February 2009 There Are Some “Guaranties” in Life, But Do You Want to Be the One Making Them? Analyzing the Unique Rules for Bad Debt Losses of Guarantors By Hale E. Sheppard Hale Sheppard examines the complexities of bad debt deductions claimed by third-party guarantors. Introduction lender, as required by the loan documents. When this People are fond of saying that there are only two guar- occurs, many lenders immediately opt to exercise anties in this world: death and taxes. This is simply their collection rights against the guarantors instead not the case, particularly in tough fi nancial times. As of pursuing the struggling borrowers. Once the guar- the economy deteriorates, the credit scores of many antor recovers from the blow of having to make good borrowers and the risk tolerance of most lenders seem on the borrower’s fi nancial blunder, his mind tends to to fall precipitously. The show must go on, though. be focused on two things: recouping the money from To obtain thehe nenecessaryces business capital from the borrower and claiming the most favorable tax fi nancial institutionstuutions iinn ttheseheh bleakeak cconditions,onditions, popoten- treatment possible. This article examines these two tial borrowersrs ooftenften sseekeeke backingcki fromro thirdird paparties interrelated issues, which will become increasingly with better finfi nancialancial resumes.resue umes. In short, borrowersborrow prevalent (and thus important to tax practitioners) as frequently needdtd too findfifid ndd a guarantor, anotherhl layer the U.S. economy continues to fl ounder. of protection for the fi nancial institution,ution, in oordorder to qualify for the loan. The guarantor,nto of ccourse,oursee, dodoese OverviewOvvervieeww offt thehee AApApplicablepllicca Law not put his neck on the line for nothing. He ordinarily demands various forms of compensation, as well as To appreciate the special rules applicable to losses certain rights of recourse against the borrower in case incurred by guarantors of debts that become worth- of default. The theory is relatively straightforward: if less, it is important fi rst to understand some general the guarantor is going to incur a signifi cant risk, he legal principles under Code Sec. 166 and the cor- is entitled to a handsome reward. responding regulations.1 Optimistic expectations notwithstanding, many In the case of a taxpayer other than a corporation, business ventures do not turn out as planned, and where any “nonbusiness debt” becomes worthless borrowers fail to make timely, full payments to the during the year, the resulting loss generally is treated as a loss from the sale or exchange of a capital asset held for not more than one year.2 In other words, the Hale E. Sheppard, J.D., LL.M., LL.M.T., is a shareholder in the loss from the worthlessness of a nonbusiness debt Atlanta offi ce of Chamberlain Hrdlicka, specializing in federal ordinarily is considered a short-term capital loss, and state tax audits, tax appeals, tax litigation, tax collection 3 issues and criminal tax investigations. with all that entails. ©2009 H.E. Sheppard CORPORATE BUSINESS TAXATION MONTHLY 37 Analyzing the Unique Rules for Bad Debt Losses of Guarantors In this context, the term “nonbusiness debt” gener- any payment under the guaranty agreement must ally means a debt other than (i) a debt that is created or be deducted (if at all) as nonbusiness bad debt, acquired in connection with the taxpayer’s trade or busi- regardless of whether there is any right of subro- ness or (ii) a debt the loss from the worthlessness of which gation, unless the guaranty was made pursuant is incurred in the taxpayer’s trade or business.4 However, to the taxpayer’s trade or business.11 a nonbusiness debt does not include certain securities, such as bonds, debentures, notes, certifi cates or other According to the regulations interpreting this evidence of debt that are issued by a corporation, a legislative history, a payment in discharge of part government or a political subdivision of a government, or all of the taxpayer’s agreement to act as guaran- with interest coupons or in tor should be treated as registered form.5 Whether a worthless debt only if (i) debt is a nonbusiness debt To appreciate the special rules the guaranty agreement is a question of fact in each was entered into in the case, and the use to which applicable to losses incurred by course of the taxpayer’s the debtor puts the bor- guarantors of debts that become trade or business, or as a rowed funds has no bearing worthless, it is important fi rst to transaction for profi t;12 (ii) on the analysis.6 understand some general legal there was an enforceable Only “bona fi de” debts legal duty imposed upon qualify for purposes of principles under Code Sec. 166 and the taxpayer, as guaran- Code Sec. 166. A debt is the corresponding regulations. tor, to make the payment, bona fi de if it “arises from though it is not necessary a debtor-creditor relation- that the party collecting ship based upon a valid and enforceable obligation to from the guarantor actually brings a legal action to pay a fi xed or determinable sum of money.”7 A gift or force payment;13 (iii) the guarantor entered into the a contribution to capital, therefore, is not considered guaranty agreement before the obligation became a bona fi de debt.8 worthless (or partially worthless in the case of an As mentioned above, there are special rules in cases agreement entered into in the course of a guarantor’s of losses sustained by guarantors of debts that become trade or business);14 and (iv) the guarantor received worthless.9 The legislative history is instructive on this reasonable consideration for entering into the guar- topic. The general rule allowing a short-term capital anty agreement.15 loss is stated inn ththee fofollowingollo manner: There is another key issue: timing. Simply stated, in what tax year may the guarantor claim the bad debt [W]hen a taxpayeraxppayer hhasas a loss aarisingg ffrom the guguar- deduction? The relevant legislative history sets forth anty of a loan,ann, hhee iiss to rereceiveece ve the same treatmentreatme two different rules, the application of which depends as where he hashas a lossloloss fromf a loan whichih hehk makes on whether the guarantor has the right of subrogation directly. Thus, if the guaranty agreementg ment aroseose oout or ootother rightg of recourseco againstg the borrower. of the guarantor’s trade or business,ine , the guaguarantorarantor would still be permitted to deduct the loss resulting If the guarantor has no right over against the from the transaction against ordinary income. If the maker of the obligation, the payment under the guaranty agreement was a transaction entered into guaranty is deductible as a bad debt for the year for profi t by the guarantor (but not as part of his in which the payment is made. trade or business), he would be able to deduct the resulting loss as a nonbusiness debt.10 [On the other hand] The legislative history also clarifi es that short-term If the guaranty agreement . requires payment capital loss treatment generally is appropriate in by the guarantor upon default by the maker of the cases of corporate debt. It states the following in note (i.e., the borrower), and the guarantor has this regard: a right to subrogation or other right against the maker, [then] no deduction will be allowed to the Congress also wishes to make it clear that in the guarantor until the year in which the right over case of a guarantor of a corporation obligation, against the maker becomes worthless (or partially 38 February 2009 worthless, where the guaranty occurs in connec- of worthlessness. According to one tax court judge tion with the guarantor’s trade or business).16 citing John Milton’s Paradise Lost, “[t]he cases involving the issue of when a debt becomes worth- There are special rules where the second scenario less are as ‘thick as autumnal leaves that strow the applies. In particular, where the guaranty agreement brooks in Vallombrosa.’”21 provides for a right of subrogation or other similar Bad debt disputes are highly fact sensitive; no right against the borrower, the guarantor may not two cases are exactly alike. Nevertheless, a re- treat the debt as worthless for federal income tax view of various cases and IRS rulings addressing purposes until the year pertinent issues provides in which the right of sub- valuable guidance as to rogation or other similar Bad debt disputes are highly fact the likelihood of with- right becomes “totally sensitive; no two cases are exactly standing scrutiny if the worthless” (or partially IRS challenges a bad worthless in the case of an alike. Nevertheless, a review of debt deduction. These agreement that arose in various cases and IRS rulings issues, which are dis- the course of the guaran- addressing pertinent issues provides cussed in greater detail tor’s trade or business).17 below, include (i) when The regulations are lib- valuable guidance as to the likelihood a payment is made; (ii) eral with respect to the of withstanding scrutiny if the IRS whether a guarantor has types of evidence that are challenges a bad debt deduction. a right of subrogation or relevant to the worthless- other right of recourse ness issue. They generally against the debtor; and state that in determining whether a debt is wholly or (iii) if so, when the debt becomes totally worthless partially worthless, the IRS will consider “all pertinent for purposes of Code Sec. evidence,” including the value of any collateral secur- ing the debt and the debtor’s fi nancial condition.18 The When Is Payment Made? regulations further clarify that in certain circumstances A guarantor may not claim a bad debt deduction a taxpayer is not required to take legal action in order before making payment on the guaranty, regardless of to claim that a debt is worthless.