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#2169 signed 8-31-95



In Re:



NO. 90-40292-7



This case was before the Court on March 9, 1995, for argument on the government's motion for summary judgment. The matter arose from the debtor's objection to the Internal Revenue Service's claim. The Court granted summary judgment on one issue, denied it on another, and took under advisement a third issue which raised only a question of law. The debtor appeared by counsel John H. Stauffer, Jr. The IRS appeared by Justice Department Trial Attorney Jaye Rooney. The Court has again reviewed the briefs, considered the parties' oral arguments, reviewed the applicable case law and statutes, and is now prepared to rule on that third issue.


The debtor purchased stock in a subchapter S corporation from his sister for $50,000. To finance the purchase, he signed a note for $50,000 in 1987 which called for him to make two payments in 1988. The note also contained a due-on-demand clause and drew interest at 9% per annum. A payment schedule for the note shows that the debtor had paid a total of $9,000 by the end of 1987. He conceded in 1994 that he had not yet made any more payments on the note. Using $50,000 as his basis in the stock, the debtor took a deduction on his 1987 tax return as a result of a loss the corporation sustained that year. The IRS disallowed the deduction, claiming that the debtor's basis was not the amount of the note but only the amount he had actually paid, $9,000.


The tax basis of a taxpayer's interest in a subchapter S corporation is its "cost"--a term that is not defined in the IRC--to him. Case law has defined "cost" to include a note given to finance a purchase where the note is the taxpayer's direct obligation and not a sham, and its amount does not exceed a reasonable estimate of the property's existing fair market value. Brannen v. Commissioner, 722 F.2d 695, 701-02 (11th Cir. 1984) (cost for depreciation purposes); Muserlian v. Commissioner, 932 F.2d 109, 114-17 (2nd Cir. 1991) (costs for purposes of stepped-up basis in new partner's share in partnership assets); Silverstein v. United States, 349 F. Supp 527, 529-31 (E.D.La. 1972) (cost for purposes of net-operating-loss deduction). In seeking summary judgment, the IRS has not claimed that the debtor's transaction with his sister was a sham or that the amount of the note was not reasonable estimate of the stock's fair market value. Instead, it claims only that the debtor's basis was limited to the $9,000 he had paid on the note by the time he took the deduction rather than the full $50,000 he had given, in the form of a promissory note, for the stock. This position is contrary to the cases just cited.

To support its view, the IRS initially relied only on two Tenth Circuit cases. Goatcher v. United States, 944 F.2d 747 (1991); Uri v. Commissioner, 949 F.2d 371 (1991). These decisions affirmed lower court rulings disallowing net-operating-loss deductions because the taxpayers were only secondarily liable as guarantors of loans to subchapter S corporations. 944 F.2d at 751-52; 949 F.2d at 373-74. The rulings do not purport to exclude from a taxpayer's basis the amount of his direct liability on a personal note given to a third party in return for corporate stock.

In a supplemental pleading, the IRS cited additional authorities. One is simply another case disallowing a deduction where the taxpayers had guaranteed their S corporation's debt. Brown v. Commissioner, 706 F.2d 755, 756-57 (6th Cir. 1983). This adds nothing to the inapplicable Tenth Circuit rulings already discussed.

Another authority added is an IRS Revenue Ruling that a taxpayer's basis in an electing small business corporation (the Court believes this means an S corporation) did not increase when he gave an unsecured demand promissory note to the corporation but only when he later paid the note. Revenue Ruling 81-187. The last is a case where the taxpayers owned two corporations, one of which had loaned money to the other in return for a promissory note; without transferring any money, the taxpayers substituted their own note for that one and gave themselves a new note from the debtor corporation. Underwood v. Commissioner, 535 F.2d 309, 310-11 (5th Cir. 1976). The court affirmed the ruling that the taxpayers' basis in the debtor corporation did not increase until they actually paid their note to the creditor corporation. 535 F.2d at 312-13. These two authorities are also inapplicable here because they involved, in essence, taxpayers promises to pay themselves money--to transfer money from one pocket to another, so to speak--which were deemed to have no economic substance until the taxpayers actually paid the money. In this case, by contrast, the debtor's promise was to pay a third party, his sister, in return for stock she transferred to him. The Court believes it is reasonable to ignore taxpayers' promises to transfer money from one pocket to another until they actually complete the transfer since they retain the right to excuse themselves from performing such promises. However, when taxpayers make promises to pay a third party, even a related one, the right to enforce the promise belongs to that third party, so the possibility of forced payment becomes real. This distinction justifies a difference in the tax treatment of such promises. Under Brannen, Muserlian, and Silverstein, the IRS can still try to show that the promise to pay the third party was a sham.

In sum, the Court does not believe the debtor's basis in in the corporation's stock was limited as a matter of law to the amount he had actually paid his sister when he claimed the loss deduction for 1987. The IRS's motion for summary judgment on this issue must be denied.


Dated at Topeka, Kansas, this _____ day of August, 1995.





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