Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

S CORPORATION SHAREHOLDER WINS BASIS CASE IN TAX COURT

June 16, 2006

We have covered several cases where the IRS has shot down attempts by S corporation owners to deduct losses attributable to loans they made to S corporations. The IRS usually prevails when the taxpayer makes a loan to the S corporation using funds borrowed from a relative, or even (in effect) from the S corporation itself.

HOW IT'S DONE

In a Tax Court decision yesterday, a taxpayer demonstrated the right way to get loan money to an S corporation to get basis for pass-through losses. Timothy J. Miller owned Miller Medical Systems, Inc. (MMS), an S corporation "in the business of manufacturing mobile and modular medical diagnostic facilities."

The tax law only allows you to deduct S corporation losses to the extent you have basis in S corporation stock, or in debt you have loaned to the S corporation (click here for a more detailed explanation of these rules). Furthermore, you have to be "at-risk" for that basis - in crude terms, you have to be on the hook for it.

Continuing losses meant Mr. Miller was running out of basis by 1992. He had guaranteed a line of credit from Huntington Bank to MMS. The borrowings against the line didn't give Mr. Miller any basis for losses because guarantees of S corporation debt don't create basis. To get more basis, Mr. Miller replaced a line of credit from Huntington to MMS by entering into a personal line of credit with the bank under the same terms. He then entered into his own line of credit with MMS and took a security interest in the MMS property; the bank then took a secured interest in his security interest.

Four co-investors in the group signed guarantees of Mr. Miller's line of credit; in an unusual arrangement, they waived any right to go after Mr. Miller if the they had to make good on the guarantee.

And in due time, they had to.

IRS: NO SUBSTANCE, NO BASIS

The IRS tried to disallow Mr. Miller's deductions by arguing that "in substance" Mr. Miller was just guaranteeing the old loan, rather than borrowing personally:

Respondent [IRS] contends, however, that no substantive indebtedness was created between petitioner [Mr. Miller] and Huntington as a result of the restructuring because MMS remained in substance the borrower from Huntington. In respondent's view, petitioner was at best some kind of accommodation surety with respect to the indebtedness, a role insufficient to give him basis under section 1366(d)(1)(B).

The Tax Court rejected the IRS argument, noting that Mr. Miller was listed as the borrower on the bank records, and that the bank sought additional security from Mr. Miller when it later increased the line, including a second mortgage on his parents house.

AT-RISK

The IRS also said that the guarantees by his co-owners meant he was not "at-risk" for the guaranteed amounts. The Tax Court rejected the argument, saying that just because somebody else might be on the hook if he couldn't pay didn't mean he didn't have to pay if he could:

In short, there was no certainty that the guarantors would be called upon to satisfy the indebtedness. As a consequence, we conclude that petitioner had a realistic possibility of loss thereon.

This "realistic possibility of loss" standard is one of two ways the courts have enforced the at-risk rules. Some courts have used a different "worst-case scenario" view, which looks at who ends up holding the bag if everything goes bad. The Eighth Circuit, which includes Iowa, has used the "realistic possibilty" standard (See Moser, 914 F.2d 1040, no link available). If not overturned on appeal, this case will be helpful guidance for Iowans and other Eighth Circuit taxpayers.

The Moral? If you need to borrow money to fund your S corporation, visit your friendly banker. Don't borrow from your other businesses, or from your family, or from your co-owners. If you have to get a guarantee, make it clear that you are on the hook first.

Cite: Miller, T.C. Memo 2006-125