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Maloof v. Commissioner - 456 F.3d 645 (6th Cir. 2006)

Rule:

In interpreting the (materially indistinguishable) predecessor statute to 26 U.S.C.S. § 1366, a taxpayer must make an "economic outlay" in order to increase his basis in S corporation debt (or stock) under this provision. Before the taxpayer may increase his basis, there must have occurred some transaction which, when fully consummated, left the taxpayer poorer in a material sense. "Economic outlay" has been the coin of the realm when it comes to assessing whether a transaction increases a taxpayer's basis, and the United States Tax Court consistently has concluded that a taxpayer guarantor does not make an economic outlay until required to honor the guarantee. 

Facts:

The  Internal Revenue Service (IRS) issued over $3 million in tax deficiencies against an owner of a S corporation. This owner claimed significant deductions for losses incurred by S corporations that he owned. Under 26 U.S.C.S. § 1366(d)(1), the owner's deductions from these losses could not exceed his basis in the stock or debt of the corporations. Recognizing that the losses greatly exceeded his initial investment in the corporations, the owner claimed that a $4 million bank loan to the corporations in 1993, on which the owner was a co-obligor and guarantor, permissibly increased his basis in debt of the S corporation to the shareholder (or possibly stock of the S corporation owned by the shareholder). The Tax Court upheld over $3 million in tax deficiencies. The owner appealed to the Court of Appeals. 

Issue:

 Did the owner properly increased his basis in stock or debt when he became a co-obligor and guarantor of the loan to allow him these deductions?

Answer:

No

Conclusion:

The appellate court held that the relevant statutes and case law permitted an increase in basis in debt (or stock) only when the taxpayer made an economic outlay to the corporation, and the owner's status as a co-obligor on the loan established just the possibility, not the reality, of an economic outlay for the corporation. The appellate court therefore affirmed the decision of the tax court upholding over $3 million in tax deficiencies issued by the IRS against the owner.

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