly held S corporations have sufficient debt basis to deduct S losses. While previous decisions focused on the "economic outlay" principle and whether the indebtedness ran "directly" from the S corporation to the shareholders, recent taxpayer victories indicated that the transaction's original form (i.e., how the corporation treated it for book purposes) is ultimately the deciding factor.

Case Law

While the courts consistently decided against taxpayers who tried to restructure debt to increase tax basis, the reasons for their findings varied considerably. For example, in Burnstein, TC Memo 1984-74, debt transferred from one S corporation to another did not create basis for shareholders with identical ownership interests in both corporations. When the funds were first transferred, they were recorded on the books as loans between the two corporations. At year-end, the return preparer made adjusting entries to reclassify the loans as running to and from the shareholders. The court sided with the IRS. Because the amounts were transferred directly from one corporation to the other, any debt was not a debt directly from the S corporation to the shareholders.

Ten years later in Hitchins, 103 TC 711 (1994), the court determined that the shareholder's basis in his S stock did not include debt owed to him by a C corporation that was assumed by the S corporation in partial payment of its own debt to the C corporation. Even though the shareholder had made an economic outlay, it was significant that the C corporation was not relieved of its obligati6n and that the shareholder therefore had recourse against the C corporation in the event of default. As a result, the court held that there was no investment by the shareholder in the S corporation. The shareholder might have succeeded in establishing basis if he had adopted a different form of the transaction. The court suggested that the shareholder could have loaned money to the S corporation to repay its debt to the C corporation, and the C corporation could have in turn repaid its debt to the shareholder.

Several years later in Bergman, 8th Cir., 4/19/99, a shareholder executed a restructuring similar to the one suggested by the court in Hitchins. In Bergman, one S corporation issued checks to pay off a debt owed to another S corporation. The second S corporation loaned the same amount to the...