Rev. Rul. 81-187

ISSUE

May a shareholder in an electing small business corporation, under the circumstances described below, claim a deduction from gross income under section 1374 of the Internal Revenue Code for a net operating loss incurred by the corporation?

FACTS

On November 1, 1979, A, an individual, the owner of all the outstanding stock of X, an electing small business corporation as defined in section 1371 of the Code, executed an unsecured demand promissory note of 20x dollars in favor of X and transferred the note to X. When A transferred the note, A's adjusted basis in X stock was zero. On February 1, 1980, A paid 20x dollars to X in full satisfaction of the note issued by A in 1979. For the taxable year ending December 31, 1979, X incurred a net operating loss of 18x dollars.

LAW AND ANALYSIS

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

Section 1374(b) of the Code provides that each person who is a shareholder of an electing small business corporation at any time during a taxable year of the corporation in which it has a net operating loss shall be allowed as a deduction from gross income, for his or her taxable year in which or with which the taxable year of the corporation ends, an amount equal to his or her portion of the corporation's net operating loss (as determined under section 1374(c)).

Section 1374(c)(2) of the Code provides that 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 the adjusted basis of the shareholder's stock in the corporation plus the adjusted basis of any indebtedness of the corporation to the shareholder. These amounts are to be determined as of the close of the taxable year of the corporation, without regard to any adjustment under section 1376 for the taxable year.

The legislative history of section 1374(c)(2) of the Code indicates that the deductible net operating loss of any shareholder is limited "to the adjusted basis of the shareholder's investment in the corporation; that is, to the adjusted basis of the stock in the corporation owned by the shareholder and the adjusted basis of any indebtedness of the corporation to the shareholder." S. Rep. No. 1983, 85th Cong., 2nd Sess. 220, 1958-3 C.B. 922, 1141. In Perry v. Commissioner, 54 T.C. 1293, 1296 (1970), aff'd. United States Court of Appeals, 8th Circuit, No. 20,657, 5/12/71, the court concluded that the foregoing committee report language reveals an intent on the part of the committee to limit the adjusted basis of the shareholder's investment in the corporation to the "actual economic outlay" of the shareholder. The court further stated:

The rule which we reach by this interpretation is no more than a restatement of the well-settled maxim which requires that "Before any deduction is allowable there must have occurred some transaction which when fully consummated left the taxpayer poorer in a material sense." (Citation omitted.)

In the present case, A, in 1979, merely executed and transferred A's demand note to A's wholly owned corporation, making no payment on the note until the following year. Since A incurred no cost in executing the note, its basis to A was zero. Thus, in 1979 there was no economic outlay to X from A. Since Congress intended to limit a shareholder's adjusted basis to his or her actual economic outlay for purposes of the net operating loss deduction, there is no increase in A's adjusted basis in X stock until 1980, when A paid the note.

HOLDING

A may not claim a deduction from gross income under section 1374 of the Code for the net operating loss incurred by X in 1979 because A's adjusted basis in X stock was zero.