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past, Morris has always attempted 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 beginning he was forced to
give the bank a personal guarantee). In addition, the corporation 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 on 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 advanced to the corporation in its earlier years, the IRS would probably object to the debt-toequity
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 flow 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 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 might in turn advance the money to
the corporation 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 Internal Revenue Code in recent 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 investors/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 flow.
They would be followed some years in the future by a healthy long-term capital gain. Thus, an
investor with high taxable income could be offered short-term pass-through tax losses with a nice
long-term gain waiting in the wings. In those days, long-term capital gain was taxed at only 40% of
the rate of ordinary income, so the tax was not only deferred, but also substantially reduced. These
businesses were known as tax shelters.
Exhibit 9.2 Passive activity losses.