The rule that limits the losses of an S corporation that may be taken into account by a shareholder to the sum of (i) the adjusted basis of the shareholder in stock of the corporation and (ii) the shareholder’s adjusted basis in any indebtedness of the corporation to the shareholder is significantly more stringent than the equivalent rule for partnerships and has long been a troublesome trap for S corporations and their shareholders.1 Debt obligations of the corporation to persons who are not shareholders do not increase the loss limitation, even if the debt arose from a borrowing from another entity owned by shareholders of the S corporation or is guaranteed by those shareholders. Thus, the allowability of pass-through losses to a shareholder of an S corporation will in many instances turn on whether the activities of the corporation were funded through (x) capital contributions or loans from the shareholder or (y) loans to the corporation from anyone else.
As a case on point, the Tax Court held two years ago, in Broz v. Commissioner,2 that amounts borrowed by an S corporation that were attributable to a bank loan made to another corporation under common control could not be taken into account by the S corporation shareholder in determining his basis for these purposes, even though book entries had been made and loan documents executed, after the funds were advanced, to categorize the loans as having been made from the affiliated corporation to the common shareholder and by that shareholder to the corporation incurring the losses. The Tax Court also disallowed numerous deductions by reason of a failure to establish the existence of a relevant “active trade or business.” The recent affirmance of Broz by the Court of Appeals for the Sixth Circuit is discussed below.
