S Corporation Losses, a Shareholder Loan, and a Guarantee
Corvid Labs Inc. has been an S corporation since formation with one shareholder, Dana, who materially participates in the business. On January 1, Year 1, Dana's stock basis was $50,000. In Year 0 she also lent the corporation $30,000 under a signed note bearing a stated interest rate and a fixed maturity date; the corporation has made every scheduled interest payment and is current. In Year 1 the corporation earned $5,000 of tax-exempt interest, distributed $20,000 to Dana, and sustained an ordinary business loss of $120,000. During Year 1 Dana also personally guaranteed a $200,000 bank loan to the corporation, on which the corporation is current. Dana asks how much of the $120,000 loss she may deduct in Year 1 and what happens to the remainder.
1. Compute Dana's Year 1 deductible loss and suspended loss, showing the order in which basis is adjusted and the effect of the $30,000 note.
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Stock basis rollforward (order matters - income first, then distributions, then losses, per Reg. 1.1367-1(f)):
- Beginning stock basis: $50,000
- Plus tax-exempt interest (increases basis even though not taxable): +$5,000 = $55,000
- Less distribution: the distribution is tax free to the extent of basis and cannot reduce basis below zero: -$20,000 = $35,000
- Loss is limited to remaining stock basis: -$35,000 = $0
Debt basis. The $30,000 note is bona fide debt (written note, stated interest, fixed maturity, interest actually paid), so it is a second basis pool. Losses that exceed stock basis reduce debt basis: -$30,000 = $0.
Result for Year 1:
- Total deductible loss: $35,000 + $30,000 = $65,000
- Suspended loss: $120,000 - $65,000 = $55,000, carried forward indefinitely and deductible in a later year to the extent basis (stock or debt) is restored by income, contributions, or new loans.
Character note: the $65,000 is an ordinary loss from the S corporation (Dana is not at risk/activity limitations issue since she materially participates and actively participates). The $20,000 distribution is not taxable because basis after the income allocation exceeds it.
2. Does Dana's personal guarantee of the $200,000 bank loan create basis she can use against the suspended loss?
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No. A shareholder guarantee of corporate debt is a contingent obligation, not an economic outlay. Basis in indebtedness of the corporation arises only when the shareholder actually parts with something of value - typically, when she is called upon to pay under the guarantee and the cash is actually advanced, or when she pledges personal assets that are actually used to satisfy the debt.
Consequences:
- The $200,000 guarantee contributes $0 to Dana's basis while the corporation is current on the loan.
- The same conclusion would apply to a mere pledge of her personal assets; a promise to pay in the future is not an outlay.
- If Dana later pays the bank, the payment is treated as a loan to or capital contribution to the corporation, creating basis at that time, and the $55,000 suspended loss may then be freed up (subject to the passive activity and at-risk rules at her level).
Watch for the counter-case: if the note were not bona fide debt - no interest, no maturity, repayment contingent on profits - it would be recharacterized as equity and would not create a separate debt basis pool. That is why documentation and actual interest payments matter here.
3. Corvid is considering issuing preferred stock with a 2x liquidation preference to an outside investor. What are the consequences for the S election?
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This terminates the S election. An S corporation may have only one class of stock (IRC Sec. 1361(b)(1)(D)). The regulations test this by whether all outstanding shares confer identical rights to distribution and liquidation proceeds; the governing provisions (articles, bylaws, agreements) control, not actual distributions. A 2x liquidation preference gives the preferred holder rights that differ from Dana's, creating a second class of stock.
Timing and effect of termination.
- The corporation ceases to be an S corporation on the date the terminating event occurs - the date the second class of stock is issued (Sec. 1362(d)(2)). There is no grace period and no retroactive fix; a mid-year issuance splits the year into an S short year and a C short year.
- The C short year creates entity-level tax, a second accounting period, and requires allocating income between the S and C portions.
- Dana's suspended loss is limited to basis and must be absorbed in the S short year; the corporation's subsequent distributions to Dana would be C corporation dividends to the extent of E&P.
- Re-electing S status generally requires a five-year waiting period (Sec. 1362(g)); a late or inadvertent termination could seek relief, but a deliberate preferred issuance is not inadvertent.
Escape route. If the instrument is structured as straight debt under Sec. 1361(c)(5) - written obligation, not convertible, no equity features, interest not contingent on profits - it is not treated as a second class of stock and the election survives. The investor's economics would need to be renegotiated accordingly.