Postliquidation Payment on Loans Guaranteed by a Shareholder

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Potomac, MD

Editor’s note: This case study has been adapted from PPC Tax Planning GuideS Corporations, 16th edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, TX 2002 ((800) 323-8724; www.ppcnet.com).

Facts: Dr. Linda Morris is the sole shareholder of BioTech Solutions, Inc., an S corporation. The company performs medical research in anticipation of obtaining patents on medical devices. Two years ago, the corporation borrowed $1.5 million from First National Bank for its biotech research business. The bank required Dr. Morris to guarantee the loan.

Due to unforeseen circumstances, the corporation suffered reverses and was liquidated. The loan balance at liquidation was $900,000. Several months later, Dr. Morris paid $1 million ($900,000 principal + $100,000 accrued interest) to the bank under the loan guaranty. Issue: Can Dr. Morris deduct the $1 million payment on her personal return?

Analysis

Under the doctrine of subrogation, when the guarantor of a corporations debt makes a payment under the guarantys terms, the guarantor steps into the shoes of the corporations creditor. The corporations debt becomes the guarantors obligation. Thus, the loss the guarantor sustains is a loss from the worthlessness of the debt; see Putnam, 352 US 82 (1956).

A payment under a loan guaranty is treated as a worthless debt under Regs. Sec. 1.166-9(d) if the agreement:

1. Was entered into in the course of the taxpayers trade or business or a transaction entered into for profit;

2. Is legally enforceable; and

3. Was entered into before the debt became worthless.

The guarantor must have received reasonable compensation for guaranteeing the loan. When an S shareholder guarantees a loan to the S corporation, the compensation can be indirect. Indirect compensation occurs under Regs. Sec. 1.166-9(e), for example, when a guaranty is given in accordance with normal business practice or for a good-faith business purpose. In addition, Regs. Sec. 1.166-9(d)(3) and (c) provide that the guarantor must have had a reasonable expectation that he or she would not be required to make any payments under the guaranty. Further, the payment must not constitute a capital contribution.

In Rev. Rul. 60-48, the IRS ruled that the noncorporate guarantor of a corporate obligation required to make payments on the obligations of an insolvent or liquidated corporate debtor that he or she guaranteed can take a Sec. 166 bad-debt deduction. The deduction will qualify as a business or nonbusiness bad debt depending on the facts of each case.

According to Sec. 166(d)(2), a business bad debt arises from:

1. A debt created or acquired in the ordinary course of the taxpayers trade or business; or

2. A worthless debt, the loss from which is incurred in the taxpayers trade or business.

To determine whether the loss was incurred in the taxpayers trade or business, the focus is on the relationship between the loss and the taxpayers business. If, at the time of worthlessness, it is proximate to the conduct of the trade or business, the debt will qualify as a business bad debt under Regs. Sec. 1.166-5(b).

In Generis, 405 US 93 (1972), the Supreme Court considered whether the taxpayers payment under an indemnification agreement qualified as a business or nonbusiness bad debt. It stated that in determining whether the relation is proximate, the taxpayers dominant motivation for making the guarantee must be business oriented. Significant motivation between the debt and the taxpayers business does not satisfy this requirement.

The Court stated that the taxpayers status as an employee was a business interest, while his status as a shareholder was a nonbusiness interest. Evidently, the taxpayer may establish a business bad debt by showing that the guaranty was given to protect the taxpayers status as an employee, source of income or business relationship or business reputation.

Dr. Morris $1 million payment will be treated as a worthless business bad debt if she guaranteed the corporations loan in the course of her trade or business. If Dr. Morris was an employee of the corporation and actively engaged in its business activities, the payment would probably qualify as a worthless business bad debt and receive ordinary loss treatment.

However, if the guaranty was not made in Dr. Morris trade or business, but rather in a transaction entered into for profit, the payment will be treated as a worthless nonbusiness bad debt. If Dr. Morris was actively engaged in the full-time practice of medicine and was a passive investor in the corporation, it would probably qualify as a nonbusiness bad debt and receive short-term capital loss treatment (subject to the $3,000 annual limit on deducting a net capital loss).

Regardless of whether the payment is deemed a business or nonbusiness bad debt, the bad-debt treatment applies to payments of both principal and interest. Sec. 163, which allows deductions for interest, does not apply, according to Regs. Sec. 1.166-9(a) and (b). Dr. Morris would report the full $1 million payment as a bad debt.

Conclusion

An S shareholder who guarantees a corporations debt and who is later required to make a payment under the guaranty can deduct the payment as a bad debt, provided it is not deemed a capital contribution. The payment will qualify as a business bad debt if the loan guaranty was made in the shareholders course of business. The payment will qualify as a nonbusiness bad debt if the guaranty was not made in the taxpayers trade or business, but rather in a transaction entered into for profit.