Experienced Tax
Accountant – 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 me if you would
like to discuss these rules and their application to you. I look forward to
hearing from you. Click this link to view our YouTube video http://youtu.be/EYJdQtbPZAI
Amare
Berhie
(651) 621-5777, (952) 583-9108, (612) 224-2476, (763) 269-5396
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