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Lessons from the Tax Court: Don’t guarantee S corp loans

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in Small Business Tax

Does your S corporation need an influx of cash to keep operating on all cylinders? If that’s the case, you have several potential options at your disposal. For instance, you might make a capital contribution to the S corp or arrange a loan. If you go the loan route, you could borrow the money personally and lend it to the corporation or simply guarantee corporate loans.

Be aware:
There’s no income tax benefit for guaranteeing a loan. Taxpayers numerous times have raised this issue in the courts—to no avail.

Latest example:
The owners of an S corp tried to deduct losses resulting from a series of notes that they personally guaranteed. But the Tax Court said the guarantee did not, by itself, increase the owners’ tax bases in the S corp shares. The losses sustained by the owners are deductible only up to the amount of their investment in the firm plus any additional capital contributions plus any loans from shareholders to the corporation. The guarantee does not count until if and when the owners are forced to ante up to pay off the loans.

Furthermore, the Tax Court ruled that advances from another company controlled by the S corp owners will not qualify as shareholder loans unless there is specific documentation that supports such treatment. (Russell, TC Memo 2008-246)

On the other hand, if you borrow funds from a bank and then contribute the proceeds to an S corp, you will increase your basis in the shares you own.

Tip: Alternatively, you could borrow funds personally and then lend the company the money with a written loan document. The Tax Court has said that those “back-to-back” loans increase an owner’s basis for tax purposes. (Miller, TC Memo 2006-125)

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