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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.

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