## Facts

- J.H. Harris and William J. Martin formed Harmar, a Louisiana Subchapter S corporation, to acquire and convert a New Orleans theater into a wedding hall.
- Each shareholder contributed $1,000 for Harmar stock and loaned $47,500 to Harmar for operating expenses.
- Harmar acquired the property at closing on November 1, 1982, using $700,000 borrowed from a bank.
- Harmar executed two promissory notes (each $350,000) payable to the bank; Harris and Martin personally guaranteed Harmar’s bank debt.
- Harmar generated losses that passed through to Harris and Martin, who claimed net operating loss deductions on their individual returns.
- The IRS disallowed the portion of the claimed deductions that exceeded each shareholder’s basis in Harmar stock and shareholder debt.
- The district court granted summary judgment to the United States in the shareholders’ refund suit; the shareholders appealed.

## Issues

1. Whether shareholders’ personal guarantees of an S corporation’s third-party bank debt increase their basis for purposes of the S-corporation loss limitation rules.
2. Whether corporate bank debt can be treated as indebtedness of the corporation to the shareholders absent an actual shareholder advance or payment on the guarantee.

## Decision

- The Fifth Circuit affirmed summary judgment for the United States.
- The court held that Harris and Martin’s guarantees of Harmar’s bank debt did not increase their bases in Harmar.
- The court rejected recharacterizing the bank loan as shareholder-to-corporation indebtedness because Harmar was the borrower and the shareholders made no corresponding out-of-pocket advance of those funds.

## Legal Principles

- An S-corporation shareholder’s deductible passthrough losses are limited to the shareholder’s adjusted basis in stock plus adjusted basis in qualifying indebtedness of the corporation to the shareholder.
- Shareholder basis is tied to actual economic investment or outlay (capital contributions or direct loans to the corporation).
- A personal guarantee of corporate debt owed to a third-party lender does not create shareholder basis unless and until the shareholder pays on the guarantee and thereby becomes the corporation’s creditor.
- Courts generally respect the transaction’s actual debtor-creditor relationships when they reflect genuine economic substance; a shareholder cannot obtain additional basis by treating corporate third-party debt as shareholder debt without a real advance or payment.

## Conclusion

Because Harmar, not the shareholders, borrowed the bank funds and the shareholders only provided guarantees without making an additional economic outlay, the shareholders could not increase basis to deduct losses beyond their stock and direct shareholder-loan bases, and the IRS’s disallowance was upheld.


Harris v. United States, 902 F.2d 439 (5th Cir. 1990)