Loan guarantees do not increase S corporation shareholder’s basis

The guarantees lacked any economic outlay, the Tax Court holds.
By Charles J. Reichert, CPA

The Tax Court held that a taxpayer could not increase the basis of her S corporation stock for unpaid judgments resulting from her personal guarantees of defaulted loans of the S corporation. According to the court, the taxpayer had no economic outlay due to the loan guarantees, and an economic outlay was necessary to create additional basis in her stock.

Facts: Sandra Phillips owned 50% of the stock in Olson & Associates of NW Florida Inc. (Olson), an S corporation that developed and sold real estate in northwest Florida and southern Alabama. The corporation was highly leveraged, and most of its debt was guaranteed by Phillips, Carl Olson Jr. (the other 50% shareholder), and/or their spouses. After the S corporation defaulted on virtually every loan it owed in 2007, the lenders sued Phillips and the other loan guarantors for payment and were awarded judgments approximating $105 million in 2008 and 2009.

The judgments were allocated among the taxpayer and the other co-guarantors. Phillips considered her allocation as deemed capital contributions that increased the basis of her stock by $1,553,360 in 2008 and $30,187,249 in 2009. Because of the additional basis, the taxpayer and her husband were able to deduct larger losses in tax years 2008 through 2010 than they would have otherwise and carried back net operating losses to 2004 and 2005. After examining the returns for those years, the IRS disallowed the additions to basis and the resulting deductions and assessed deficiencies totaling $1,888,647 plus penalties for those years. The taxpayers petitioned the Tax Court for relief.

Issues: A shareholder of an S corporation may deduct his or her respective share of the S corporation's losses only to the extent of his or her stock basis plus the basis of any S corporation debt owed to the shareholder. For an S corporation shareholder to increase the basis in his or her debt, the taxpayer must have an actual economic outlay. The courts have consistently held that, as a general rule, a shareholder's loan guarantee by itself cannot create basis. However, in Selfe, 778 F.2d 769 (11th Cir. 1985), the Eleventh Circuit held that a loan guarantee can create basis without the shareholder's paying the corporation's debt. The court held that a basis increase may be justified when the facts demonstrate that the lender looked primarily to the shareholder for repayment of the loan. In Selfe, those facts were: (1) The taxpayer had originally taken out the loan that the corporation later assumed; (2) the taxpayer pledged her own assets as collateral at the time of the loan origination, and those assets remained pledged after the corporation assumed the debt; (3) the corporation was a poor credit risk; and (4) the bank's loan officer testified that the bank looked to the taxpayer, not the corporation, for repayment.

The Phillipses argued that Sandra Phillips had in substance borrowed money directly from the lenders and then made a capital contribution to the S corporation. Citing Selfe, they stated they believed they had made an economic outlay, due to the court judgments against them demonstrating that the creditors looked to Phillips as a source of repayment, even though she had not actually made any payments toward those judgments.

Holding: The Tax Court held that Phillips's stock basis should not be increased because of the loan guarantee. The court distinguished this case from Selfe because there was no evidence that Phillips had a prior relationship with the lenders. Also, Phillips did not pledge personal assets as collateral, Olson was a well-established company at the time it borrowed the money, and there was no evidence the banks saw Phillips as the primary obligor on the loans or as the primary source of repayment of them. They sought payment from her only after Olson defaulted and its collateral was insufficient to cover the loan balances. The court stated that any judgment payments made by Phillips would be economic outlays required to create basis, but since she had not made any such payments, no basis increase was warranted.

  • Phillips, T.C. Memo. 2017-61

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.

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