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Debt-Financed Losses in S Corporations and Partnerships

Partners in partnerships are allowed to deduct operating losses in partnerships that their shareholder counterparts in S corporations cannot deduct. The difference results from a difference between partners and shareholders as to entity-level debt. That debt increases a partner’s tax basis in her partnership interest. That debt will not increase a shareholder’s tax basis in her corporate shares (unless she is the lender).

The difference in basis treatment results from a difference in how partners and shareholders are treated as to the business of the entity. Partners are treated as actually participating in the partnership’s business. In this sense, the partnership is the vessel through which the partners conduct business. Consistent with this view, the partnership’s debts are treated as debts of the partners.

In an S corporation, though, the corporation is the entity conducting business. Its shareholders are not. They hold shares in the S corporation. Under subchapter S law, they even share the cost of paying taxes on the corporation’s operations. Further, if the corporation generates an operating loss, the shareholders report that loss on their income tax returns. However, unless the loss is financed with shareholder debt financing, S corporation shareholders cannot deduct the corporation’s debt-financed losses.

The rule limiting a shareholder’s deductions for debt-financed losses applies even if the loss is financed with debt from a person related to the shareholder. The Ninth Circuit Court of Appeals recently confirmed that result in Messina v. Commissioner, 2019 W.L. 7209828 (9th Cir. 2019). That decision affirmed a 2017 Tax Court opinion, which held that the shareholders of an S corporation could not deduct that corporation’s losses financed with loans from another of the shareholders’ wholly-owned S corporation. The Messinas rightly argued that they were economically financing those losses. In fact, had they conducted business in a partnership (including an LLC taxed as a partnership), they would have been able to deduct those losses. In fact, that result prevails even if an unrelated third party provided the financing.            

The Messinas might have structured their affairs in S corporations to produce a different result. For instance, they could have contributed their S corporation shares to the S corporation making the loan. That transaction (which is treated as an F reorganization) might have been precluded by regulatory matters. The Messinas were in the casino business, a highly regulated industry. Undoubtedly, they would have had to ask a gaming commission for approval.

They also could have personally borrowed the money from their lending S corporation and then lent those proceeds to the operating S corporation. Again, business or regulatory concerns might have precluded that structure.

The structure they chose, however, highlights limits on using S corporations for businesses that require significant debt financing. Taxpayers contemplating a choice between a tax partnership and an S corporation should be alert to those limits.

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