320 Planning and Forecasting
amount of loss is limited by a stockholder ’s basis in his investment in the cor-
poration. Basis includes the amount invested as equity plus any amount the
stockholder has advanced to the corporation as loans. As the corporation oper-
ates, the basis is raised by the stockholder ’s pro rata share of any profit made
by the corporation and lowered by his pro rata share of loss and any distribu-
tions received by him.
These rules might turn Morris’s traditional financing strategy on its head
the next time he sits down with the corporation’s bank loan officer to negotiate
an extension of the corporation’s financing. In the past, Morris has always at-
tempted to induce the loan officer to lend directly to the corporation. This way
Morris hoped to escape personal liability for the loan (although, in the begin-
ning he was forced to give the bank a personal guarantee). In addition, the cor-
poration could pay back the bank directly, getting a tax deduction for the
interest. If the loan were made to Morris, he would have to turn the money
over to the corporation and then depend upon the corporation to generate
enough profit so it could distribute monies to him to cover his personal debt
service. He might try to characterize those distributions to him as repayment
of a loan he made to the corporation, but, given the amount he had already ad-
vanced to the corporation in its earlier years, the IRS would probably object to
the debt to equity ratio and recharacterize the payment as a nondeductible
dividend fully taxable to Morris. We have already discussed why Morris would
prefer to avoid characterizing the payment as additional compensation: His
level of compensation was already at the outer edge of reasonableness.
Under the subchapter S election, however, Morris no longer has to be
concerned about characterizing cash f low from the corporation to himself in a
manner that would be deductible by the corporation. Moreover, if the loan is
made to the corporation, it does not increase Morris’s basis in his investment
(even if he has given a personal guarantee). This fact limits his ability to pass
losses through to his return. Thus, the subchapter S election may result in the
unseemly spectacle of Morris begging his banker to lend the corporation’s
money directly to him, so that he may in turn advance the money to the corpo-
ration and increase his basis. This would not be necessary in an LLC, since
most loans advanced to this form of business entity increase the basis of its
owners.
Passive Losses
No discussion of pass-through entities should proceed without at least touching
on what may have been the most creative set of changes made to the Code in re-
cent times. Prior to 1987, an entire industry had arisen to create and market
business enterprises whose main purpose was to generate losses to pass through
to their wealthy investor/owners. These losses, it was hoped, would normally be
generated by depreciation, amortization, and depletion. These would be mere
paper losses, incurred while the business itself was breaking even or possibly
generating positive cash f low. They would be followed some years in the future