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
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 https://www.suntrust.com/loans 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.