Deducting S corporation losses.
In William H. Maloof, TC Memo 2005-75, the court considered whether an S corporation shareholder's personal guarantee, pledge of stock or loss of control resulted in an economic outlay entitling him to increase his basis.
Maloof was the sole shareholder of Level Propane, Petroleum & Gases Co., which provided propane gas and services to customers in 14 states. The company generated approximately $18 million in annual revenues and had about 600 employees. To sustain its growth it borrowed $4 million from Provident Bank in July 1993. The money had three principal components: $750,000 secured by equipment; a $2.5 million revolving-term loan secured by tanks and supply contracts; and a $750,000 demand loan secured by inventory and accounts receivable. As additional collateral, Maloof pledged all his shares of Level Propane and a $1 million life insurance policy.
From 1990 through 2000 Level Propane had substantial losses. Maloof increased his basis in the company by the amount of the $4 million loan to claim Level Propane's net operating losses as pass-through deductions. The company was forced into involuntary bankruptcy when it defaulted on the loan. At no time, however, did the bank demand payment or begin collection action against Maloof.
The IRS determined that Maloof had insufficient basis against which to deduct S corporation losses and, therefore, assessed the deficiencies in tax for the years 1990 through 2000.
Maloof claimed he was entitled to increase his basis in the stock of Level Propane by $4 million because he personally had guaranteed the loan, pledged stock to secure it and incurred a cost when he lost "control" of Level Propane. Citing an Eleventh Circuit Court of Appeals precedent, United States v. Selfe, Maloof argued his pledge of stock constituted an economic outlay Finally, he suggested the transaction be recharacterized as a personal loan he made to Level Propane.
Result. For the IRS. The court found that Maloof's personal loan guarantee, his pledge of stock and the bank's control of Level Propane did not constitute an economic outlay to create basis. A taxpayer makes an economic outlay when he or she incurs a "cost" on a third-party loan or is left poorer in a material sense after the transaction. Guaranteeing a bank loan does not constitute an economic outlay because the shareholder is only secondarily liable. Because Maloof did not need to perform under the loan or make any payment, the court held that his personal guarantee did not increase his basis in Level Propane.
Taxpayers are bound by the "form" of their transactions and may not argue that the "substance" of their transaction triggers different tax consequences. Therefore, Maloof had to accept the tax consequences of his choice.
The Tax Court has held that pledging personal assets is not an economic outlay sufficient to increase basis (see Luiz v. Commissioner, TC Memo 2004-21). The court found the facts in Selfe were distinguishable and thus noncontrolling. Because the bank did not require Maloof to make payment on the loan, he did not make an economic outlay and could not increase his basis.
Maloof owned the Level Propane S corporation shares at all times. He did not substantiate any loss of control or provide the court with a means to value the cost associated with such loss.
* William H. Maloof v. Commissioner, TC Memo 2005-75.
Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.
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|Author:||Nash, Claire Y.|
|Publication:||Journal of Accountancy|
|Date:||Mar 1, 2006|
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