A recent Tax Court case serves as a reminder of one of the important differences between partnerships and S corporations. The income tax basis of the interest of a partner in a partnership is not only a function of the amount that the partner contributes to the partnership as a capital contribution, but also includes the partner’s share of any of the indebtedness of the partnership. In the case of an S corporation, a shareholder obtains tax basis in his shares for the amounts he contributes to the corporation, but does not obtain tax basis in his shares from corporate-level indebtedness. The tax basis of a shareholder’s or partner’s interest in his shares or partnership interest is important for a number of reasons, not the least of which is that the amount of tax losses passed through from the entity that he is allowed to deduct is limited to the amount of his tax basis. In the case of an S corporation, a shareholder may deduct losses passed through from the corporation to the extent of the tax basis in his shares and the tax basis in any loans that he has made to the corporation.
Shareholders have attempted to augment their tax basis by guaranteeing loans made to the corporation by banks of other creditors and then arguing that the guarantee effectively means that the shareholder has loaned money to the corporation. The courts have generally not allowed a shareholder to increase his tax basis through a guarantee of corporate-level indebtedness because the lender is still looking primarily to the corporation to repay its loan.
In the recent Tax Court case of Tinsley (TC Summary Opinion 2017-9), Mr. Tinsley attempted to increase his basis in the shares of an S corporation first by guaranteeing a bank loan made to the corporation and then claiming, when the corporation was dissolved, that he had assumed the loan in his capacity as the guarantor. He argued that this amounted to a capital contribution to the corporation for which he should have tax basis.
Command Computers was an S corporation owned by Tinsley that sustained a tax loss in 2010 before liquidating in August of that year. Upon the liquidation, the loan was renewed by the bank but was done so in the name of Command Computers, even though the corporation had been liquidated. The Tax Court did not accept Mr. Tinsley’s argument that he had effectively assumed the loan upon the liquidation of Command Computers, finding that the loan remained in the name of Command Computers as the borrower and that the bank was looking primarily to the assets of Command Computers rather than to Mr. Tinsley for repayment of the loan.
The best way for a shareholder to increase his tax basis by using borrowed funds is for the shareholder to borrow from the bank and then either reloan the funds to the corporation or use the borrowed funds to make a capital contribution to the corporation. Taxpayers have not been successful with guarantees of loans made to corporations.