Personal loan guarantee not basis.

Losses from an S corporation flow through to its shareholders, who

can deduct them on their individual tax returns as long as they have

sufficient basis to absorb them. Economic outlays such as capital

contributions and loans by a shareholder to an S corporation will

increase a shareholder’s basis. Generally, loan guarantees, pledges

of collateral and other forms of indirect borrowing are not considered

economic outlays. The Eleventh Circuit Court of Appeals created an

exception in Selfe v. U.S., 778 F.2d 769, in which a taxpayer borrowed

money and later loaned that money to her newly formed S corporation. The

corporation then assumed her liability for the loan, but the bank

required the taxpayer to personally guarantee its repayment. The court

permitted a basis increase because of the loan guarantee, since the

substance of the transaction showed she was the primary obligator on the


Last year, the Sixth Circuit refused to apply the Selfe exception

to a case in which the taxpayer cosigned on the loan but the bank never

sought payment from him.

William Maloof was the sole shareholder of Level Propane, Petroleum

& Gases Co., which borrowed $4 million from a bank. Maloof

personally guaranteed the loans by pledging all of his stock in it and

other S corporations and a $1 million insurance policy on his fife.

Level Propane defaulted on the loan and was forced into bankruptcy, but

the bank did not demand payment. From 1990 to 2000, Level Propane

sustained large losses. Maloof increased his basis by $4 million because

of the loan guarantee and then deducted the losses on his individual

return. The IRS took the position that no increase in basis was

warranted, disallowed the losses and assessed a tax deficiency against

him. Maloof petitioned the Tax Court.

Maloof argued that his personal guarantee of the loan and the

pledging of his stock and insurance policy constituted economic outlays

that increased his basis. The Tax Court rejected this argument, stating

the bank never sought his personal assets for repayment of the loan. The

taxpayer also argued he had an economic outlay because he incurred a

“cost” when he lost control of the corporation. No evidence

was presented supporting any loss of control, nor was any evidence

offered that measured a cost related to that loss. Finally, the taxpayer

argued that, in substance, he had borrowed the money and in turn

transferred it to the corporation and that the holding in Selfe should

be followed. The court ruled the Selfe holding did not apply because

Maloof never personally borrowed any money and the bank never sought any

payments from him (see “Tax Matters,” JofA, Mar.06, pages

78-79). Maloof appealed to the Sixth Circuit.

Result. For the IRS. The appeals court said Maloof’s basis

could be increased if the corporation was indebted to him or if he had

incurred a cost evidenced by an economic outlay. The loan agreement

clearly showed the corporation as the borrower, and the corporation

would be indebted to him only if he used personal assets to pay the

corporate loan. Even though the taxpayer cosigned the loan, the bank

never sought his assets for repayment. Based on this, the court

concluded Maloof never incurred any type of economic outlay

This decision marks another defeat for taxpayers attempting to

increase their S corporation’s stock basis with a loan guarantee.

It should also be noted that if the taxpayer had shown that the loan was

his, the interest payments made by the corporation to the bank on his

behalf would be constructive dividends. He still would have had some

additional tax liability.

* William H. Maloof v. Commissioner, 456 F.3d 645.

Prepared by Charles J. Reichert, CPA, professor of accounting,

University of Wisconsin, Superior.


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