While not a procedure case, for those wanting a primer in an important nook when it comes to the tax treatment of shareholder positions in S Corporations, I recommend a reading of this week’s Tax Court opinion in Phillips v Commissioner.
Phillips addresses the limits on shareholders’ ability to generate basis when the shareholders guarantee a corporate debt rather than make a bona fide loan themselves to the corporation. The facts in Phillips involve shareholders in S Corps that were in the business of developing and selling real estate in Florida, a business that was hit hard by the great recession. Husband and wife Robert and Sandra Phillips personally guaranteed loans of the S corporations. When the economy turned south, the banks sued the Phillips (and other guarantors) on the guarantees, resulting in millions of dollars in judgments, which the Phillips were unable to pay.
How did this trigger a tax dispute? The Phillips increased their basis by a pro rata amount of the creditor judgments. A shareholder’s basis in an S Corp is important as items of loss are passed through reducing basis. A shareholder in S Corps may only claim the benefit of the loss or deduction to the extent of the shareholder’s basis (and basis in bona fide debt the corporation owes him) under Section 1366(d). The judgments were in the many millions of dollars; so were the losses that the S Corp was racking up. So, with the basis creation, the Phillips claimed losses they otherwise would not have been able to use immediately, generating NOLs that they used to carryback to years when everyone in Florida real estate was living high on the hog.
The problem is that there is a long line of cases holding that a shareholder’s loan guarantee for loans that the S Corp itself incurs is insufficient to generate basis needed to soak up the losses. Those cases provide that absent an economic outlay, (i.e, the shareholder paying on the guarantee), there is no basis impact from the guarantee itself.
This is a useful contrast with subchapter K, where partnership liabilities are generally allocated to partners. In contrast, the liabilities of the S Corp only generate a basis kick up when in fact the shareholder makes the loan to the corporation or actually pony up the dollars as a result of the creditor seeking payment on the guarantee. It does not matter that the S Corp shareholders could have structured the financing differently (e.g., borrowed the money and then loaned the $$$ to the corp).
The taxpayers in this case made the creative argument that while they accepted that a guarantee itself is generally insufficient to generate basis, there was enough adverse economic impact on them to justify a basis boost. To that end, the taxpayers emphasized that the creditors sued them individually, obtaining a judgment resulting in liens against their property.
Phillips notes that the taxpayers attempted to make lemonade out of lemons, but restates the maxim that taxpayers are generally stuck with the consequences of the form they choose. In Selfe v US the 11th Circuit found a limited exception for the “no basis from a guarantee rule” if the shareholders can establish that the lender in substance viewed the shareholder as the primary obligor. No doubt the presence of the liens and the judgment has some economic impact, but under 11th Circuit (and other) precedent it was not enough to move the needle:
Petitioners urge that the deficiency judgments against Mrs. Phillips gave rise to an “actual economic outlay” by (among other things) impairing her credit. This argument misapprehends the theory that formed the basis for the Eleventh Circuit’s remand in Selfe. The theory was that the bank, while nominally lending to the S corporation, may in substance have lent to the shareholder, who then contributed the loan proceeds to the corporation. In order to identify the “true obligor” in such circumstances, it is necessary to examine the lender’s intentions and other economic facts existing when the lender makes the loan. A court’s entry of a deficiency judgment against a guarantor many years later, after the corporation has defaulted and the corporation’s collateral has proven insufficient, is simply not relevant in determining whether the lender, when initially extending credit, looked to the shareholder as the primary source of repayment.
At the end of the day, this is a pretty tough outcome for the taxpayers. The rationale for the difference in treatment for S Corp shareholders and partners is due in part on the theory that the S Corp shareholders are generally not personally liable on the corporate debts. The guarantee is a bit too remote; when the creditor comes knocking and in fact obtains a judgment (as here) that liability is no longer remote.
Philips is a good reminder that form matters, especially when using S Corps (a lesson we also explored in Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure) and shareholders seeking to ensure basis to offset losses should structure the transaction in the form of a direct loan to the shareholder, followed by a shareholder loan or contribution to capital.