S Corporations’ Shareholders as Guarantors of Loans Owed to Third Parties

By Zev Landau

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“A taxpayer may engineer his transactions to minimize taxes, but he cannot make a transaction appear to be what it is not.”

—Irving Loeb Goldberg,
Judge of the U.S. Court of Appeals for the 5th Circuit

AUGUST 2006 - For treatment of S corporation income and losses by the shareholders and for limitations on corporate losses and deductions that shareholders may claim, IRC section 1366 is the tax law on point.

IRC section 1366(d) states that the aggregate amount of losses and deductions that an S corporation’s shareholder may take into account for any taxable year may not exceed the sum of the adjusted basis of her stock and her basis in any amount the corporation owes her.

Financing techniques of businesses have become more sophisticated, and business people must be alert to the amount of risk associated with the economic and financial aspects of their business transactions. It is unsurprising that litigation in tax courts became more frequent when the interpretation of indirect financing by shareholders was at stake and a disagreement between petitioners and the IRS emerged. The test was: Did the pass-through deductions and losses from an S corporation exceed the shareholder’s basis in the stock and the corporate debt to him (collectively called the investment by the shareholder in his corporation)? Based on facts relating to the structure of the corporate financing, was it appropriate to categorize the debt as corporate debt to the shareholder?

Taxpayers claimed that even though a corporation owed money to third parties, such as financial institutions, the substance of the arrangement made shareholders the real creditors, because they were the guarantors of the loans. Debts to banks augmented their basis in the corporate debt, and more losses could be deducted.

The IRS objected, and the courts refuted the taxpayers’ positions, mostly because there was no evidence of an economic outlay by the shareholders. In most cases judges did not think that guarantees were an economic outlay and a cause of augmentation in basis of debt. The courts believed that before a deduction is allowable some transaction must have occurred that, when fully consummated, left the taxpayer poorer in a material sense. The S corporation’s indebtedness must run directly to the shareholder. A bank loan to an S corporation does not satisfy the statutory requirements. Nor do intercompany loans between S corporations controlled by the same shareholders always constitute compliance with the shareholder-debt/corporate-pass-through-losses issues.

Close scrutiny of a loan transaction between related S corporations may result in different conclusions. In Culnen v. Commissioner (T.C. Memo 2000-139), the court stated:

[I]n explaining the statutory requirement that the indebtedness of the S corporation must run directly to the shareholder, we made it clear that an indebtedness to an entity with pass through characteristics that has advanced the funds to the S corporation and is closely related to the taxpayer does not satisfy the statutory requirement. We did not say, however, that the fact that the borrowed funds originate with the closely related entity precludes the indebtedness of the S corporation from running directly to the shareholder. Certainly, where there is a close relationship among the S corporation, the taxpayer, and the related entity, we will scrutinize the relationships established with respect to the transfer of funds to ensure that those relationships comport with the statutory requirement.

In Underwood v. Commissioner (63 T.C. 468), the court focused on a reverse scenario and warned:

When a taxpayer interposed himself between the two corporations by causing the corporations to substitute for the one-legged indebtedness running between the S corporation and the second corporation a two-legged indebtedness, running, first, from the S corporation to him and, second, from him to the second corporation, we concluded that the taxpayer had paid out no funds and would not until his note to the second corporation became due. On that basis, we were unable to distinguish his liability from that of a guarantor, who makes no investment until he pays his obligation. We relied on a long list of cases for the proposition that basis-giving indebtedness does not arise where a shareholder merely guarantees a subchapter S corporation’s debt.

Only the kind of an indebtedness that evidences an actual investment by the shareholder, not merely one given in return for a promise by the shareholder for some future outlay, will increase basis. Put differently, what is required to provide basis for deductions and losses is an actual economic outlay, a term that deserves clarification.


Studying the decision in Maloof v. Commissioner [T.C Memo 2005-75 (04/06/2005)] is instructive for many reasons:

  • The reader gets a brief insight about financing techniques for business organizations;
  • It demonstrates that law, economics, and finance are connected;
  • It emphasizes the virtue of proving that economic outlay was incurred by the taxpayer whenever financing transactions are performed;
  • It teaches the importance of solid argumentation in representing clients and the merits of identifying factual differences between various scenarios and court cases; and
  • It indirectly reminds financial accountants that losses deducted by S corporation shareholders reduce the basis of stock and corporate debt to shareholders. In preparing an S corporation’s tax return, an accountant should not assume that the face value of the loans on the balance sheet is also the tax basis of the shareholder in debt.

William Maloof was the sole shareholder of several S corporations involved in the gas industry. One S corporation, Level Propane, Petroleum & Gases Co. (S1), provided propane gas to rural areas in Ohio before expanding into neighboring states. Typically, corporations engaged in marketing and providing energy products and services require large infusions of capital to sustain growth. Initially, S1 funded its capital needs with transfers from various corporations in which Maloof also owned all the shares.

Debt financing and loan payments. After the resources of equity capital were exhausted, S1 obtained financing from a bank; a loan of $4 million consisted of several components secured by different collaterals. The loan was structured as follows:

  • A $750,000 equipment note secured by equipment that S1 purchased with the loan proceeds. Traditional equipment-financing means taking possession of the equipment and using it as collateral for the loan. Some financing experts believe that the fact that entrepreneurs can often borrow all the money they need in order to buy new or used equipment makes traditional equipment-financing exciting.
  • A $2.5 million revolving term loan secured by petroleum tanks and supply contracts. Contracts, just like purchase orders or work in progress, have some value, and from a financing point of view they are considered assets that can be used as collateral.
  • A $750,000 demand loan secured by the inventory and accounts receivable of S1. Each bank has its own policy regarding what types of inventory it will accept as collateral. Because tracking inventory levels and values accurately is very expensive, it is difficult to get just pure inventory financing without using the company’s receivables as extra collateral.
  • Maloof pledged all the shares of S1 and a $1 million insurance policy on his life.

The New York State Society of CPAs online dictionary (www.nysscpa.org/prof_library/guide.htm) defines a pledged asset as an “asset placed in a trust and used as collateral for a debt.” Guaranty, on the other hand, is a “legal arrangement involving a promise by one person to perform the obligations of a second person to a third person, in the event the second person fails to perform.”

Initially, the only payments that S1 made to the bank were payments of interest. The principal was never paid. S1 generated substantial losses during the years at issue. Eventually, the corporation defaulted on the loan and was forced into bankruptcy.

Arguments and observations. The facts show that the shareholder increased his basis in the stock of S1 by the amount of the $4 million loan in order to claim as pass-through deductions the operating losses of S1. The IRS argued that the basis in the stock could not be increased by the amount of the $4 million loan, because it had never been repaid, nor had Maloof ever been called upon to pay any amount under the loan. At no time did the bank demand payment from the petitioner individually or begin collection action against S1, the actual debtor. The IRS used the passivity of the bank against the petitioner when it disallowed the losses, which the petitioner claimed on his personal tax returns each year without experiencing default on the payments due to the bank on the loan. In reality, it is possible that despite corporate losses, banks may either renew a loan upon assignment of certain assets, or not ask for payment altogether, as the experience of S1 demonstrates. Either way, the lack of action by the bank diminished Maloof’s economic risk, at least temporarily.

Maloof was convinced that his personal guaranty of the loan was equivalent to an increase in his loan and, therefore, entitled him to deduct $4 million of additional losses on his personal tax return. He was well aware that the bank, not the shareholder himself, was the lender, and his legal advisors knew that the language in the IRC states that debts to shareholders are included in their aggregate basis for loss deductions, but their position was that guarantees, in fact, converted the bank loan, at least in substance, to owner’s equity.

Many previous cases asserted that a shareholder’s guaranties of loans to an S corporation do not constitute an economic outlay, because the shareholder is only secondarily liable. The fact that shareholders may be primarily liable on indebtedness of a corporation to a third party does not mean that this indebtedness is “indebtedness of the corporation to the shareholder” within the meaning of IRC section 1374(c)(2)(B): “No form of indirect borrowing be it guaranty, surety, accommodation, co-making or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation.” In another case, the declaration was that the shareholders must make actual disbursements on the indebtedness before they can augment their bases for the purpose of deducting losses.

Maloof relied primarily on the decision in Selfe v. United States [778 F.2d 769 (11th Cir. 1985)]. In Selfe, the court agreed that an economic outlay is required before a stockholder in an S corporation may increase her basis. It disagreed, however, with the proposition that a stockholder/taxpayer must, in all cases, absolve a corporation’s debt before she can recognize an increased basis as a guarantor of a loan to a corporation. Instead, a shareholder who has guaranteed a loan to an S corporation may increase her basis where the facts demonstrate that the shareholder has borrowed funds individually and subsequently advanced them to the corporation. This is a significant distinction from the facts in Maloof.

In Selfe, the issue was not whether the taxpayer’s contribution was a loan or an equity investment. The issue was whether the taxpayer’s guarantee of the corporate loan was in itself a contribution to the corporation sufficient to increase the taxpayer’s basis in the corporation. In most cases, a mere guarantee of a corporate loan is insufficient, absent subrogation, to increase a taxpayer’s basis.

Maloof failed to distinguish between the facts in Selfe and his own case. Not only did Maloof’s corporation never pay the loan principal, unlike Selfe, but Maloof asked the bank to convert his personal loans to corporate debt and designate him as a guarantor.

In his appeal to the court, Maloof asked the judge to consider the substance of the loan guarantee transaction rather than focus on the formality. The court turned down Maloof’s plea, holding that he, like all taxpayers, is bound by the form of his transaction and may not argue that its “substance” is different in order to achieve more-favorable tax consequences.

Is loss of control considered an economic outlay? Maloof thought that he suffered an economic loss when the bank gained control of S1’s affairs. In his view, suffering an economic loss was synonymous with economic outlay. The IRS maintained that only when the guarantor shareholder has honored the guaranty, and a monetary economic outlay has in fact occurred, does the debt run to the shareholder—meaning that honoring the guarantee is the triggering event for increase in debt basis for the purpose of deducting losses. At the same time, honoring a guarantee does not require absolving the debt.

Maloof never honored his guarantee. He was never required by the bank to make any payments either in cash or in kind; his corporation never became indebted to him instead of to the bank, such as under the doctrine of subrogation. Maloof did not substantiate any alleged loss of control, nor provide the court with a means to value the loss of control.

Maloof claimed that pledging stock of S1 was an economic outlay based on Selfe and the Estate of Leavitt v. Commissioner [90 T.C. 206 (1988)]. In Selfe, the court said that a shareholder does not, in all circumstances, have to “absolve” a corporation’s debt to increase basis. Maloof apparently disregarded the fact that in Selfe the taxpayer borrowed funds in her individual capacity, and only then pledged her personal assets as collateral for a loan. Selfe later formed an S corporation and advanced the borrowed funds to that entity. This was the point when Selfe converted her personal loan into a corporate loan, which assumed the loan and committed itself to repay it. Selfe became a primary guarantor instead of a debtor. Maloof disregarded the fact that Selfe pledged her personal assets, which were unrelated to the corporation and pledged before the corporation was formed. This was a clear indication that the bank looked at Selfe and her personal pledged assets for repayment of the loan.

Maloof offered no evidence that he personally borrowed funds from the bank and then advanced those funds to S1, or that the bank looked primarily to him for repayment. There was no testimony from a bank loan officer that the bank looked to the taxpayer as primary obligor, testimony that Selfe was able to provide. Similarly, the collateral on which the bank depended in Maloof’s case belonged to S1, a corporate debtor, not to the petitioner, another reason why Maloof could not use the “economic outlay” argument. Until the bank calls upon a petitioner individually to make some payment on the loan, the petitioner has experienced no economic outlay and may not increase his basis in the S corporation. As the court in Maloof said, “Because petitioner has offered no evidence that the bank looked primarily to him for repayment, we conclude that Selfe is distinguishable and, therefore, does not control this case.”

Is a pledge of assets considered an economic outlay? In Selfe, the court held for a guarantor who pledged stock that is then not available as collateral for other investments. If lost time-value or use of the collateral has an economic significance, then the pledge is an economic outlay. In Maloof, the court focused on IRC section 1012, which defines cost to mean the amount paid for property in cash or property. A guarantee does not constitute such payments.

Arguments by Other Taxpayers

Maloof is not the first taxpayer to disagree with the IRS’s interpretations of the significance of loan guarantees. The following examples demonstrate positions that taxpayers have taken with respect to loan guarantees:

  • A guarantor’s obligation is presumed to be unconditional and a guarantor is liable on the default of primary obligor without notice or demand.
  • The possibility that, under state law, lending institutions may grant a general lien on all properties owned by borrowers while they were guarantors implies that an economic outlay was incurred.
  • Under partnership rules, an increase in proportionate share of partnership liabilities is deemed to be a contribution of capital, so the same rule should apply to an S corporation, also a pass-through entity. (This is a weak argument because the rules for partnerships are different from those for S corporations.)
  • When financial ratios indicate that a corporation is thinly capitalized or even insolvent, a formal loan from a lending institution, guaranteed by the shareholders, is in substance equity financing. (The weakness of this argument is that a recharacterization of loan as equity is an issue that is usually invoked by the IRS.)

Zev Landau, MBA (Tax), CPA, is associated with the accounting firm of Konigsberg Wolf & Co., P.C., CPAs and Business Consultants, New York, N.Y.




















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