S corporation shareholder denied basis increase for guarantee
Court judgments enforcing guarantees insufficient to create basis
INSIGHT ARTICLE |
On April 10, 2017, the tax court ruled in Phillips v. Commissioner, TC Memo 2017-61, that a shareholder’s guarantee of S corporation debt did not create tax basis for the shareholder, even when a lender successfully sued the shareholder to enforce the guarantee. Instead, the court held that the shareholder would only get basis when she made actual payment pursuant to those guarantees.
There’s a long history of IRS-taxpayer disagreement regarding when an S corporation shareholder can generate tax basis associated with company debt. Much of the controversy was resolved in 2014 with the release of Treasury guidance that indicated that S corporation shareholders only get basis for bona fide debt running directly between the shareholder and the S corporation. The regulations also clarified that shareholders do not get basis for merely guaranteeing a loan or by acting as a surety, accommodation party, or in a similar capacity. The regulations do not, however, clearly articulate how these rules might apply when a shareholder becomes responsible for the debt – for example, following a court judgment.
Olsen & Associates of NW Florida, Inc. was a Florida S corporation that developed and sold residential and commercial real estate. Like many real estate developers, it relied heavily on bank financing, which was guaranteed in most cases by the company’s shareholders. Following a downturn in the company’s business starting in 2007, the company defaulted on many of its loans, at which point its lenders sued the shareholder at issue in the case (among others) seeking enforcement of her guarantees. Those actions resulted in final judgments against the shareholder and other guarantors aggregating over $100 million.
Following those judgments, the shareholder took the position that she was entitled to increase her basis by her pro rata share of those judgments, presumably based on the notion that she was now primarily responsible for repayment of the debt. She subsequently filed amended returns in order to claim previously suspended losses against that basis.
The tax court disagreed with the taxpayer and concluded that there had to be an actual economic outlay – i.e. payment – for the shareholder to get basis. The judgment itself was not sufficient. The court went on to distinguish the case from an appellate court case from that same district, Selfe v. U.S., 778 F. 2d 769 (11th Cir. 1985), where the court had concluded that in circumstances where the evidence suggested that the lender looked primarily to the shareholder for repayment, it might be possible for the shareholder to get basis in the loan. The tax court outlined several differences between the facts in Olsen compared with those in Selfe – most notably that in Selfe the lender testified that it looked primarily to the shareholder for repayment. Instead, the court in Olsen concluded that without payment there could be no basis adjustment.
It is interesting that the tax court felt the need to distinguish the facts from those in Selfe, which has been criticized by other courts and is generally seen as having little precedential value. By doing so, the decision likely further erodes the ability of taxpayers to rely on a “substance over form” argument when suggesting that a shareholder should be entitled to tax basis for corporate debt. S corporation shareholders looking to generate loan basis would be well served to tailor their arrangements as closely as possible to the form outlined in the regulations in order to limit exposure.