Tax Court restricts S corporation shareholder's basis for loss deductions.

In a case of first impression, the Tax Court recently held in Hitchins, 103 TC No. 40 (1994), that a shareholder's basis in an S corporation does not include third-party debt payable to the shareholder assumed by the corporation.

Sec. 1366(a) allows S shareholders to deduct on their individual returns their pro rata share of the corporation's losses and deductions. However, Sec. 1366(d)(1) specifies that the deduction on the shareholder's return cannot exceed the sum of the shareholder's adjusted basis in his S stock plus the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder. Any corporate losses or deductions not deductible on the shareholder's return due to lack of basis can be carried forward indefinitely and are deductible by the shareholder when he has sufficient basis (Sec. 1366(d)(2)).

Previous cases have established certain rules as to the meaning of "any indebtedness of the S corporation to the shareholder." First, there must be an "actual economic outlay" by the shareholder. Four appellate courts have rejected mere loan guarantees of an S corporation's debt by a shareholder as constituting an actual economic outlay for shareholder basis purposes when the shareholder makes no payment on the loan (e.g., see Uri, Jr., 949 F2d 371 (10th Cir. 1991)). Second, the S corporation debt must run directly to the shareholder. For example, a shareholder who also is a partner in a partnership cannot increase his basis in the S corporation as a result of a loan from the partnership to the S corporation (Frankel, 61 TC 343 (1973)).

In Hitchins, the taxpayer founded Champaign Computer Company (CCC), a C corporation, which developed a database for various chemicals in 1985 and 1986. CCC was to be reimbursed for this software development, and ownership of the software would be transferred to another company (yet to be formed). In 1986, Hitchins personally loaned CCC $34,000, which CCC treated as a "loan from shareholder." Later in 1986, Hitchins and two other people formed ChemMulti-Base Company, Inc. (CMB) as an S corporation. Hitchins owned 50% of CMB.

On Oct. 1, 1986, CCC billed CMB for expenses incurred by CCC to develop the database. CMB issued a note payable to CCC for this amount. Later, CMB paid part of the note and agreed to repay CCC's debt to Hitchins in consideration of the remainder CMB's debt to CCC. CMB made a journal entry debiting its liability to CCC and crediting a liability to Hitchins. However, CCC was still liable to Hitchins in the event of a default by CMB. Also, no note was executed between Hitchins and CMB.

In deducting his share of CMB's losses on his 1986-1988 individual returns, Hitchins included in his CMB stock basis the loan transferred from CCC to CMB. The IRS disallowed this increase in basis and also assessed the negligence penalty (under then Sec. 6653(a)). The taxpayer argued that, as part of an overall plan, CCC was acting on CMB's behalf when CCC borrowed the money from Hitchins (even though CMB did not yet exist when this loan was made). The Tax Court rejected this argument: None of the parties treated the loan as being from Hitchins to CMB. Also, there were two steps involving the notes between CCC and CMB, which made the existence of an overall plan unlikely. CMB gave a note to CCC for $65,645 and later assumed CCC's $34,000 debt to Hitchins.

Next, Hitchins argued that Sec. 1366(d)(1)(B) refers to "any indebtedness" without qualification. Therefore, CMB's debt to Hitchins should increase his basis. The Service responded that "of" and "to" in "any indebtedness of the S corporation to the shareholder" requires the loan to be directly from the shareholder to the corporation. Therefore, CMB's debt to Hitchins did not qualify.

The Tax Court held that CMB's debt to Hitchins did not qualify for an increase in shareholder basis because "indebtedness" in Sec. 1366(d)(1)(b) must be strictly construed. Citing the legislative history of Sec. 1374(c)(2 which Congress reenacted without relevant change as Sec. 1366(d)(1) in 1982, the court ruled that the S corporation's debt to the shareholder must represent an "investment" by the shareholder. CMB's debt to Hitchins did not qualify; CCC was still liable to Hitchins on this debt if CMB defaulted. Thus, Hitchins's position ultimately depended on his status as a creditor and shareholder of CCC. The court concluded that Hitchins was merely "a creditor beneficiary of CMB," not "an investor in CMB." However, the court rejected the Service's imposition of the negligence penalty because the statutory language was unclear.

The Tax Court then offered two ways that Hitchins could have obtained the increase in basis. Both involved extra steps that would have changed the form of the loan. The first and simplest way would have been for Hitchins to provide CCC with a written release from liability, along with CMB's issuance of a replacement note payable to Hitchins. Even though the outlay of funds was from Hitchins to CCC, the court held that a constructive furnishing of the funds by the shareholder to the S corporation would be recognized under Sec. 1366(d)(1)(B), citing Gilday, TC Memo 1982-242, and Rev. Rul. 75-144.

The second way would have been for Hitchins to loan CMB $34,000, followed by CMB's payment of the $34,000 to CCC, and CCC's payment of the $34,000 to Hitchins. Both of these approaches result in the S corporation as the sole unconditional debtor to the shareholder, who made the loan.

In Hitchins, the Tax Court clearly emphasized the form of the transaction over its economic substance. There is a precedent in a Sec. 1374 case (Sec. 1366's predecessor) in which the Eleventh Circuit disregarded the form of the transaction and looked to its substance. In Selfe, 778 F2d 769 (11th Cir. 1985), the Court of Appeals held that if the shareholder could prove that her guarantee was in reality a loan from her to the S corporation, she could increase her basis in the corporation. A bank had extended a line of credit to Selfe based on her pledge of stock in another company to the bank. Although the bank later made the loans to her thinly capitalized S corporation, a bank official testified that the bank looked primarily to her collateral and personal guarantee for repayment. (In footnote 3, the court stated: "It is not clear from the bank officer's deposition testimony that the bank was primarily looking to the taxpayer for repayment. Mr. Anthony, the bank officer, testified that the loans originally advanced to the taxpayer were converted to corporate loans because 'it just made more sense to have the company primarily liable and then the individuals would be just as liable as they were when the loans were direct to them.' Mr. Anthony also testified, however, that the taxpayer's collateral and personal guaranty were `primarily' why the bank renewed the corporation's loans. On remand, the court will have to determine what the bank's intentions were.")

Thus, the form of the transaction was a loan by the bank to the S corporation, but if the substance was a loan by the bank to Selfe, who then made a contribution to the S corporation's capital, her basis should be increased. Selfe is the only appellate court decision allowing a shareholder's loan guarantee, without any payment by the guarantor, to increase the shareholder's basis in an S corporation.

There are two lessons for tax advisers in Hitchins. The first lesson is that a loan should be structured so that the S corporation is solely obligated to the shareholder, who has made an outlay of funds for the loan. The second lesson is that "netting" transactions such as occurred in Hitchins, even though reasonable in an economic sense, are fraught with danger in the strictly construed realm of taxation. (See also Tax Clinic, "Using Loans to Increase Basis in S Corporations," TTA, May 1989, at 320, and "Back-to-Back Loans May Not Create Basis," TTA, Feb. 1995, at 86.)