When can losses be deducted against S corporation basis?

It is an article of faith among many tax planners that, absent any other restriction (like the passive activity loss limitation), an S shareholder should be able to deduct S losses to the extent chat he has tax basis in S stock and debt. When it appears that losses will exceed basis, planners frequently advise clients to increase their investment in S corporation debt, to secure basis sufficient to permit the deductibility of passthrough losses.

These practices are based on the plain language of Sec. 1366(d)(1) and are sanctioned by Rev. Rul. 75-144, which held that a taxpayer could deduct S passthrough losses when he had substituted his own note for that of the S corporation to a third party lender (a "back-to-back" loan). This rule has sometimes been described as the "economic outlay doctrine."

This doctrine arose in cases tried in the Tax Court soon after S corporations were created by the Technical Amendments Act of 1958 (1958Act). Following enactment of the new law, in a flurry of litigation, taxpayers claimed basis in S debt as guarantors and sureties for S debt to third parties. In some cases, taxpayers exchanged notes with their S corporations and claimed passthrough deductions on the strength of a corporate note received in exchange for a personal note.

In Perry, 54 TC 1293 (1970), relying on language found in the Senate Finance Committee Report accompanying the 1958 Act, the Tax Court held that no such deductions were allowable. Quoting the Finance Committee Report, the Tax Court emphasized that the Committee contemplated that shareholders would be allocated losses up to the amount of their basis in an "investment" in S stock and debt. Denying the Perrys' claim for passthrough losses supported by corporate notes received in exchange for personal notes, the court held that no deduction is allowable when shareholder debt does not arise out of an "investment" in an S corporation.

The line of judicial decisions embodying this economic outlay doctrine predates the Sec. 465 at-risk rules. While the doctrine originally appeared to serve the purpose of applying"at risk-like" principles to S shareholder debt basis issues, over the years the economic outlay doctrine has grown more restrictive than the rules under Sec 465.

In Wilson, TC Memo 1991-544, a profitable S corporation lent funds to unprofitable S corporations owned by the same parties. The profitable corporation distributed the debt of the unprofitable corporations to shareholders, who then claimed passthrough losses from the unprofitable S corporations on the strength of their tax basis in the distributed debt. Citing previous decisions on the economic outlay doctrine (including Perry), the Tax Court denied the taxpayers' claimed deductions.

The court did not discuss whether the shareholders had either at-risk or regular income tax basis in the debt. The case appears to have been decided solely on the question of whether the distributed debt represented a shareholder "investment" in debt of the unprofitable S corporations, considered under the precedent of prior cases involving the economic outlay doctrine.

Since the owners of both the profitable and unprofitable corporations were the same in Wilson, many practitioners find it difficult to see how the shareholders did not suffer a real economic detriment as a result of the unprofitable corporations' losses. Apparently, for an S debt to qualify as an "investment" under the economic outlay doctrine, it will not be enough for the shareholder to have both at-risk and regular income tax basis in the debt. In fact, even if the shareholder will bear the economic cost of an S loss, he may not be enticed to deduct a passthrough loss against his basis in S debt unless the debt was acquired in the "right" way.

In Letter Ruling (TAM) 9403003, the IRS held that an exchange of funds between shareholders and related S corporations, which left shareholders holding S debt, would not qualify as the "right" way to acquire S debt when the refunded debt originally ran between the related corporations.

According to the Service in the TAM, Rev. Rul. 75-144 should apply only when the shareholder substitutes his note for an S note to an unrelated third-party lender.

Moreover, while the cases and rulings in this area deal almost exclusively with S debt, the Senate Finance Committee Report quoted in Perry applies the term "investment" to both stock and debt. Thus, it is not at all apparent chat a distribution from one S corporation of the debt of another, followed by cancellation as a contribution to capital, will allow a taxpayer to circumvent the economic outlay doctrine. Similarly, in fact patterns like that of TAM 9403003, if taxpayers use cash distributed from the collection of the debt by the creditor corporation to acquire stock in the loss corporation, the IRS could hold that loss corporation passthrough losses are nondeductible, on the strength of the economic outlay doctrine.

In view of the reasoning in Wilson and TAM 9403003, practitioners should be very careful in structuring transactions in which shareholders are to acquire additional basis in S stock or debt to support the deduction of passthrough losses. In general, when S debt runs originally between related entities, a simple assignment of the debt, or even repayment and replacement with shareholder funds, may allow the Service to challenge passthrough S deductions on the strength of the economic outlay doctrine.