S Shareholder's Personal Guarantee Did Not Allow for Increased Basis

For many years, B operated a trucking business, set up as Partnership P. In 1988, B formed S corporation C, which provided maintenance and parts for the P trucks. In 1990, B took a second mortgage on his home to secure a debt that C owed to the Bank.

In 1992, to obtain operating capital, the Bank extended a line of credit to C. B had to sign a personal guarantee to repay such funds and had to mortgage additional real estate. At approximately the same time, P transferred almost all its assets to C. C assumed all P's liabilities and took over its trucking business. No cash was involved; B treated the transaction as a sale of P's assets to C, with no gain to P.

For 1990 and 1991, C realized operating losses, which B deducted (through net operating loss carrybacks and carryovers).

The IRS denied these deductions, claiming that B lacked sufficient tax basis in his C investment. The Tax Court, in a memorandum opinion, held for the Service; B's personal guarantee of C's debt on the Bank loan did not entitle him to increase his basis in C.

Under Sec. 1366, S shareholders may deduct their pro rata shares of the corporation's losses to the extent the losses are supported by the shareholders' adjusted bases in the stock and in debt of the S corporation to the shareholders.

Unless the S shareholders incur an economic outlay on debt that the corporation owes to third parties, the shareholders are not entitled to increase their bases in their stock by the debt's amount. Accordingly, mere shareholder guarantees of corporate debt to third parties generally do not qualify as an economic outlay or as debt from the S corporation to the shareholder until (and unless) the shareholder pays part or all of the debt. Likewise, if corporate debt to third parties is merely secured by the shareholders' property, no economic outlay has occurred, no debt to the shareholders exists and shareholders are not entitled to increase their bases in the S corporation by the amount of the corporate debt that the shareholders secured.

B contends that he is entitled to increase his tax basis in C's debt to the Bank, to the extent he personally guaranteed and secured such debt.

In this case, the Bank extended funds directly to C, and C has made all payments on the debt. B could have structured the debt as debt to himself, but chose to avoid primary liability. B's secondary liability, as guarantor, may have been necessary for the Bank's approval of the debt. Until (or unless) B is called on to pay the debt, his secondary liability is not enough, for tax purposes, to treat the debt as if it were made to B. B has not established that he incurred an economic outlay for C's debt to the Bank, and B is not entitled to increase his tax basis in his C investments.

Because P assets were transferred to C, B also contends that he is entitled to increase his tax basis in C by (1) the amount that the value of the assets P transferred to C exceeds the amount of P's liabilities assumed by C, (2) the amount of P "equity" transferred to C and (3) the amount of certain additional amounts allegedly owed to P.

To avoid recognition of partnership capital gain on the transfer of assets to C, P's partners structured the transfer as a sale of assets to C for the assumption of P's liabilities, the amount of which was treated as equaling P's tax basis in the assets. The transaction was not structured as a taxable distribution of partnership assets to the partners followed by a contribution of the assets to C with a stepped-up tax basis.

Even if the value of the P assets transferred to C exceeded the P liabilities assumed by C, P "equity" was transferred to C and C owed additional amounts to P, such excess value, equity or amounts would not increase the tax bases of C's shareholders.

The distinctions that exist between partnerships, sole proprietorships and corporations do so from a tax viewpoint by design. To treat the partnership transfer as having been made directly by the partners would be to deliberately obfuscate the distinction when no such action is called for. P, not the shareholders of the S corporation, made the transfer to C, and only P would receive tax basis associated with the transfer.

Despite the similar ownership interests of the P partners and the C shareholders, B, as a C shareholder, may not increase his tax basis in his investment in C for purported value of P assets (in excess of P's liabilities assumed), for purported P equity transferred to C, or for amounts owed to P.

Estate of Alton Bean, TC Memo 2000-355