Rev. Rul. 75-144

The Internal Revenue Service has been asked to amplify Rev. Rul. 70-50, 1970-1 C.B. 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 Rev. Rul. 70-50 are that an electing small business corporation incurred net operating losses for two consecutive years and that the shareholder's portion of the loss for the second year was greater than the adjusted basis of his stock in the corporation. In the third year, the corporation defaulted on a bank loan guaranteed by the shareholder under the guaranty. The shareholder paid the bank loan in satisfaction of his guaranty.

Rev. Rul. 70-50 holds that although the shareholder's guaranty of the corporation's indebtedness did not create an indebtedness of the corporation to the shareholder, when the shareholder later paid the corporation's creditor in satisfaction of his guaranty, the corporation became indebted to the shareholder under the doctrine of subrogation. This conclusion was based on the general rule, as observed by the Supreme Court of the United States in Putnam v. Commissioner, 352 U.S. 82 (1956), 1957-1 C.B. 501, that after the guarantor performs on his contract of guaranty the debtor's indebtedness to the creditor becomes an indebtedness owed to the guarantor.

Rev. Rul. 70-50 concludes 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.

Rev. Rul. 70-50 was clarified by Rev. Rul. 71-288, 1971-2 C.B. 319, to provide that the indebtedness of the corporation to the shareholder arising in the year upon payment by the shareholder under his guaranty did not relate back to the second year, and would not entitle the shareholder to deduct any portion of the corporation's losses in the second year in excess of the adjusted basis of his stock in that year.

The Service has been asked to state its position where the facts are the same as in Rev. Rul. 70-50, as clarified, except that instead of actually paying money to the bank in satisfaction of his guaranty, the shareholder, in the third year, executed his own promissory note for the full amount due and substituted it for the note of the corporation. The bank accepted the note in satisfaction of the guaranty and relieved the corporation of its liability on the old note. The shareholder made no payment on his own note until the fourth year.

The specific questions raised are (1) whether the execution of the shareholder's own note, and its acceptance by the bank, constitute a payment of the debt that would cause the indebtedness of the corporation to accrue to the shareholder under the doctrine of subrogation, and (2) whether the shareholder would have a basis in such indebtedness as of the end of the third year so that he would be entitled to deduct from his income his share of net operating losses of the corporation, if any, in that year, or in any subsequent year, under section 1374 of the Code.

As the Putnam case explained, after actual performance by the guarantor on his contract of guaranty, the corporation's obligation to the bank generally becomes an obligation to the guarantor under the doctrine of subrogation. Whether the subrogation occurs is determined by State law. If subrogation occurs, a guarantor who has discharged his obligation by giving his own promissory note which the creditor has accepted in full satisfaction becomes a creditor of the principal even though the guarantor's note remains unpaid. In such a case the guarantor's basis in the corporation's indebtedness is its cost to him, which includes the face amount of the note he gave up.

Accordingly, the execution of a note by a shareholder, together with the acceptance of the note by a bank, under the circumstances described above, caused the indebtedness of the corporation to accrue to the shareholder, and created a basis in the indebtedness for purposes of computing his share of net operating losses of the corporation, if any, in the third year, or in any subsequent taxable year of the corporation, under section 1374 of the Code.

Rev. Rul. 70-50 is amplified.