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In order to increase their basis to be able to absorb the S
corporation's losses, Lubbock surrendered the demand notes it was
holding, the taxpayers substituted a personal note to replace it,
and the S corporation issued a demand note for the same amount to
the taxpayers. The net effect was that, after the paper
transactions, the taxpayers owed Lubbock for the loan it had
originally made to the S corporation, and the S corporation owed
money to the taxpayers.
Before the transactions the S corporation had never made any
payments of principal or interest on the loans. Sometime later
the S corporation paid all of the interest owing to Lubbock. The
taxpayers also made an interest payment. A year later the S
corporation made another interest payment to Lubbock.
Approximately a year after that the taxpayers made another
payment for interest and ultimately paid off the loan.
In holding that the transaction did not serve to increase
the taxpayers' basis in the S corporation, both the Tax Court and
the Court of Appeals for the Fifth Circuit analogized the
transaction to a loan guaranty. Furthermore, in affirming the
Tax Court decision the Court of Appeals stated:
In the transaction at issue in this case, the taxpayers
in 1967 merely exchanged demand notes between themselves and
their wholly owned corporations; they advanced no funds to
either Lubbock or Albuquerque. Neither at the time of the
transaction, nor at any other time prior to or during 1969
was it clear that the taxpayers would ever make a demand
upon themselves, through Lubbock, for payment of their note.
Hence, as in the guaranty situation, until they actually
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