Despite Entry of Judgment to Enforce Guaranty, Taxpayer Denied Basis in S Corporation Debt

The Courts generally look to an “actual economic outlay” that makes the taxpayer poorer in some objective fashion to allow the taxpayer to claim basis in debt for an S corporation.  In the case of Phillips v. Commissioner, T.C. Memo 2017-61, the taxpayer argued that the fact that judgments had been entered against her should give her the right to treat a portion of the debt as basis for claiming losses.

The taxpayer owned 50% of an S corporation that fell on hard times during the real estate crisis, defaulting on several loans which had been guaranteed by Sandra.  The banks sued to collect on the guarantees and obtain judgments against Sandra.  However, Sandra had not actually made any payments on the debts.

Sandra argued that she should be allowed to claim her portion of the debt as basis for claiming losses on her return.  She agreed that a guarantee, without more, does not provide for basis in S corporation stock, but that these judgments should meet the requirements for something more.

The case would be appealable to the 11th Circuit, a Circuit that had previously found that “something more” short of actual payment on the guarantee that would create basis.  Sandra argued that her case offered similar facts as that case, Selfe v. United States, 778 F.2d 769, 772 (11th Cir. 1985).

The Tax Court described the facts in Selfe as follows:

In Selfe, the taxpayer started a retail clothing business as a sole proprietorship and secured bank financing. She pledged assets owned by her and her family as collateral for the loans. The business was later incorporated and elected S corporation status, whereupon the corporation (at the bank’s request) was substituted as the obligor on the loans. However, the taxpayer’s personal assets remained pledged as collateral and, as the company’s sole shareholder, she personally guaranteed the loans. Selfe, 778 F.2d at 770-771.

While the taxpayer in Selfe never actually made a payment on the guarantees, the 11th Circuit allowed her to treat the debt as basis for claiming losses.  The 11th Circuit found:

Rather, it concluded that a basis increase may be justified “where the facts demonstrate that, in substance, the shareholder has borrowed funds and subsequently advanced them to her corporation.” Id. at 772-773. Establishment of this factual predicate would require proof that “the lender looks to the shareholder as the primary obligor.” Id. at 774.

In this particular case, the Court found such facts could exist in this case.  The Court noted:

These included the facts that: (1) the bank originally extended credit to the taxpayer individually, with the corporation substituted later as the obligor; (2) the taxpayer pledged her own assets as collateral for the loan, and her assets remained pledged after the loan was reissued in the company’s name; (3) the S corporation was “a fledgling enterprise,” was “operated by a novice in a highly competitive field,” and was “thinly capitalized,” thus making it a poor credit risk; and (4) the taxpayer “presented the deposition testimony of her loan officer stating that the bank primarily looked to the taxpayer and not the corporation for repayment of the loan.” Selfe, 778 F.2d at 774.

While the appeals panel did not absolutely conclude this meant the bank looked to the shareholder for repayment, the panel believed that it was a reasonable question of fact that needed to be resolved and sent it back to the trial court.

But the 11th Circuit has noted subsequently that the Selfe case was unique and the Tax Court concluded that this case was materially different and that there were not the factors present in Selfe that enabled the use of the debt as basis.

The Tax Court noted:

The facts in the instant case differ from those in Selfe on each of the important points identified by the Court of Appeals. There is no evidence that Olson’s lenders had a prior relationship with petitioners or that petitioners previously had been obligors on these loans. Petitioners did not pledge any of their personal assets as collateral for the loans; all the collateral (consisting primarily of real estate) was supplied by the SPEs or their subsidiaries. Olson was a well-established company with a good reputation, and petitioners conceded that the loans when made were “clearly supported by the collateral that was pledged.” Most importantly perhaps, petitioners produced no testimony or other evidence from any of the lending banks that any bank “look[ed] to the shareholder as the primary obligor” on any loan. Id. at 774. It is hard to see how a taxpayer could establish a bank’s intentions or expectations on this point without producing testimony from someone at the bank.

The Tax Court also did not agree that the judgment indicated that the bank was looking to her for repayment when the loan was made.  The Court held, rather:

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.