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Repayments of Business Debt When a small business fails,
the entity or the owners are often required to pay its
debts long after business operations cease. This article discusses the
treatment of these payments and payments by guarantors of
the entity’s debts. Claudia L.
Kelley, Ph.D., CPA For more information about this article, contact Dr. Kelley at kelleycl@appstate.edu or Mr. Norman at jnorman@gwllp.com. Executive Summary
Seventy-two percent of the 23 million small businesses in the U.S. are sole proprietorships, according to the Small Business Administration’s (SBA) Office of Advocacy. Approximately 83% of small businesses use some form of credit.1 Lenders often extend loans to these businesses based on the principal owner’s creditworthiness. The business owners may have to borrow the funds used in the business, personally guarantee the business’s debt or seek a guarantee from acquaintances or family. According to the SBA, one-third of all small businesses fail after just two years; however, the entity or its owners often continue to pay debts long after business operations cease. Is the interest deductible?
This article discusses the circumstances under which (1) former business owners can deduct interest on these payments and (2) guarantors can take a bad debt deduction when required to pay the outstanding debt. Interest Tracing Rules The Tax Reform Act of 1986 enacted Sec. 163(h)(1), which eliminated the personal interest deduction and limited the deductibility of other types of interest. This forced taxpayers to classify interest to determine its proper tax treatment. The interest tracing rules under Temp. Regs. Sec. 1.163-8T(a)(3) classify interest ex-pense based on the taxpayer’s use of the debt proceeds. Thus, taxpayers are required to maintain records of the link between expenditures and related debt. Under Temp. Regs. Sec. 1.163-8T(a)(3), disbursements of debt proceeds are traced to specific expenditures and the debt allocated accordingly. Interest on that debt is allocated in the same way. Moreover, under Temp. Regs. Sec. 1.163-8T(c)(1), the allocation is not affected by the use of property to secure the debt. For example, if a taxpayer borrows $50,000, secured by his or her personal art collection and uses the proceeds to purchase business equipment, the interest is business interest. Reallocation Rules Temp. Regs. Sec. 1.163-8T(c)(2) states that interest expense on debt used for business purposes remains business interest until the earlier of the date the debt is repaid or is reallocated to another expenditure. Debt incurred to acquire a capital asset (e.g., equipment) is reallocated to another expenditure when the asset’s use changes or, if earlier, when proceeds from the asset disposition are used for another purpose. The reallocated debt cannot exceed the proceeds from the asset disposition. When the asset’s use changes, the reallocated debt cannot exceed the asset’s fair market value (FMV) at the time of the change.
Accrued Interest Under Temp. Regs. Sec. 1.163-8T(c)(2), debt is allocated to an expenditure for the period beginning on the date the debt proceeds are used to make the expenditure and ending on the earlier of the date the debt is repaid or reallocated. Interest accruing on a debt for any period is allocated in the same manner as the debt, regardless of when the interest is actually paid. Under Temp. Regs. Sec. 1.163-8T(c)(2)(ii)(B), accrued interest is treated as debt; interest accruing on unpaid interest is allocated in the same way as the unpaid interest.
Planning Strategy To maintain the business interest deduction, proprietors should be advised (1) not to change how they use business assets after operations cease and (2) to avoid using the assets for personal purposes. If a proprietor changes use, he or she should document the date that the use changes; documentation should include the loan balance, as well as the asset’s FMV. Establishing the asset’s value enables the taxpayer to continue to deduct business interest for any loan amount in excess of the asset’s value as of the date of change. He or she should also seek other sources of cash for personal expenditures, rather than selling business assets. The above examples illustrate how interest payments made after business operations cease can continue to be deductible. However, under Sec. 163(a), a taxpayer can deduct such interest only if he or she is liable for the debt. If a person pays another’s obligation, neither gets an interest deduction. In sole proprietorships, the person deducting the interest has to be directly liable for the debt. In the case of a failed business entity, the entity liable for the debt should pay the interest to preserve the deduction. However, what happens when the entity does not have any assets remaining to pay the debt, which occurs in many cases. Often, the owner or another party—the guarantor—pays the entity’s obligation, which changes the tax consequences. Guarantors Small business owners often have to execute a guarantee or ask family or friends to execute such an agreement for their business’s debt. Additionally, employees often advance funds to struggling small businesses. When the entity becomes insolvent, the guarantor2 has to meet the obligation. The resulting tax consequences to the guarantor can vary depending on whether the debt is business or nonbusiness. Bad Debts Under Regs. Sec. 1.166-9(a), a loss sustained by a guarantor unable to recover from a debtor is a bad debt loss. Because the guarantor acquires the debt by subrogation (i.e., the substitution of one debt for another), he or she must prove that the debt is unrecoverable from the original debtor to deduct the loss. Typically, the subrogation right is worthless when the guarantor pays the creditor. The guarantor must also be unable to recover from any co-guarantor to deduct that portion of the debt. Regs. Sec. 1.166-9(a) and (b) treat the guarantor’s payment of both principal and interest as bad debt. A business bad debt is an ordinary loss deduction; a nonbusiness bad debt is a short-term capital loss.3 A guarantor’s tax classification is critical in determining the tax treatment of payments required on a guarantee. Regs. Sec. 1.166-9(d) states that, to deduct these payments, the guarantor must have entered into the guarantee in the course of his trade or business or in a transaction entered into for profit. Further, the guarantor must demonstrate that he or she received reasonable consideration for entering into the agreement. Under Regs. Sec. 1.166-9(e), such consideration has to be direct and in the form of cash or property with respect to guarantees for related individuals. These requirements are often a trap for the innocent taxpayer who has guaranteed a loan for a family member or friend and is now repaying the bank without an offsetting tax deduction.
Based on the facts in Example 7, E’s father-in-law cannot deduct the payments on his guarantee. To qualify for the deduction, E’s father-in-law would have to show a profit motive in guaranteeing the loan. Whether a bad debt is business or nonbusiness is a question of fact. According to Regs. Sec. 1.166-5(b)(1), to qualify as a business bad debt, the debt must have been acquired in the course of the taxpayer’s trade or business or proximately related to that trade or business at the time of worthlessness. Generally, payments made by a guarantor of a corporate obligation are deductible as a nonbusiness bad debt.4 The courts have long recognized that a shareholder’s business normally is not the same as the corporation’s business, even if he or she is a controlling shareholder. However, payments made by partners on behalf of their partnerships were business bad debts when the partners’ payments were in furtherance of the partnership’s business.5 Taxpayers may qualify for a business bad debt deduction under other circumstances. In Rev. Rul. 71-561, an employee was allowed a business bad debt deduction, under Regs. Sec. 1.166-9(a), on the repayment of a guarantee granted to his supervisor, an officer of the employee’s corporation. According to the Service, the employee was motivated to guarantee the supervisor’s debt to protect his employment and his future potential with the company. This motivation was proximately related to the taxpayer’s trade or business as an employee. Further, in Rosati,6 the court found that a corporate officer was entitled to a business bad debt deduction on a guarantee when his action as a guarantor was motivated by a desire to protect his employment. Under Regs. Sec. 1.166-5(b), a guarantor may qualify for a business bad debt deduction by establishing that he or she is in the trade or business of guaranteeing loans, a question of fact. Further, the courts have found in favor of a taxpayer who had limited guarantor activities. For example, in Alfred S.V. Carpenter,7 the taxpayer had guaranteed loans to businesses he thought would succeed. Over seven years, he guaranteed loans to seven corporations. The court allowed a business bad debt deduction, concluding that, even though the bulk of the taxpayer’s income came from investments, he was in the business of guaranteeing loans. According to the court, a taxpayer may have more than one trade or business activity.8 Additionally, in Ruppel,9 a taxpayer prevailed in establishing his lending activities as a trade or business. Thus, the question arises as to when a guarantee will qualify as a trade or business. Unfortunately, there is no bright-line test that will ensure a business bad debt deduction. However, if a taxpayer enters into a transaction with a profit motive, keeps separate books and records and reports a guarantee fee separately on his or her return, the taxpayer may be able to establish an activity as a trade or business. Tax Planning According to the cases favoring taxpayers and Field Service Advice (FSA) 199911003,10 a taxpayer can establish his or her lending and/or guarantor activities as a trade or business based on the following:
For related-party loans, guarantors should receive reasonable consideration for their service, to preserve a deduction in the event that they must pay a debt. Interest Deduction Guarantors generally are denied an interest deduction under Sec. 163(a) for interest payments on the primary debtor’s default. Rather, they are often relegated to the less-favorable nonbusiness bad debt deduction and the related capital loss limits. Interest payments are deductible only if the debt is the taxpayer’s direct obligation. The Service and the courts have reasoned that a guarantor is only secondarily liable. Sec. 163 allows a taxpayer to deduct interest only on an obligation for which he or she was primarily liable from the inception of the debt. In Putnam,11 for example, the Supreme Court stated that, under the theory of subrogation, payments made by a guarantor did not create a new debt, but instead preserved the old debt, with the guarantor substituted for the creditor. The debt is not discharged by the guarantor’s payment, but preserved against the primary debtor. Following Putnam, courts have applied this reasoning to conclude that a guarantor remained secondarily liable to a primary debtor. The cases disallowing an interest deduction hold that, if the debt when originally incurred was that of the primary debtor, it will remain such, even if the guarantor later becomes directly liable to the creditor.12 “The courts reached this conclusion on the inapposite theory that the guarantor has a theoretical right of recovery from the primary debtor.”13 Bankruptcy In Stratmore,14 the Third Circuit, in reversing the Tax Court and other circuit precedent, held that interest accrued and paid after a corporate debtor’s discharge in bankruptcy is deductible by the guarantor under Sec. 163. In that case, the taxpayers were officers and stockholders in a manufacturing corporation and had guaranteed certain of the company’s debt. The company filed for a Chapter 11 reorganization. As part of the reorganization plan, the company paid its creditors 25 cents on the dollar. The taxpayers agreed to honor their obligations of the remaining 75 cents and also stipulated they would forgo their claims against the company. Any creditor whose debts are discharged in bankruptcy is enjoined from instituting an action to collect such debt. Thus, if a guarantor wishes to make a claim against a principal debtor, he or she has to do so before a bankruptcy discharge. Because the taxpayers (guarantors) had no legal action for reimbursement, the Third Circuit concluded that the obligation for the debt became solely theirs. According to the court, to be deductible, the interest has to be for the taxpayer’s benefit. Interest is a payment for the use of principal over time. Thus, the interest accumulated for the guarantor’s benefit and should be deductible by them. This decision should provide authority for a guarantor’s interest deduction when reimbursement is legally precluded by bankruptcy. Insolvency The Third Circuit, in Stratmore, did not address whether a primary debtor’s insolvency has the same effect as bankruptcy on a guarantor’s liability for the underlying debt and, thus, entitlement to an interest deduction. An earlier Tax Court decision, Tolzman,15 found that the guarantor of a corporation’s debt became directly and primarily liable following the company’s insolvency. Creditors demanded payment, the corporation was unable to pay and the guarantor’s obligation became fixed, direct and noncontingent. Thus, the amounts paid for interest accruing subsequent to the insolvency were paid on the guarantor’s own debt. The court stated, “[t]he mere fact that petitioners at one time were guarantors of a corporate note is not controlling. Instead, we must determine whether the interest accrued at a time when petitioners’ liability was no longer secondary and indirect.” Taxpayers who pay interest under an obligation as guarantor may be entitled to an interest deduction if interest accrued after they became primarily liable for the debt. Guarantors may become primarily liable for debt when a creditor demands payment after the original debtor becomes insolvent or because the original debt was discharged in bankruptcy. Conclusion When the U.S. economy is sluggish, many small businesses fail and their owners are forced to pay off related loans and interest. The resulting tax treatment of these payments can vary widely, based on the taxpayer’s ability to establish and document his or her relationship to the debt repayment and the debtor. This article provided guidance on how to treat such payments, so that taxpayers may receive the most beneficial tax treatment if they have to personally repay business debt. |
