Guarantor Primarily Liable for Note Could Deduct Related Accrued Interest

In 1983, G began managing a weekly business publication (EBN) as a sole proprietorship. In 1987, G incorporated EBNI, an S corporation in which G was the sole shareholder.

P was G's friend and financial backer. Over the years, they transacted business through a variety of controlled entities. In 1988, G executed a 60-day note to a trust of which P was a trustee and the sole beneficiary. This note consolidated several outstanding loans between G and P. It was signed by G and secured by all of EBNI's stock.

In 1992, EBNI filed for bankruptcy protection under Chapter 11. In the bankruptcy petition schedules, G did not list the note. At no time did the trust demand payment on the note.

On his 1993 and 1994 returns, G claimed a deduction for accrued interest relating to the note and a net operating loss carryover. The IRS denied these deductions, but the Tax Court (in a memorandum opinion) held that G could take these deductions.

Accrued Interest Deduction

The IRS determined that, because EBNI was the primary obligor and G merely a guarantor, G was not entitled to a deduction relating to accrued interest on the note. G contends that he was the obligor and therefore entitled to the deductions.

Sec. 163(a) allows as a deduction all interest paid or accrued within the tax year on indebtedness. A guarantor who becomes the primary obligor on the liability can deduct accrued interest. In addition, a taxpayer no longer in business may take deductions that result from the operation of a trade or business in which he previously engaged.

P expected that G's newspaper business would be primarily responsible for paying the note. P further viewed G as a guarantor. At the time the note was executed, EBNI's stock was collateral for the note.

The note was not listed on EBNI's bankruptcy schedules, and EBNI's reorganization plan did not provide for payment of the note. P testified that he did not object to the omission of the note because he knew that the other signers (i.e., G) were liable. On May 28, 1993, the U.S. Bankruptcy Court entered an order confirming EBNI's Chapter 11 reorganization plan; this order also discharged the note and other debts arising before confirmation of the plan. As guarantor, G then became primarily liable for the note's payments. Accordingly, G is entitled to a deduction for interest accrued after the date of confirmation of the bankruptcy plan.

R. George Gregersen, TC Memo 2000-325