## Facts

- VAFLA Corporation was formed to acquire and operate an amusement park near Tampa, Florida, and soon became financially distressed, with liabilities exceeding assets and little collateral.
- Daniel Leavitt and other shareholders each acquired VAFLA stock with an initial $10,000 basis.
- In August 1979, Leavitt and six other shareholders executed joint and several guarantees to the Bank of Virginia for VAFLA’s indebtedness.
- On September 12, 1979, VAFLA borrowed $300,000 from the Bank of Virginia and executed a promissory note; the bank required shareholder guarantees as a condition of lending.
- VAFLA, not the shareholders, made all principal and interest payments on the bank loan; the shareholders made no out-of-pocket payments and were never required to perform on the guarantees.
- VAFLA’s financial statements and returns described the bank loan as a loan from the shareholder-guarantors, but VAFLA’s payments were not treated as taxable income to the shareholders.
- VAFLA elected Subchapter S status, and shareholders claimed pass-through loss deductions for 1979–1981 exceeding their $10,000 stock bases, asserting the guarantees increased basis.
- The Commissioner disallowed loss deductions exceeding each shareholder’s $10,000 basis; the Tax Court sustained the deficiencies, and the shareholders appealed.

## Issues

1. Whether an S corporation shareholder’s guarantee of corporate bank debt, without any payment by the shareholder, increases the shareholder’s stock (or debt) basis for purposes of deducting pass-through losses under then-applicable I.R.C. § 1374.

## Decision

- The Fourth Circuit affirmed the Tax Court and sustained the Commissioner’s deficiency determinations for 1979–1981.
- The court held the $300,000 obligation was a bank loan to VAFLA in both form and substance.
- The court held the shareholders’ guarantees, without any actual payments, did not increase their bases in VAFLA stock and did not permit loss deductions beyond their $10,000 bases.

## Legal Principles

- An S corporation shareholder’s allowable loss deductions are limited to the shareholder’s adjusted basis in stock plus the adjusted basis of any indebtedness of the corporation to the shareholder (as provided by the applicable Subchapter S basis rules).
- Shareholder basis increases through actual capital contributions and bona fide, direct indebtedness running from the corporation to the shareholder.
- A mere guarantee of third-party corporate debt is a contingent liability and does not create basis unless and until the shareholder actually pays on the guarantee and thereby becomes the corporation’s creditor (e.g., by reimbursement or subrogation rights).
- Bookkeeping labels or tax-return characterizations cannot convert a third-party loan to the corporation into shareholder debt basis where the corporation is the obligor and the shareholder makes no economic outlay.

## Conclusion

Because VAFLA was the primary obligor on the bank loan and the shareholders never paid under their guarantees, the guarantees did not create direct corporate indebtedness to the shareholders or otherwise increase basis, so pass-through loss deductions were limited to the shareholders’ $10,000 stock bases.


Estate of Leavitt v. Commissioner, 875 F.2d 420 (4th Cir. 1989)