Rev. Rul. 70-50

Advice has been requested whether the payment of a debt of an electing small business corporation by a shareholder of the corporation under the circumstances described below creates an indebtedness of the corporation to the shareholder for the purpose of computing a net operating loss allowable to the shareholder under section 1374(c)(2) of the Internal Revenue Code of 1954.

The shareholder guaranteed payment of a loan made by a bank to an electing small business corporation. The corporation incurred net operating losses for two consecutive years. The shareholder's portion of the loss for the second year was greater than the total of his basis in the stock. In the third year the corporation defaulted on the loan, and demand was made upon the shareholder under the guaranty. The shareholder paid the debt in satisfaction of his guaranty.

Section 1374(a) of the Code provides, in general, that a net operating loss of an electing small business corporation for any taxable year shall be allowed as a deduction from gross income of the shareholders.

Section 1374(c) of the Code provides, in part, as follows:

(2) Limitation.--A shareholder's portion of the net operating loss of an electing small business corporation for any taxable year shall not exceed the sum of--

(A) the adjusted basis * * * of the shareholder's stock in the electing small business corporation, determined as of the close of the taxable year of the corporation * * *, and

(B) the adjusted basis * * * of any indebtedness of the corporation to the shareholder, determined as of the close of the taxable year of the corporation * * *.

In the case of William H. Perry v. Commissioner, 47 T.C. 159 (1966), affirmed 392 F. (2d) 458 (1968), it was held that the allowable portion of a net operating loss properly deductible by a shareholder in an electing small business corporation does not include corporate debts to third parties that have been guaranteed by the shareholders. The obligation of the shareholder-guarantor was secondary and not an indebtedness of the corporation to the shareholder under section 1374(c)(2)(B) of the Code. See also Rev. Rul. 69-125, C.B. 1969-1, 207, which holds that for purposes of the net operating loss allowed shareholders of an electing small business corporation, debts owed a partnership are not "indebtedness of the corporation to the shareholder" even though the shareholders own a majority interest in the partnership.

The Perry case is distinguishable from the instant case because in the Perry case the taxpayer did not pay any of the company's debts. Thus, as observed by the Supreme Court of the United States in Max Putnam et al. v. Commissioner, 352 U.S. 82 (1956), Ct. D. 1800, C.B. 1957-1, 501, only after the guarantor performs on his contract of guaranty does the debtor's indebtedness to the creditor become an indebtedness owed to the guarantor. Accordingly, in the instant case when the taxpayer paid the corporation's debt the original debt shifted from the original creditor to the stockholder, and thus the corporation was in fact indebted to the stockholder.

Accordingly, the amount paid by the shareholder as the result of the satisfaction of his obligation as guarantor of the debt of the electing small business corporation is treated as an indebtedness of the corporation to the shareholder for the purpose of computing the net operating loss allowable to him as a shareholder in accordance with section 1374 of the Code. It should be noted that the basis of the indebtedness in the hands of the shareholder is reduced pursuant to the provisions of section 1376(b)(2) of the Code.