S Shareholders Not Entitled to Increase Bases by Guarantee of Corporate Debt.

In July 1991, E entered into an agreement to buy land, build a video rental store and lease it. The lease provided that, if the property was environmentally contaminated, the lessee could terminate it.

E then formed S corporation R, and assigned all his rights under the lease to R. R subsequently purchased the property and owned no other assets. The land was contaminated, but the state of Florida agreed to cover the costs of environmental remediation.

Because of the contamination and R's lack of assets, it experienced some difficulty in getting a construction loan. R eventually obtained a one-year loan. To secure the loan, R pledged the property and its improvements; in addition, E personally guaranteed both the mortgage and R's commitment to indemnify the bank for any environmental liability.

In 1992, E received distributions from R, which he did not report as taxable capital gains, claiming that his adjusted basis in R included the loans he had personally guaranteed.

The IRS disagreed and issued a deficiency notice. In a memorandum opinion, the Tax Court held for the Service, ruling that E could not treat his personal guarantee of R's bank loan as a capital contribution that increased his basis in R. The' Court of Appeals (opinion Kravitch, J.) affirms.

Operating a small business as an S corporation has certain tax consequences. The corporation is not subject to the corporate income tax; instead, its profits and losses "pass through" to its shareholders' personal income tax returns. When an S corporation with no accumulated earnings or profits makes a distribution to a shareholder, the shareholder must recognize capital gain only on that portion of the distribution that exceeds his adjusted basis in the shares of the S corporation's stock. The shareholder's adjusted basis in the stock is increased by amounts the shareholder contributes to the S corporation's capital. The more money a shareholder puts into the S corporation, the higher his adjusted basis. The higher his adjusted basis, the less capital gain he realizes if the S corporation makes a distribution to him; the less capital gain he realizes, the lower his potential tax liability.

A shareholder in an S corporation who personally guarantees a debt of the corporation may increase basis in the corporation by the amount of the debt when the facts demonstrate that, in substance, the shareholder has borrowed funds and subsequently advanced them to the corporation. In general, an economic outlay is required before a stockholder in an S corporation may increase basis. However, this rule does not require a stockholder/taxpayer to, in all cases, absolve a corporation's debt before he may recognize an increased basis as a guarantor of a loan to a corporation. When the nature of a taxpayer's interest in a corporation is in issue, courts may look beyond the form of the interest and investigate the substance of the transaction. A shareholder's guarantee of a loan to an S corporation may be treated for tax purposes as an equity investment in the corporation when the lender looks to the shareholder as the primary obligor.

In re Lane, 742 F2d 1311 (11th Cir. 1984), lists the following factors "to facilitate a determination of whether advances to a corporation constitute debt or equity":

1. Names given to the certificates evidencing the indebtedness;

2. Presence or absence of a fixed maturity date;

3. Source of payments;

4. Right to enforce payment of principal and interest;

5. Participation in management flowing as a result;

6. Status of the contribution as to regular corporate creditors;

7. Intent of parties;

8. "Thin" or adequate capitalization;

9. Identity of interest between creditor and stockholder;

10. Source of interest payments;

11. Ability of the corporation to obtain loans from outside lending institutions;

12. Extent to which the advance was used to acquire capital assets; and

13. Failure of the debtor to repay on the due date or to seek a postponement.

Sec. 385(b) provides in relevant part:

The regulations prescribed under this section shall set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists.

The factors may include:

1. Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest,

2. Whether there is subordination to or preference over any indebtedness of the corporation,

3. The ratio of debt to equity of the corporation,

4. Whether there is convertibility into the stock of the corporation and

5. The relationship between holdings of stock in the corporation and holdings of the interest in question.

The Tax Court found that the bank loans to R were not the same, in substance, as loans to E followed by capital contributions to R. It therefore held that E could not increase his basis in the corporation by the loans' amounts.

Relying on the facts that R provided valuable collateral for the loans and that the corporation had ample cashflow to service loans, the Tax Court concluded that the loans did not "lack economic substance." Its reasoning shows that its conclusion that the loans had economic substance was equivalent to a finding that the bank looked to the corporation as the primary obligors on the loans. This finding was not clearly erroneous.

The bank originally made the loans to R, not to E, and E never pledged any of his personal assets to secure the loans.

The bank viewed R as a secure business concern likely to repay its loans. The collateral (including the real property, buildings and leases) was worth nearly twice the amount of the loans. The cashflow from the leases would be significantly higher than the debt payments to the bank. The fact that the bank required personal guarantees of the loans does not, in itself, indicate that the bank looked to E for repayment. It was simply the bank's general policy to require personal guarantees on loans to closely held corporations.

E contends that, despite R's collateral and cashflow, the bank could not have looked primarily to the corporation as a source of repayment, because the properties' environmental contamination placed its income at some risk. Although the contamination did make R's future slightly less secure, the mere presence of a risk did not require the conclusion that the bank could not have expected repayment from R.

E has not presented one of the unusual sets of facts that would lead us to conclude that the substance of the bank loans did not equal their form. We agree with the Tax Court, therefore, that they correctly refused to allow E to include the amounts of the guaranteed loans in his basis in R.

ELI T. SLEIMAN, 11TH CIR., 9/10/99, AFF'G TC MEMO 1997-530