J.H. Harris, and William J. Martin v. United States
66 A.F.T.R.2d (RIA) 5104, 1990 U.S. App. LEXIS 9028, 902 F.2d 439 (1990)
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Rule of Law:
A shareholder's personal guarantee of a loan made to their Subchapter S corporation does not increase the shareholder's stock basis for the purpose of deducting corporate losses unless the shareholder makes an actual economic outlay by making a payment on the guaranteed debt.
Facts:
- J.H. Harris and William J. Martin (Taxpayers) contracted to purchase a theater for $665,585 with the intent to convert it into a wedding hall.
- To limit liability and for other business reasons, Taxpayers formed Harmar, a Louisiana corporation that elected to be taxed under Subchapter S of the Internal Revenue Code.
- Taxpayers each contributed $1,000 for stock in Harmar and loaned the corporation an additional $47,500 each for operating expenses.
- Hibernia National Bank (Hibernia) loaned $700,000 directly to Harmar for the acquisition of the theater.
- Harmar executed two promissory notes for $350,000 each, payable to Hibernia, as the sole maker of the notes.
- Harris and Martin each personally executed a continuing guarantee for the full $700,000 of Harmar's indebtedness to Hibernia.
- One of the notes was also secured by a pledge of certificates of deposit owned by Harris and his other wholly-owned corporation.
- In its first year of operation ending in 1982, Harmar reported a net operating loss of $104,013.
Procedural Posture:
- Taxpayers Harris and Martin each claimed half of Harmar's $104,013 net operating loss as a deduction on their individual 1982 income tax returns.
- The Internal Revenue Service (IRS) audited the returns and disallowed the portion of the deductions that exceeded each taxpayer's basis, which the IRS calculated as $48,500 per shareholder.
- The IRS assessed additional tax liability against the Taxpayers, which they subsequently paid.
- Taxpayers filed a suit for a tax refund in the United States District Court against the United States (Government).
- The district court granted the Government's motion for summary judgment, dismissing the Taxpayers' suit.
- Taxpayers, as plaintiffs-appellants, appealed the district court's decision to the United States Court of Appeals for the Fifth Circuit.
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Issue:
Does a shareholder's personal guarantee of a loan made to their Subchapter S corporation, without any payment on that guarantee, constitute an economic outlay that increases the shareholder's stock basis, thereby allowing for a larger deduction of the corporation's net operating losses on the shareholder's personal tax return?
Opinions:
Majority - Garwood, Circuit Judge
No. A shareholder’s guarantee of a loan to their Subchapter S corporation does not increase their basis in the corporation's stock without an actual economic outlay. The court held that taxpayers are bound by the form of the transaction they choose. The loan was unambiguously made from Hibernia to Harmar, as evidenced by the promissory notes, mortgage, and the consistent treatment of the debt on Harmar's own books and tax returns. The court rejected the taxpayers' attempt to recharacterize the transaction's substance, emphasizing that a mere guarantee is a contingent liability and does not constitute an economic outlay until the guarantor actually makes a payment. Citing precedents like Brown v. Commissioner and Estate of Leavitt, the court aligned itself with the majority of circuits that require a shareholder to be made 'poorer in a material sense' through a direct contribution, loan, or payment on a guarantee to increase their basis. The pledge of collateral by Harris was also deemed insufficient to constitute an economic outlay.
Analysis:
This decision solidifies the Fifth Circuit's adoption of the strict 'economic outlay' test for increasing a Subchapter S shareholder's stock basis, aligning it with the majority view held by other circuits. By rejecting the more lenient 'substance-over-form' approach advocated in Selfe v. United States, the court established a clear, bright-line rule that provides certainty for taxpayers and the IRS. The ruling clarifies that contingent liabilities, like guarantees or pledges of collateral, are insufficient to generate basis; a shareholder must make an actual payment or direct contribution to be 'at risk' in a way that the tax code recognizes for loss deduction purposes. This holding significantly limits the ability of S-corp shareholders to deduct corporate losses in excess of their direct cash or property investments.
