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WHEREVER YOU ARE, S CORPORATION LOAN GUARANTEES DON'T WORK

August 07, 2006

S corporations, as longtime readers know, don't generally pay federal taxes. Instead thier income and loss passes through to their owners' 1040s, and the owners pay the taxes.

The ability to reduce personal tax by corporation losses can be a powerful tax planning tool, but it has its limits. The most important limit is "basis." Shareholders can only deduct S corporation losses to the extent of their basis in S corporation stock and the amount of money they have loaned to to the corporation. The ability to deduct for loans is further limited by requirements that the taxpayer be "at-risk" and have an "actual economic outlay."

These requirements tripped up William Maloof. He guaranteed $4 million in bank loans to S corporations that he owned and deducted losses based on the bank loans. The IRS said that the guarantee wasn't enough and that he owed over $3 million in taxes for an 11-year period beginning in 1990. The 6th Circuit court of appeals last week upheld the IRS, citing many other court cases holding that guarantees just don't work.

An interesting sidelight: the taxpayer argued that the case should be decided using 11th Circuit precedent, which he thought was more favorable than the 6th Circuit. Why? He argued that he lived with his mother in the Florida (11th Circuit), rather than with his wife in Ohio. This prompted tax blogger Stuart Levine to make the immortal comment: "Note to Counsel: Your client's name is 'Maloof' not 'Oedipus.'" In any case, the Sixth Circuit said the result would have been the same in the Eleventh Circuit anyway.

The Moral? If you want to deduct S corporation losses, don't guarantee the loan. Borrow from the bank yourself and make your own loan to the corporation. To see how it is done, look at Miller, T.C. Memo 2006-125, discussed here.

Cite: Maloof, No. 05-1967 (CA-6, 8/4/2006)

UPDATE: The TaxProf has more.

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