Academic journal article Journal of Accountancy

Deducting S Corporation Losses

Academic journal article Journal of Accountancy

Deducting S Corporation Losses

Article excerpt

When an S corporation incurs losses, its shareholders can directly deduct their share of them in accordance with the flowthrough rules of subchapter S. A shareholder's aggregated amount of losses and deductions for any taxable year can't exceed the sum of his or her adjusted basis of stock in the S corporation and any indebtedness of the corporation to the shareholder (IRC section 1366(d)). Unless they make an actual "economic outlay" under the arrangement, taxpayers generally may not increase their basis in S corporation stock as a result of a loan guarantee, pledge of stock as collateral or loss of control of the corporation.

In William H. Maloof, TC Memo 2005-75, the court considered whether an S corporation shareholder's personal guarantee, pledge of stock or loss of control resulted in an economic outlay entitling him to increase his basis.

Maloof was the sole shareholder of Level Propane, Petroleum & Gases Co., which provided propane gas and services to customers in 14 states. The company generated approximately $18 million in annual revenues and had about 600 employees. To sustain its growth it borrowed $4 million from Provident Bank in July 1993. The money had three principal components: $750,000 secured by equipment; a $2.5 million revolving-term loan secured by tanks and supply contracts; and a $750,000 demand loan secured by inventory and accounts receivable. As additional collateral, Maloof pledged all his shares of Level Propane and a $1 million life insurance policy.

From 1990 through 2000 Level Propane had substantial losses. Maloof increased his basis in the company by the amount of the $4 million loan to claim Level Propane's net operating losses as pass-through deductions. The company was forced into involuntary bankruptcy when it defaulted on the loan. At no time, however, did the bank demand payment or begin collection action against Maloof.

The IRS determined that Maloof had insufficient basis against which to deduct S corporation losses and, therefore, assessed the deficiencies in tax for the years 1990 through 2000.

Maloof claimed he was entitled to increase his basis in the stock of Level Propane by $4 million because he personally had guaranteed the loan, pledged stock to secure it and incurred a cost when he lost "control" of Level Propane. …

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