You, Peter Sleiman, entered into a lease agreement with Blockbuster Video, Inc. Your lease stipulated that you purchase land, build a video rental store, and lease it to Blockbuster. You then set up an S Corporation, REE, Inc. and assigned the lease to REE. REE then obtained bank loans of approximately $1 million by pledging the property the S Corporation had purchased as collateral. Mr. Sleiman, you personally guaranteed the loans, however the bank did not contact you for repayment.
Analysis
Is Mr. Sleiman eligible for a $1 million step-up in basis for the guaranteed loans?
Mr. Sleiman is NOT eligible for a $1 million step up in basis because of the personal guarantee on the loans.
Mr. Sleiman is not eligible for the $1 million step up in basis because of a few reasons. In Selfe v. United States, 778 F.2d769 (11th Cir.1985), the case involved a sole proprietor who incorporated her existing business into an S Corporation. While a sole proprietorship, she obtained bank loans in her own name, secured by property that she owned.
Once incorporated she then transferred her personal loans to the corporation. Once she transferred her personal loans, the bank maintained that the debt be secured with her personal property outside of the corporation.
In the case of Mr. Sleiman, the loans were obtained after the formation of the corporation and the loans were secured by property purchased by the corporation. REE, Inc. already had “ample cash-flow to service”, the loans meaning they did not “lack economic substance,” meaning the banks looked to the corporation as the primary obligor on the loan.
Had the loans been guaranteed by Mr. Sleiman’s personal property or credit and the banks looked at him as the primary obligor then he would have had a possible basis increase.
In the case Selfe v. United States, 778 F.2d769, the taxpayer established a line of credit in her own name, secured by stock that she and her family owned. At the bank’s request, she converted her personal loans into corporate loans. She executed a personal guarantee but the bank retained its security interest in the original pledged stock. Unlike Selfe, REE, Inc. obtained the loans after the corporation was formed and also provided the collateral for the loans.
Conclusion
“The economic outlay doctrine” states a stockholder’s basis increases when they make some type of investment or expenditure that runs directly between the S corporation and the stockholder. Meaning shareholder’s guarantee of a loan to an S corporation is typically treated as an equity investment in the corporation when the lender looks to the shareholder as the primary obligor. Mr. Sleiman did not demonstrate any personal costs or expenditures with respect to the loans acquired by REE, therefore he is not eligible for a basis increase. The bank looked primarily at the corporation and its collateral when it considered the loans. The outcome in this case is that because there was “ample cash-flow to service the loans” they did not “lack economic substance” and REE was responsible for the loan and not Sleiman.
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