Losses from an S corporation flow through to its shareholders, who can deduct them on their individual tax returns as long as they have sufficient basis to absorb them. Economic outlays such as capital contributions and loans by a shareholder to an S corporation will increase a shareholder’s basis. Generally, loan guarantees, pledges of collateral and other forms of indirect borrowing are not considered economic outlays. The Eleventh Circuit Court of Appeals created an exception in Selfe v. U.S., 778 F.2d 769, in which a taxpayer borrowed money and later loaned that money to her newly formed S corporation. The corporation then assumed her liability for the loan, but the bank required the taxpayer to personally guarantee its repayment. The court permitted a basis increase because of the loan guarantee, since the substance of the transaction showed she was the primary obligator on the loan.
Last year, the Sixth Circuit refused to apply the Selfe exception to a case in which the taxpayer cosigned on the loan but the bank never sought payment from him.
William Maloof was the sole shareholder of Level Propane, Petroleum & Gases Co., which borrowed $4 million from a bank. Maloof personally guaranteed the loans by pledging all of his stock in it and other S corporations and a $1 million insurance policy on his life. Level Propane defaulted on the loan and was forced into bankruptcy, but the bank did not demand payment. From 1990 to 2000, Level Propane sustained large losses. Maloof increased his basis by $4 million because of the loan guarantee and then deducted the losses on his individual return. The IRS took the position that no increase in basis was warranted, disallowed the losses and assessed a tax deficiency against him. Maloof petitioned the Tax Court.
Maloof argued that his personal guarantee of the loan and the pledging of his stock and insurance policy constituted economic outlays that increased his basis. The Tax Court rejected this argument, stating the bank never sought his personal assets for repayment of the loan. The taxpayer also argued he had an economic outlay because he incurred a “cost” when he lost control of the corporation. No evidence was presented supporting any loss of control, nor was any evidence offered that measured a cost related to that loss. Finally, the taxpayer argued that, in substance, he had borrowed the money and in turn transferred it to the corporation and that the holding in Selfe should be followed. The court ruled the Selfe holding did not apply because Maloof never personally borrowed any money and the bank never sought any payments from him (see “Tax Matters,” JofA , Mar.06, pages 78–79). Maloof appealed to the Sixth Circuit.
Result. For the IRS. The appeals court said Maloof’s basis could be increased if the corporation was indebted to him or if he had incurred a cost evidenced by an economic outlay. The loan agreement clearly showed the corporation as the borrower, and the corporation would be indebted to him only if he used personal assets to pay the corporate loan. Even though the taxpayer cosigned the loan, the bank never sought his assets for repayment. Based on this, the court concluded Maloof never incurred any type of economic outlay.
This decision marks another defeat for taxpayers attempting to increase their S corporation’s stock basis with a loan guarantee. It should also be noted that if the taxpayer had shown that the loan was his, the interest payments made by the corporation to the bank on his behalf would be constructive dividends. He still would have had some additional tax liability.
William H. Maloof v. Commissioner, 456
F.3d 645.
Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.
