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Individual Denied S Corporation Basis Increase for Unpaid Judgments on Real Estate Foreclosures

(Parker Tax Publishing April 2017)

The Tax Court held that an S corporation shareholder could not increase her basis by the amount of judgments against her resulting from her guarantees on foreclosed real estate owned by the S corporation because she made no payments on the judgments. Her claims for passthrough loss deductions and net operating loss carrybacks resulting from the purported basis increases were denied, but she was not liable for an accuracy-related penalty. Phillips vs. Comm'r, T.C. Memo. 2017-61.

Sandra Phillips was a 50 percent owner of Olson & Associates (Olson), a Florida S corporation engaged in developing and selling real estate. Olson relied heavily on debt to finance its projects. Most of its $191 million in debt was secured by mortgages on its real estate properties. Almost all of the loans were guaranteed by Olson's two shareholders, including Mrs. Phillips, and/or their spouses.

In 2007, the nationwide downturn in the real estate market caused a decline in Olson's sales, revenue, and cash flow. Olson defaulted on almost every loan owed by it or its subsidiaries. Olson's lenders foreclosed on the properties pledged as collateral and, because of the decline in values, enforced the shareholders' guarantees to satisfy the deficiencies. The lenders obtained judgments in 2008 and 2009 of approximately $105 million against Phillips and her coguarantors, who were jointly and severally liable. Phillips made no payments toward any of the judgments, nor did she make any payments directly to the lenders under the guaranties.

In 2010, after receiving a formal tax counsel's opinion, Phillips took the position that she was entitled to increase the basis in her Olson stock as a result of the judgments entered against her. She claimed an additional capital contribution of approximately $1.5 million for 2008 and approximately $30 million for 2009. As a result of these purported basis increases, Phillips claimed net operating losses for 2008 through 2010 and carryback losses to her 2004 and 2005 tax liabilities.

The IRS audited Phillips and determined that she was not entitled to any basis increase resulting from her loan guarantees or the unpaid judgments against her. The IRS sent Phillips a notice of deficiency for the disallowed deductions plus a 20 percent accuracy-related penalty.

Before the Tax Court, Phillips argued alternately for an increase in her stock basis and in the debt of the S corporation, and said that her guaranties and the judgments against her constituted an economic outlay as required for basis increases in S corporation debt. Relying on the decision in Selfe vs. U.S., 778 F.2d 769 (11th Cir. 1985), Phillips argued that, even though no payments had been made, the judgments themselves demonstrated an actual economic outlay because the lenders looked to Phillips as a source of repayment. Phillips also argued that the deficiency judgments against her gave rise to an actual economic outlay because they impaired her credit.

Selfe involved a taxpayer who started a business and secured financing as a sole proprietor, pledging assets as collateral for the loans. The business was later incorporated and elected S corporation status. At that point, the corporation was substituted, at the bank's request, as the obligor on the loans, but the taxpayer's personal assets remained pledged as collateral. As sole shareholder, the taxpayer also personally guaranteed the loans. She never made any payment on her guaranty but claimed that the guaranty gave her additional basis. The Eleventh Circuit concluded that a basis increase may be justified where the facts show the shareholder has borrowed funds and then advanced them to the corporation.

The Tax Court rejected Phillips' arguments and held that she was not entitled to any basis increase. Phillips was not, however, liable for the accuracy-related penalty that the IRS had assessed against her.

With respect to her reliance on the decision in Selfe, the court noted that none of the factors that were present in Selfe applied. Unlike in Selfe, there was no evidence that Olson's lenders had a prior relationship with Phillips or that she had ever been an obligor on any loans. Phillips did not pledge any personal assets as collateral. The S corporation in Selfe, the court noted, was a fledgling enterprise and poorly capitalized, making it a poor credit risk, whereas Olson was a well-established company with a good reputation; further, Phillips admitted that when the loans were made, they were clearly supported by the pledged collateral. Most importantly, the Tax Court said, Phillips produced no evidence, by testimony or otherwise, that any lender looked to her as the primary obligor on any loan.

The court also rejected Phillips' credit impairment argument, saying a deficiency judgment entered against a guarantor many years after a default was irrelevant in deciding whether the lender looked to Phillips as the primary source of repayment when it made the loan.

The Tax Court also addressed the method Phillips used to calculate her purported basis increase. The court determined that, even if Phillips had shown she was entitled to a basis increase, the pro rata allocation reflecting her 50 percent ownership in Olson was incorrect. The co-guarantors were jointly and severally liable for the judgments and Phillips, the court said, gave no reason to believe that the judgment creditors would pursue all co-guarantors equally rather than targeting the deepest pocket. The speculative nature of the computation in the absence of an actual payment on the judgments, the court noted, provided further support for the rule that no basis increase is permitted without an actual economic outlay.

The Tax Court did note, however, that Phillips could have shown an economic outlay if she had made a payment toward the judgments. Such a payment would create a debt from Olson to her and give rise to additional basis in the amount of the payment.

Finally, the Tax Court found that the IRS should not have imposed the Code Sec. 6662 accuracy-related penalty on Phillips. The penalty applies to the portion of an underpayment attributable to negligence or any substantial understatement of income tax. The term "negligence," the court said, is defined as any failure to make a reasonable attempt to comply with the Code, and the term "substantial" is defined as an underpayment exceeding the greater of $5,000 or 10 percent of the tax required to be shown on the return. The IRS conceded most of the penalties, which were attributable to the passthrough losses for which Phillips had obtained an opinion from competent tax counsel. The Tax Court determined that the remaining underpayment was not due to negligence and did not exceed the $5,000/10 percent threshold.

For a discussion of the calculation of S corporation basis, see Parker Tax ¶32,840.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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