Q: We have an S corporation in Massachusetts. We lost money the first
couple of years. After claiming profits for three or four years, we lost money in 1999 and 2000. I understand how "basis" works for tax purposes, and our basis has been used up.
Some credit lines were opened in the name of the business, and in the name of the shareholder who personally signed for them. The name of the shareholder and the business name appear on each monthly
statement from the issuer. If the business closed tomorrow, the
shareholder who signed would be personally responsible for the money outstanding.
The question is: Can the outstanding debt be used as basis for tax purposes, regarding Schedule K-1 losses? Example: $0 tax-reporting basis left, but $10,000 in debt outstanding, plus a loss of $5,000 (for the shareholder in question) for any given tax year. Can the full $5,000 be deducted as S-corp losses because of the shareholder's personal responsibility for the outstanding debt?
A: Generally, a shareholder's guarantee of an S corp's debt will not give the shareholder "basis," which is defined as contributions in the form of cash, property, or loans to the corporation -- an amount that becomes the basis against which the shareholder can deduct losses. The IRS will view this as the corporation's debt, with no economic outlay on the part of the shareholder. The courts have consistently denied a basis increase for the shareholder on debt that is personally guaranteed or co-signed on behalf of the corporation.
However, when a shareholder-guarantor pays the S corp's debt in
satisfaction of his obligation as a guarantor, he steps into the creditor's shoes and the S corp becomes obligated to the shareholder. In this case, there will be a debt from the S corporation to the shareholder when the shareholder makes a payment of the corporation's debt to the lender under his guarantee. The shareholder will have basis (from which to deduct losses) starting in the first year payment is made under his guaranty. If the payment on the corporation's debt does not happen until the year the corporation terminates, then the shareholder will have basis at that time.
Cindy Hockenberry, enrolled agent
National Association of Tax Practitioners
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