Shareholder's loan guarantee

Arend, Laukhuf & Stoller, Inc.

Before you agree to act as a guarantor, endorser, or indemnitor of a debt obligation of your closely held corporation, you should be aware of the possible tax consequences if your corporation defaults on the loan and you are required to pay principal or interest under your guarantee agreement.

If you are compelled to make good on the obligation, the payment of principal or interest in discharge of the obligation generally results in a bad debt deduction. The deduction may be either a business bad debt deduction or a nonbusiness bad debt deduction. If it's a business bad debt, it's deductible against ordinary income. A business bad debt can be either totally or partly worthless. If it's a nonbusiness bad debt, it's deductible as a short-term capital loss, which is subject to certain limitations on deduction of capital losses. A nonbusiness bad debt is deductible only if it's totally worthless.

In order to be treated as a business bad debt, the guarantee you enter into must be closely related to your trade or business. If the reason for guaranteeing the loan of your corporation was to protect your job, it's considered as closely related to your trade or business as an employee. But employment must be the dominant motive for the guarantee. If your annual salary exceeds your investment in the corporation, this fact tends to show that the dominant motive for the guarantee was to protect your job. On the other hand, if your investment in the corporation substantially exceeds your annual salary, that's evidence that the guarantee was primarily to protect your investment rather than your job. For example, where a shareholder-employee's salary was $13,300 and his investment in the corporation was $1,000,000, his guarantee of the corporation's loan wasn't primarily for business-related reasons.

Except in the case of guarantees to protect your job, it may be difficult to show the guarantee was closely related to your trade or business. You would have to show that the guarantee was related to your business as a promoter, for example putting together oil deals between your corporation and others, or that the guarantee was related to some other trade or business separately carried on by you.

If the reason for guaranteeing your corporation's loan isn't closely related to your trade or business and you are required to pay off the loan, you can take a nonbusiness bad debt deduction if you show that your reason for making the guarantee was to protect your investment, or you entered the guarantee transaction with a profit motive. For example, suppose you guarantee payment of a bank loan to your corporation and your corporation defaults on the loan. If you make full payment, you will be able to take a nonbusiness bad debt deduction because you entered into the guarantee to protect your investment in the corporation.

In addition to satisfying the above requirements, a business or nonbusiness bad debt is deductible only if: (1) you have a legal duty to make the guaranty payment, although there's no requirement that a legal action be brought against you; (2) the guaranty agreement was entered into before the debt becomes worthless; and (3) you received reasonable consideration (but not necessarily cash or property) for entering into the guaranty agreement.

Any payment you make on a loan you guaranteed is deductible as a bad debt in the year you make the payment, unless the guarantee agreement (or local law) provides for a right of subrogation against the corporation. If you have this right, or some other right to demand payment from the corporation, you can't take a bad debt deduction until these rights become partly or totally worthless.

No bad debt deduction is allowable, however, for any payment you make as a guarantor, endorser, or indemnitor of your corporation's loan if the payment is actually a capital contribution to your corporation. Whether or not a shareholder's guarantee of his corporation's debt is considered a capital contribution is determined on the basis of the facts at the time the obligation to guarantee was entered into. If your corporation couldn't have obtained the loan without your guarantee, the payment may be considered a contribution to capital.

If your corporation is organized as an S corporation, you may deduct your pro rata share of the corporation's losses and deductions, but only to the extent of your basis in the corporation's stock and any indebtedness of the corporation to you. Although one court has held that an S corporation shareholder is entitled to a basis increase for this purpose if he guarantees his corporation's loan, other courts disagree.

You should also consider the following before entering into the guarantee agreement:

• If you pay interest under your obligation as guarantor, you may not take an interest deduction, but must treat the payment as a business or nonbusiness bad debt. However, you may be entitled to an interest deduction if you pay interest that accrued after you became primarily liable for the debt, either because the creditor demanded payment from you after the corporation became insolvent or because the corporation's debt was discharged in bankruptcy, leaving you as the primary debtor. Treating the payment as interest won't be to your advantage if the interest is considered personal interest, which is nondeductible. For example, interest is personal if it's allocable to your trade or business as an employee.
• If the debt you guarantee is discharged or forgiven, it has been held that only your corporation has cancellation of indebtedness income. That income can't be attributed to you.
• If life insurance is taken out on your life as additional security for the loan and you pay the premiums, you won't be able to deduct the premiums because you are considered an indirect beneficiary of the insurance.

Only tax issues involving a guarantee by a shareholder of his corporation's loan are discussed above. There are, however, certain nontax issues that you may want to take into account, such as the extent of your liability under the guaranty where you jointly guarantee the corporation's loan along with other shareholders, or whether you can limit your liability under the guarantee.

Please call our firm if you would like to discuss these rules and their application any further.