90 T.C. 206 (1988), 32041-84, Estate of Leavitt v. C.I.R.

Docket Nº:32041-84, 36453-84, 36454-84, 36455-84
Citation:90 T.C. 206
Opinion Judge:NIMS, JUDGE:
Party Name:ESTATE OF DANIEL LEAVITT, DECEASED, CHARLES D. FOX, III, EXECUTOR,, ESTATE OF EVELYN M. LEAVITT, DECEASED, CHARLES D. FOX, III, EXECUTOR, ET AL., [1] Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Dianne E. H. Wilcox, for the petitioners. Stephen M. Friedberg, for the respondent.
Judge Panel:FOOTNOTES TO DISSENT OF JUDGE FAY
Case Date:February 10, 1988
Court:United States Tax Court
 
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Page 206

90 T.C. 206 (1988)

ESTATE OF DANIEL LEAVITT, DECEASED, CHARLES D. FOX, III, EXECUTOR,, ESTATE OF EVELYN M. LEAVITT, DECEASED, CHARLES D. FOX, III, EXECUTOR, ET AL., [1] Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Nos. 32041-84, 36453-84, 36454-84, 36455-84

United States Tax Court

February 10, 1988

Ps were shareholders in V, an electing small business corporation under subchapter S of the Internal Revenue Code. Ps guaranteed a loan issued by a bank to V. At the time the loan was made, V's liabilities exceeded its assets, and V was unable to meet its cash flow requirements. The loan was issued by the bank only because of Ps' financial strength. However, all payments of principal and interest on the loan were made by V.

Held, absent an economic outlay by Ps, Ps' guarantees of the loan do not increase their basis in their stock in V. Brown v. Commissioner, 706 F.2d 755 (6th Cir. 1983), affg. T.C. Memo. 1981-608, and Calcutt v. Commissioner, 84 T.C. 716 (1985), followed. Selfe v. United States, 778 F.2d 769 (11th Cir. 1985), explained. In re Lane, 742 F.2d 1311 (11th Cir. 1984), distinguished.

Page 207

Dianne E. H. Wilcox, for the petitioners.

Stephen M. Friedberg, for the respondent.

OPINION

NIMS, JUDGE:

Respondent determined deficiencies in petitioners' Federal income tax as follows:

Docket No. Tax year ended- Deficiency
32041-84 Dec. 31, 1979 $4,767.77
Dec. 31, 1980 1,577.06
36453-84 Dec. 31, 1979 3,031.29
Dec. 31, 1980 16,472.46
Dec. 31, 1981 13,919.88
36454-84 June 30, 1980 901.00
June 30, 1981 1,041.00
June 30, 1982 1,252.00
36455-84 Dec. 31, 1979 1,320.98
Dec. 31, 1980 1,495.88
Dec. 31, 1981 2,298.86
These cases were consolidated for trial, briefing and opinion pursuant to Rule 141(a). [2] After concessions and stipulations,[3] the only issue for decision is whether a shareholder's guarantee of the debt of an electing small Page 208 business corporation under subchapter S of the Internal Revenue Code increases the shareholder's basis in his stock in the corporation. All the facts have been stipulated. The stipulations of fact and attached exhibits are incorporated herein by this reference. At the time the petitions in these cases were filed, Charles D. Fox, III, Anthony D. Cuzzocrea and Marjorie F. Cuzzocrea resided in Roanoke, Virginia. [4] Daniel and Evelyn Leavitt, whose estates are petitioners in docket No. 32041-84, filed a joint Federal income tax return for the taxable year 1979. [5] Anthony D. Cuzzocrea and Marjorie F. Cuzzocrea filed joint Federal income tax returns for the taxable years 1979, 1980 and 1981. VAFLA Corporation (hereinafter referred to as the corporation), was an electing small business corporation under subchapter S during the years in issue and was incorporated in February, 1979, to acquire and operate the Six-Gun Territory Amusement Park near Tampa, Florida. The initial issue of the corporation's capital stock took place in March, 1979, and consisted of 100,000 shares. Daniel Leavitt and Anthony D. Cuzzocrea each paid $10,000 cash for their shares on or before September 30, 1979. The first taxable year of the corporation consisted of seven months and ended on September 30, 1979. As of September 30, 1979, the corporation had suffered a net operating loss of $265,566.47 and had a retained earnings deficit of $345,370.20. During its second taxable year ending September 30, 1980, the corporation suffered a net operating loss of $482,181.22 and had a retained earnings deficit of $1,093,383.56. During its third taxable year ending September 30, 1981, the corporation suffered a net operating loss of $475,175.70 and had a retained earnings deficit of $1,908,680.22. From August 2, 1979, through August 27, 1979, Anthony D. Cuzzocrea and Daniel Leavitt, as well as other shareholders, Page 209 signed guarantee agreements whereby each agreed to be jointly and severally liable for all indebtedness of the corporation to the Bank of Virginia. All the guarantees to the Bank of Virginia were unlimited except the guarantee of Anthony D. Cuzzocrea which was limited to $300,000. The corporation borrowed $300,000 from the Bank of Virginia for which it issued a promissory note to the bank dated September 12, 1979. The purpose of the loan was to fund VAFLA's existing and anticipated operating deficits. At the time the loan was made, the corporation's liabilities exceeded its assets, and the corporation had so little available cash that it could not meet its cash flow requirements. Virtually all of the corporation's assets were encumbered as collateral for a purchase money indebtedness of approximately $1 million to National Service Industries, Inc. In processing the loan, the Bank of Virginia was provided a statement of income for the corporation for its first three months of operation during which the corporation experienced a loss of $142,410.16, resulting in a negative net worth of $82,410.16 as of May 31, 1979. Seven of the corporation's shareholders agreed to guarantee the $300,000 loan personally. According to the financial statements submitted to the bank, these shareholders had an aggregate net worth of $3,407,286 and immediate liquidity (cash and securities) of $382,542. The loan was approved only because of the financial strength of the guarantors. The Bank of Virginia loan was consistently shown on the corporation's financial statements and tax returns for its fiscal years ending 1979, 1980 and 1981, as a loan from shareholders. However, during those years, the corporation made the following principal payments to the Bank of Virginia:
Dec. 26, 1979 $10,000
July 15, 1980 10,000
Jan. 6, 1981 10,000
All interest payments were also made by the corporation. None of the payments by the corporation on the principal or the interest of the loan were reported by the corporation or petitioners as constructive dividends. Page 210 Daniel and Evelyn M. Leavitt deducted a loss of $13,808 attributable to the corporation on their 1979 joint Federal income tax return. Respondent disallowed $3,808 of this deduction. Anthony D. and Marjorie F. Cuzzocrea deducted losses of $13,808, $29,921 and $22,746 attributable to the corporation on their 1979, 1980 and 1981 joint Federal income tax returns, respectively. Respondent disallowed all of these deductions in excess of $10,000. Respondent takes the position that shareholders Daniel Leavitt and Anthony D. Cuzzocrea may not deduct losses attributable to the corporation in excess of their initial basis in their shares of the corporation. Petitioners maintain that their guarantees of the $300,000 loan to the corporation from the Bank of Virginia increased their basis in their stock sufficiently to allow deductions for their proportionate shares of losses attributable to the corporation during the years in issue. Former section 1374, [6] as in effect during the years in Page 211 issue, permitted a shareholder in a subchapter S corporation to deduct his portion of the corporation's net operating loss from his gross income. Former section 1374(c) limited the amount of the deduction to the sum of (1) the adjusted basis of the shareholder's stock in the corporation and (2) the adjusted basis of any indebtedness of the corporation to the shareholder. The corporation sustained losses for the taxable years 1979, 1980 and 1981. Before the guarantee transaction, petitioners Daniel Leavitt and Anthony D. Cuzzocrea each had an adjusted basis in their stock in the corporation of $10,000. We must determine whether petitioners' guarantee of the $300,000 loan from the Bank of Virginia to the corporation increased the basis in petitioners' stock in the corporation. It is well settled that: the fact that shareholders may be primarily liable on indebtedness of a corporation to a third party does not mean that this indebtedness is ‘ indebtedness of the corporation to the shareholder‘ within the meaning of section 1374(c)(2)(B). No form of indirect borrowing, be it guaranty, surety, accommodation, comaking or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation. * * * » Raynor v. Commissioner, 50 T.C. 762, 770-771 (1968). � See also Putnam v. Commissioner, 352 U.S. 82 (1956); Underwood v. Commissioner, 535 F.2d 309 (5th Cir. 1976), affg. 63 T.C. 468 (1975); Perry v. Commissioner, 47 T.C. 159, affd. 392 F.2d 458 (8th Cir. 1968); Wheat v. United States, 353 F.Supp. 720 (S.D. Tex. 1973). Neal v. United States, 313 F.Supp. 393 (C.D. Cal. 1970). Page 212 In the instant case petitioners have never been called upon to pay any of the loan that they guaranteed. Accordingly, the guarantees that petitioners executed do not increase any indebtedness of the corporation to them. Nevertheless, petitioners ask us to view the guarantee transactions as constructive loans from the banks to petitioners and, in turn, contributions of those same funds by petitioners to the capital of the corporation. In other words, petitioners contend that their guarantees of the $300,000 loan from the Bank of Virginia to the corporation should increase their basis in the stock of the corporation. We disagree. Under former section 1374(c)(2) corporate debts to third parties guaranteed by the shareholder, whether collateralized or not, do not lead to an increase in the shareholder's basis in his subchapter S corporation stock. To increase the basis in the stock of a subchapter S corporation, there must be an economic outlay or a realization of income on the part of the shareholder. ...

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