Guidance on adding debt to a shareholder's tax basis

Subchapter S basis rules reflect contributions to and distributions from an S Corporation, including adjustments reflecting a shareholder's portion of debt, similar to partnerships. But if debt is to be added to basis, it must be genuine and reflect economic reality. Thus, committing to repay debt is not enough to allow the debt amount to be added to basis. Rather, there needs to be a real economic outlay or some other indicia that the debt actually accrues to the shareholder, as set forth in regulations from 2014 (T.D. 9682, 2014-33 I.R.B 342; sec. 1.1366-2(a), Income Tax Regs.). Courts have often upheld adding debt amounts to basis when the shareholder borrowed the sums first, then contributed them to the business, but primarily when the lender looked to the shareholder as the primary obligor. Now, the shareholder must take actual steps such as a payment to honor the obligations.

A recent Tax Court memo, T.C. Memo 2017-61, Rupert E. Phillips and Sandra K. Phillips v. C.I.R., addresses this issue in an interesting way, reiterating that mere promises alone, even based on court judgments with respect to these amounts due, aren't enough to constitute economic reality. Essentially, the U.S. Tax Court decided that agreeing to assume liability for debt only adds to basis when the taxpayer takes steps to follow up on that liability, even when that amount was borrowed and contributed to the S Corp. Recourse, without substantive action to pay money back or attach personal assets as guarantees, isn't a reflection of an investment into an S Corporation. Unpaid debt doesn't add to S Corporation basis.

The memo addresses the "foreclosure tsunami" that hit numerous real estate markets and investors, noting how the cleanup still continues today. Sandra and Rupert Phillips, a married couple, are discussed in this memo opinion. The couple were engaged in developing and selling real estate in a section of Florida that was very hard hit during the downturn of 2008 and thereafter. Mrs. Phillips owned 50 percent of the S corporation that did the development, and she and her husband personally guaranteed related bank loans.

When the market headed south, their projects cratered as well, leading to foreclosures. The lenders sued Mrs. Phillips and her partners, wanting to collect on their guarantees. While these guarantees attached to the properties now underwater, they did not attach to other assets of the guaranteeing parties. Judgments were granted, but the original guarantees still did not extend beyond the actual properties themselves. Not surprisingly, no payments were made by the shareholders on those amounts due.

However, Mrs. Phillips did declare a bump-up in partnership basis with respect to her guarantees. She asserted that the judgments against her personally meant that she was liable for these amounts still due. This increase in basis was used to take NOL losses related to past tax years and flow through loss deductions. The IRS took issue with these steps, and reassessed taxes from past years, including by disallowing the step-up in basis.

The main issue in the case was whether the petitioners were "entitled to basis credit for unpaid judgments entered against Mrs. Philips on account of personal guarantees she had furnished on loans on which the S corporation or its wholly owned subsidiaries defaulted."

An S Corporation is a pass-through entity, meaning that only one level of tax applies. Shareholders are taxed currently on income, regardless of whether distributions are made. Cash distributions decrease basis while contributions increase basis. Basis is the ceiling on the amount of losses that can be passed through to an individual. While cash is easy to define, liabilities are more opaque. Also discussed in this opinion memo is the differing treatment between corporations and pass through entities.

The tax code does not explicitly define how a shareholder can acquire basis in an S Corporation's debt, thus case law often sets definitions. Debt is generally expected to be genuine and reflect economic reality. Most courts require an "actual economic outlay by the taxpayer" (Hitchins v. Commissioner, 103 T.C. 711, 715 (1994)) before basis can be bumped up. The taxpayer must be poorer in a real sense.

The courts have also consistently held that a guarantee isn't enough to increase basis. The 4th U.S. Court of Appeals identified the concept clearly: "A guarantee, in and of itself, cannot fulfill ... (the economic outlay) requirement." Numerous forms of guarantees have thus been disallowed as economic outlay allowing for a bump-up in basis.

The court, when discussing Mrs. Phillips' situation, stated that the argument rested on a substance versus form argument. Basically, Mrs. Phillips borrowed money from an outside bank and loaned it back to the business. While the argument held that the judgments constituted a real commitment to pay back the funds, no such payments were made. The taxpayer relied on case law which held, and is commonly believed, that the way to make such guarantees work is for the taxpayer to borrow the funds and then loan them back to the S corporation or partnership, thus creating a real obligation with respect to the loan. The court decided otherwise here because Mrs. Phillips, while following commonly accepted steps, did not actually begin to honor her guarantees by paying back any of the money owed.

The court stated that a guarantee without subsequent payment will not create basis. Mrs. Phillips did not extend her guarantee to other of her property nor did she take concrete action which cost her actual money. Likewise, the other guarantors also did not pledge outside collateral to support their guarantees. Rather, the collateral was supplied by the S corporation and solely in the form of the property itself. The court decided that no evidence supported that the lenders looked to Mrs. Phillips as the primary source for repayment of the loans, despite a court order holding her liable.

No evidence proved that the loans carried over to Mrs. Phillips from the S Corporation. The tax memo confirmed that a loan to a shareholder, to be transferred to the entity, isn't enough for economic substance. Rather the court will look further to determine the true obligor, encompassing the lender's intent and other economic factors that existed at the time of the loan.

The court also questioned the fair market estimates of collateral transferred to the judgment creditors. The owners of the lots were co-guarantors, with joint and several liability. Therefore, the creditors could pursue the other investors, not just Mrs. Phillips. Arguably, the judgments could be allocated pro-rata among all guarantors. Should another shareholder make any of these payments they would get a step-up in basis, thus perhaps double-dipping with respect to the same amounts Mrs. Phillips claimed. Such a result clearly doesn't work from an IRS perspective. Again, the court noted that a payment toward the obligations would show actual economic input. Unclear from the ruling is whether having a client make some payments toward any judgment balances due will suffice to demonstrate economic reality.

The court did hold that the taxpayer was not subject to penalties as the government had not proven their case in this respect. An aggressive but subsequently disallowed tax stance did not end up accruing additional liabilities.

Thus, this opinion memorandum provides further clarity on when debt can be added to a (S Corporation) shareholder's tax basis in a flow through entity. It also makes it harder for a taxpayer to do so.