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S corporations vs. C corporations.

A major advantage of conducting business as an S corporation, rather than as a C corporation, is that S losses flow through to the shareholders, who may deduct them on their individual returns. However, Se. 1366(d)(1) limits the amount of a shareholder's pro rata share of corporate losses that currently may be deducted to the sum of the basis in the stock plus the "adjusted basis of any indebtedness of the S corporation to the shareholder." To provide basis for this purpose, the debt must run directly to the shareholder; the creditor may not be a person related to the shareholder (see Frankel, 61 TC 343 (1973)).

To qualify as "indebtedness," a shareholder generally must have acquired the debt through an actual economic outlay, viz.," there must have occurred some transaction which when fully consummated left the taxpayer poorer in a material sense" (Perry, 54 TC 1293 (1970)).

Corporate debt from a third-party lender does not create indebtedness from the corporation to the shareholder even if the shareholder guarantees the debt. Only when the guaranteeing shareholder makes payments on the debt does corporate indebtedness to the shareholder arise under the economic outlay doctrine. (See, e.g., Est. of Leavitt, 90 TC 206 (1988), aff'd, 875 F2d 420 (4th Cir. 1989).)

Even Selfe, 778 F2nd 769 (11th Cir. 1985) (widely regarded as the most pro-taxpayer decision in this area), "reaffirms that economic outlay is required before a stockholder in a Subchapter S corporation may increase her basis." However, Selfe did not require actual payment in order to meet the economic outlay test; a shareholder/guarantor who has pledged stock in another corporation to secure a loan may have experienced an economic outlay. (Of course, more was needed here to acquire basis. The Eleventh Circuit also looked to the debt-equity principles of Plantation Patterns, Inc. 462 F2nd 712 (5th Cir. 1972), to ascertain whether in substance the shareholder had borrowed funds and subsequently advanced them to her corporation.)

The IRS has approved another form of economic outlay (other than immediate payment on the guarantee). In Rev. Rul. 75-144, a shareholder/guarantor executed his own promissory note for the full amount of the corporation's liability to a third-party bank. The bank in turn accepted the note in satisfaction of the guarantee and relieved the corporation of its liability. Assuming subrogation, the Service concluded that the shareholder's note to the bank was an economic outlay supporting basis in the resulting corporate indebtedness to the shareholder. And this was so even though no payments were made to the bank on the shareholder note until the following year.

The Tax Court in Gilday, TC Memo 1982-242, extended Rev. Rul. 75-144 by finding an economic outlay even if the shareholders did not become subrogated to the bank's rights against the corporation. The corporation considered itself obligation to the shareholders and gave them its note (evidencing its indebtedness). In Letter Ruling 8747013, the Service gave its approbation to "back to back" loans to pay off corporate debt (to a bank) that had been guaranteed by the shareholders; "indebtedness" was created even though certain corporate assets pledged as collateral on the original loan remained pledged on the new loan made to the shareholders and even though the third-party creditor remained the same. Case law suggests a far less "generous" result if the shareholders control the original creditor (since payments by a shareholder to a controlled creditor are not as certain as payments to a third-party bank). See Underwood, 535 F2d 309 (5th Cir. 1976).

The Tax Court in Wilson, TC Memo 1991-544, further refined the economic outlay doctrine. The facts, as simplified, indicate brother-sister S corporations, Profitable and Loss. Profitable had loaned money to Loss. Since the shareholders did not have sufficient basis in Loss to absorb the latter's projected year-end losses, the shareholders caused Profitable to distribute to them its interest-bearing notes from Loss. The taxpayer/shareholders believed that the debt now running from Los to them represented "indebtedness" for purpose of Sec. 1366(d)(B).

Because the shareholders had not made an "economic outlay" with respect to the loans (i.e., the shareholders were not poorer in a material sense), the Tax Court refused to allow conversion of the loan, owned by an S corporation, a controlled brother corporation, into S corporation indebtedness to shareholders by debt distribution; control of the creditor corporation was critical. Thus, the debt could not be used by the taxpayer/shareholders to support loss flow-through from Loss Corporation.

Despite the Tax Court's disposition of the case, an argument can be made under the facts established in Wilson that the taxpayer/shareholders had made an economic outlay, since the value of their Profitable stock necessarily was reduced on that corporation's distribution of an asset (the Loss notes) to them. This lesser value may be manifested, for example, to the extent that the stock is used as collateral for other investments or is sold by taxpayers. Therefore, the Tax Court's conclusion that the reduction in stock value does not leave shareholders "poorer in a material sense" until corporate liquidation appears erroneous. Thus the distribution of the Loss not did have current economic effect.

Furthermore, the taxpayers paid a tax price for the notes. On a Sec. 1368(a) distribution from an S corporation, the shareholders either recognize dividend income, recognize capital gain or suffer a reduction of stock basis. Thus, there was a tax cost to the shareholders from Profitable's distribution of Loss's notes.

In fact, the shareholders reported either "passthrough income" or dividend income from the distribution of the notes. Thus, there was economic substance in Wilson.

Had the Wilson shareholders purchased the Loss note from Profitable for cash, would the economic outlay test have been satisfied, resulting in basis in Loss of flowthrough purposes? The authors think so. However, as explained, the shareholders in fact did give up economic value (reduction in value of Profitable stock), and incurred a tax cost, for the Loss note; but this was insufficient, according to the Tax Court, to meet the economic outlay test. This inconsistency heightens the difficulty practitioners have with the economic outlay doctrine; until it is clarified, taxpayers should be wary of this area of the law.
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Author:Rowan, R. Edward
Publication:The Tax Adviser
Date:Sep 1, 1992
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