## Facts

- F. Howard Hitchins and Esther E. Hitchins filed joint returns for 1986–1988; Mr. Hitchins controlled Champaign Computer Company (CCC), a C corporation.
- The Hitchinses and another couple formed ChemMultiBase Company, Inc. (CMB), which elected S corporation status; ownership was split 50/50 between the two couples.
- Under their business arrangement, CCC developed a chemical database and would later be reimbursed by the newly formed corporation (CMB) for development expenses.
- In 1986, Mr. Hitchins personally loaned $34,000 to CCC for operating expenses connected to the database; CCC issued a note to Hitchins.
- After formation, CMB became obligated to CCC for development costs and issued a note to CCC.
- CMB satisfied its obligation to CCC partly by cash and partly by “assuming” CCC’s $34,000 debt to Hitchins.
- CCC’s note to Hitchins was not canceled, and CMB did not issue a note directly to Hitchins.
- CMB incurred losses; the Hitchinses claimed pass-through loss deductions, treating the $34,000 CCC debt (assumed by CMB) as increasing Hitchins’ basis in CMB for § 1366(d) loss-limitation purposes.
- The IRS disallowed the $34,000 basis increase and asserted additions to tax for negligence under former § 6653(a).

## Issues

1. Whether a shareholder may increase S corporation basis under I.R.C. § 1366(d) by a debt owed to the shareholder by a C corporation when the S corporation assumes that debt as part of paying its debt to the C corporation, but the S corporation does not become directly indebted to the shareholder.
2. Whether the taxpayers were liable for additions to tax for negligence under former I.R.C. § 6653(a) for the years at issue, including as to the basis position.

## Decision

- The court held the $34,000 loan to CCC, though later assumed by CMB, did not increase Hitchins’ basis in CMB stock or indebtedness for purposes of § 1366(d).
- The court sustained the IRS’s limitation on deductible CMB pass-through losses to the extent based on including the $34,000 in CMB basis.
- The court held the taxpayers liable for negligence additions under § 6653(a) except that the § 6653(a)(1)(B) addition did not apply to the portion of the underpayment attributable to the $34,000 basis position.

## Legal Principles

- Under I.R.C. § 1366(d)(1), an S corporation shareholder’s loss deduction is limited to the sum of the shareholder’s basis in S corporation stock and the shareholder’s basis in indebtedness of the S corporation to the shareholder.
- “Indebtedness of the S corporation to the shareholder” requires direct debtor-creditor relationship between the S corporation and the shareholder; debt running through another entity generally does not create S corporation debt basis.
- An “actual economic outlay” by the shareholder (becoming poorer in a material sense) is necessary but not sufficient; the outlay must result in a direct obligation of the S corporation to the shareholder (or an equity investment) to increase § 1366(d) basis.
- For negligence additions under former § 6653(a), negligence includes failure to exercise reasonable care or to make a reasonable attempt to comply with the tax law; a reasonably debatable position may limit penalties for the portion attributable to that position.

## Conclusion

The Tax Court held that a shareholder’s loan to a related C corporation did not create S corporation debt basis when the S corporation merely assumed the C corporation’s debt without becoming directly obligated to the shareholder, limiting pass-through loss deductions under § 1366(d). The court also sustained negligence additions generally, while excluding the penalty portion attributable to the disputed basis treatment of the assumed $34,000 debt.


Hitchins v. Commissioner, 103 T.C. 711 (1994)