No, not Dostoyevsky’s 1864 novella, but rather Judge Morrison’s foray into the subterranean depths of underground telephone infrastructure, more about which is to be found in Patrick D. Montgomery and Patricia A. Montgomery, 2013 T. C. Memo. 151, filed 6/17/13, while I was walking the battlefield of First Manassas. Thus this delayed posting.

Pat D’s dad founded a Sub S design company for putting telephone infrastructure in the cold cold ground, which Pat D took over upon Dad’s decease. But the design company couldn’t do the actual construction, so Pat D and Pat A formed a new LLC.

The Pats personally guaranteed a million-dollar loan for the Sub S, which defaulted. The Pats also defaulted, and the lender got a judgment against the Pats for $425K.

The Pats claimed an NOL for the amount of the judgment and also operating losses from the LLC.

IRS claimed Pat A didn’t materially participate in the LLC’s business. IRS loses that one. First, Pat D’s participation helps out Pat A, per Section 469(h)(5).

Judge Morrison takes up the rest: “Both Patricia Montgomery and Patrick Montgomery were integral in the process of setting up and establishing UDI Underground, LLC. The company began in April 2007 with no employees. The Montgomerys hired 250 employees on behalf of UDI Underground, LLC, by the end of 2007. Although the Montgomerys performed some services for Utility Design, Inc., during 2007, this older company already had established its business operations. The Montgomerys spent more of their work time on UDI Underground, LLC, than on Utility Design, Inc. They did not hold any jobs outside the two companies. They credibly testified that they worked thousands of hours for UDI Underground, LLC, during 2007. We find that the Montgomerys participated in UDI Underground, LLC, for more than 500 hours during 2007. On the basis of all the facts and circumstances we also find that the Montgomerys participated in UDI Underground, LLC, on a regular, continuous, and substantial basis during 2007.” 2013 T. C. Memo. 151, at p. 10.

But the Pats had no logs, so how did they prove what they did? “The Montgomerys provided details of the nature of the activities they conducted in starting and managing UDI Underground, LLC. The tasks they described included founding the company, negotiating contracts with AT&T, hiring 250 employees, and conducting daily business. They credibly testified they worked on the business ‘day in and day out.’ They were credible witnesses and were forthcoming with information about their activities regarding UDI Underground, LLC. We find that the proof the Montgomerys provided meets the requirements of section 1.469-5T(f)(4), Temporary Income Tax Regs., supra.” 2013 T. C. Memo. 151, at p. 11.

So testimony might work even when there are no logs or appointment books.

The Pats will get some losses passed through to them. But they founder on the big loss, the $425K judgment.

Section 1366(d)(1) limits S Corp shareholders’ losses to their adjusted basis in their S Corp stock plus their basis in S Corp debt. The Pats can’t prove any basis in their stock (surprising since Pat D inherited it; but as Dad lived in FL, I suspect it was all in a trust to avoid probate. Still, why was no Form 706 filed?).

So they need the judgment from the defaulted loan to show basis in Sub S corp debt.

No dice, says Judge Morrison: “When an S corporation shareholder guarantees a loan by a bank to the S corporation, no debt has been created between the S corporation and the shareholder. However, once the S corporation shareholder pays the bank pursuant to a guarantee, the S corporation becomes indebted to the shareholder. As we held in Underwood v. Commissioner, 63 T.C. at 476, ‘it is the payment by the guarantor of the guaranteed obligation that gives rise to indebtedness on the part of the debtor to the guarantor. The mere fact that the debtor defaults and thereby renders the guarantor liable is not sufficient.’”  2013 T. C. Memo. 151, at p. 18 (Citations omitted).

Had the Pats taken out the loan, made the S Corp assume the loan obligations as primary obligor, and stepped back as guarantors, that might have worked even if they defaulted, but there is nothing in the record to support that the Pats did anything like that. See 2013 T. C. Memo. 151, at p. 19, footnote 6.

Sometimes straight forward isn’t the way forward, especially underground.