Rev. Rul. 71-288

The Internal Revenue Service has been asked to clarify Revenue Ruling 70-50, C.B. 1970-1, 178, which discusses the computation of a net operating loss deduction allowed to a shareholder of an electing small business corporation under section 1374(c)(2) of the Internal Revenue Code of 1954.

The facts presented in that Revenue Ruling are that the corporation incured net operating losses for two consecutive years and that the shareholder's portion of the loss for the second year was greater than his adjusted basis in his stock in the corporation. In the third year, the corporation defaulted on the bank loan guaranteed by the shareholder and demand was made on the shareholder under the guaranty. The shareholder paid the bank loan in satisfaction of his guaranty.

The Revenue Ruling states that when the taxpayer paid the corporation's debt the corporation became indebted to the taxpayer (stockholder). This conclusion was based on the decision of 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, wherein the Court observed that 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.

Revenue Ruling 70-50 concluded that the amount paid by the shareholder as a 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.

The specific question raised is whether the shareholder's payment of the loan in the third year in satisfaction of his guaranty relates back to the second year so that he may avail himself of the unused net operating loss for that year.

Consistent with the decision in the Putnam case, the corporation did not become indebted to the guarantor until he paid the debt of the corporation under the guaranty which, in this case, occurred in the third year. In the context of section 1374 of the Code, there is no provision for relating the indebtedness of third year back to the second year.

Accordingly, the shareholder's payment of the bank loan pursuant to his guaranty does not relate back to the prior corporate tax year. Thus, if the corporation incurred a net operating loss for its third taxable year the shareholder would be entitled to deduct his proportionate share of such loss to the extent of the sum of the adjusted basis of his stock and the corporation's indebtedness to him in that year.

Revenue Ruling 70-50 is clarified.