Guarantees: Tax Considerations and Surprises
May 13, 2019
Don’t Take It Lightly
Regardless of who or what they are, taxpayers have to be careful of saying things like, “I guarantee it” or “it’s guaranteed.”
First of all, they’re not Joe Namath guaranteeing a Jets victory over the Colts in Super Bowl III, where the worst thing that could have happened had Broadway Joe not delivered on his promise would have been a brief delay in the AFL/AFC’s first Super Bowl title.[i] Nor are they George Zimmer guaranteeing that you’re going to look good in a Men’s Wearhouse suit, where the worst thing that could have happened was that you . . . well . . . you didn’t look too good.
The foregoing results pale in significance to the sometimes surprising tax consequences that may accompany a taxpayer’s guarantee of a business entity’s liability.
What Are They?
Before we consider some of the more common instances of guarantees and their tax effects, it would be helpful if we first defined the term “guarantee,” at least for purposes of this discussion.
Generally speaking, the object of one person’s guarantee is another person’s obligation to perform an act – usually the repayment of an amount borrowed from a lender; stated differently, a guarantor will agree to satisfy an obligor’s indebtedness to a lender in the event the obligor itself fails to do so. The lender is typically viewed as the beneficiary of the guarantee because it provides the lender with a degree of protection from the adverse consequences of the obligor’s default under the loan.
That being said, one may just as easily characterize the obligor as the beneficiary of the guarantee because the lender may not otherwise be willing to make a loan to the obligor without the presence of the guarantee, or would be willing to do so only under less favorable terms (from the perspective of the borrower).
When considering the tax consequences of a guarantee, the focus is usually on the relationship between the guarantor and the obligor (the “beneficiary” for tax purposes); more often than not, these parties are a closely held business and its owners.
For example, the owners of a business will often be asked by a lender to personally guarantee a loan or a line of credit to their business.[ii] Alternatively, one company may be asked to guarantee the loan obligations of another company;[iii] the latter may be a parent, a subsidiary, or a sister company with respect to the guarantor.
It should be obvious that the guarantor provides an immediate economic benefit to the obligor by guaranteeing the obligor’s indebtedness to the lender; by doing so, the guarantor allows its own economic strength and creditworthiness to support the obligor.
It should also be obvious that the guarantor suffers an economic detriment because by guaranteeing the obligor’s indebtedness the guarantor has agreed to assume responsibility for the indebtedness in the event the obligor is unable to satisfy the indebtedness itself.[iv]
Which brings us to the tax question: how is this economic benefit measured, was any consideration provided by the obligor in exchange for this benefit, and what tax consequences are realized by the obligor as a result of the transaction?[v]
A Guarantee Fee?
The value of the economic benefit inuring to an obligor, and the “value” of the detriment suffered by the guarantor, as a result of a guarantee are not necessarily the same as the consideration (or fee) that may have been paid by the obligor in exchange for the guarantee; by analogy, think in terms of insurance coverage and insurance premiums – one would never guarantee an indebtedness unless the obligor was reasonably capable of satisfying the indebtedness.
With that in mind, how do a closely held business and those related to it even determine what an appropriate guarantee fee is?
If the guarantor is the controlling owner of the obligor-business, should a fee be imputed between them,[vi] such that the guarantor is deemed to have received an item of taxable income, and the obligor is deemed to have received a capital contribution of the same amount?
In the absence of any consideration for the guarantee, has there been a capital contribution by the guarantor-owner to the obligor-business? Has there been a distribution of earnings from the guarantor-subsidiary business entity to the obligor-parent business entity? If there has been, then how much? The amount of the foregone fee?
Herein lies the issue, and perhaps the source of much confusion among taxpayers. This state of affairs may best be illustrated by exploring a few not uncommon scenarios.
CFCs,[vii] U.S. Properties & Guarantees
Normally, a CFC’s non-Subpart F income – and, after 2017, its non-GILTI – is not taxable to its U.S. shareholder or shareholders unless and until the income is distributed to them.[viii] In the face of this principle, taxpayers once attempted to avoid U.S. income tax by taking loans from unrelated financial institutions and having their CFCs guarantee the loans.
Guarantee as Distribution
Then Congress amended the Code to require the inclusion in the U.S. shareholder’s income of any increase in investment in U.S. properties made by a CFC it controls. Such an investment of earnings by a CFC in U.S. properties, Congress determined, was tantamount to the repatriation of such earnings. Therefore, “U.S. property” was defined as including, among other things, an obligation of a U.S. person arising from a loan by the CFC to the U.S. person.
The Code and regulations then went further by providing that a CFC would be considered as holding an obligation of a U.S. person if the CFC was a guarantor of the obligation, where the loan was made by a third party.[ix]
They also provided that the amount of the obligation treated as held by the CFC, as a result of its guarantee, was the unpaid principal amount of the obligation; in other words, the IRS treated the CFC-guarantor as if it had made the entire loan directly, thereby acquiring a U.S. property interest – i.e., as if it had made a distribution to its U.S. shareholders of an amount equal to the principal amount of the loan – though the amount included in the gross income of the CFC’s U.S. shareholder was capped at the CFC’s earnings.[x]
S Corporation Shareholder Guarantees
The foregoing demonstrates that, in the case of a CFC, the corporation’s guarantee of its U.S. shareholder’s indebtedness bestowed a significant economic benefit upon the U.S. shareholders – one that may characterized, for tax purposes, as a distribution that accelerated the recognition by the U.S. shareholder of the CFC’s previously undistributed income.
However, where the taxpayer is a shareholder of an S corporation, the issue surrounding the shareholder’s guarantee of the corporation’s indebtedness is not one of income inclusion, or the acceleration of income recognition; rather, it is usually a question of whether the shareholder should be entitled to deduct their allocable share of S corporation loss up to the amount of indebtedness guaranteed by the shareholder.
Loss Limitation Rule
The Code provides that a shareholder may deduct their share of an S corporation’s losses only to the extent that such share does not exceed the sum of “the adjusted basis of the shareholder’s stock in the S corporation,” and “the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.”[xi] In other words, the shareholder cannot deduct more than the sum of the following: (i) what they have contributed to the corporation as a capital contribution,[xii] (ii) their share of corporate income and gain that has not been distributed to them by the corporation, and (iii) the amount they have loaned to the corporation. [xiii]
Any disallowed deduction – i.e., the amount by which a shareholder’s share of the corporation’s losses exceeds the shareholder’s aggregate stock and debt basis – is treated as incurred by the corporation in the succeeding taxable year with respect to the shareholder whose deductions are limited. Once the shareholder increases their basis in the S corporation, any deductions previously suspended become available to the extent of the basis increase.
The Code does not provide a means by which a shareholder may acquire basis in an S corporation’s indebtedness other than by making a direct loan to the corporation. Likewise, the courts have generally required an “actual economic outlay” by the shareholder to, or on behalf of, the corporation before determining whether the shareholder has made a bona fide loan that gives rise to an actual investment in the corporation.
A taxpayer makes an economic outlay sufficient to acquire basis in an S corporation’s indebtedness when the taxpayer incurs a ‘cost’ on a loan. The taxpayer bears the burden of establishing this basis.
It does not suffice, however, for the shareholder to have made an economic outlay. The term “basis of any indebtedness of the S corporation to the shareholder” means that there must be a bona fide indebtedness of the S corporation that runs directly to the shareholder.[xiv]
Whether a corporation’s indebtedness is “bona fide indebtedness” to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.
Moreover, a shareholder does not obtain basis for an indebtedness of the S corporation to a third party merely by guaranteeing such indebtedness.
According to most courts and the IRS, it is when a shareholder makes a payment on bona fide indebtedness of the S corporation, for which the shareholder has acted as guarantor, that the shareholder creates a direct indebtedness between themselves and the corporation – the shareholder-guarantor steps into the shoes of the original creditor vis-à-vis the corporation to the extent of such payment – and the shareholder acquires basis for that indebtedness to the extent of that payment.[xv]
That being said, some shareholders have argued, unsuccessfully, against the form of the loan transaction; specifically, these taxpayers have claimed that the lender was, in fact, looking to them for repayment of the loan, and not to the corporation. Under this theory, the shareholders would be treated as having received the loan, and then as having made a capital contribution to the corporation. Unfortunately for them, the courts have not accepted their theory; rather, the courts have bound them to the form of their transaction – a loan to the corporation that is guaranteed by the shareholders; the fact that the corporation, and not the shareholders, made the loan payments did not help their position.
However, the fact remains that a shareholder’s guarantee of their S corporation’s indebtedness to a third party bestows a valuable benefit upon the corporation – that enables the corporation to borrow from an unrelated lender – and exposes the shareholder to a contingent liability for which the corporation likely paid no consideration.
Yet neither the IRS nor the courts have shown any willingness to accept the argument that the value of this guarantee – whether it is the amount of the guarantor’s actual or imputed fee, the value of the benefit, or the value of the detriment, however determined – should be treated as a capital contribution by the shareholder to the corporation.
Of course, a possible corollary to this position – and perhaps the reason that the argument has not found any traction – is that income should be imputed to the shareholder in exchange for their guarantee of the corporation’s indebtedness.
A more likely reason, however, is probably the difficulty in determining the value of the benefit.[xvi]
Partner Guarantees and Partnership Recourse Debt
As in the case of a shareholder of an S corporation, a partner’s distributive share of partnership loss is allowed only to the extent of the partner’s adjusted basis in their partnership interest at the end of the partnership year in which the loss occurred.[xvii]
In contrast to a shareholder’s guarantee of an S corporation’s indebtedness, however, a partner’s guarantee of a partnership’s indebtedness may increase the partner’s adjusted basis for their partnership interest,[xviii] and thereby allow the partner to claim a greater portion of their share of partnership loss.
Specifically, any increase in a partner’s share of partnership liabilities, or any increase in a partner’s individual liabilities by reason of the partner’s assumption of partnership liabilities,[xix] is treated as a contribution of money by that partner to the partnership and increases the partner’s basis in their partnership interest.
Economic Risk of Loss
A partner’s share of a partnership’s liability depends upon whether the liability is a recourse or a nonrecourse liability.
A partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability. A partner’s share of a recourse liability equals the portion of that liability for which the partner bears the economic risk of loss. In other words, each partner’s share of a recourse liability is proportionate to the partner’s economic risk of loss with respect to such liability.[xx]
A partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated,[xxi] the partner would be obligated to make a payment to any person, or a capital contribution to the partnership, because that liability becomes due and payable, and the partner would not be entitled to reimbursement from another partner.
If a partner guarantees a partnership’s liability to an unrelated lender, it would appear that the partner bears the economic risk of loss with respect to that liability – the partner is obligated to pay the lender if the partnership defaults – and, consequently, should be treated as having made a capital contribution to the partnership, which would increase the basis of the partner’s partnership interest.[xxii] The fact that the partner is never actually called upon to fulfill their guarantee is irrelevant – there does not need to be an actual economic outlay[xxiii] – it suffices that they bear the economic risk of loss.
That being said, the partner’s guarantee may be disregarded if, taking into account all the facts and circumstances, the partner’s obligation under the guarantee is subject to contingencies that make it unlikely that it will ever be discharged. In that case, the guarantee would be ignored until the event occurs that triggers the payment obligation.[xxiv]
According to the IRS, a guarantee may also be disregarded where it was not required in order to induce the lender to make the loan to the partnership, or where the terms of the loan were no different than they would have been without the guarantee.[xxv]
The point of the foregoing discussion was to remind the reader of a few common business situations in which one person’s guarantee of another’s indebtedness may have significant income tax consequences; based upon the volume of litigation and regulatory activity in this area, it appears that these consequences are not yet fully appreciated by many taxpayers, who are either unaware of the issue or who try to circumvent it.[xxvi]
This post does not seek to explain or justify the different tax treatment of a guarantee in one business scenario versus another; for example, a shareholder’s guarantee of an S corporation’s indebtedness versus a partner’s guarantee of a partnership’s indebtedness.
Nevertheless, I hope that the following themes were conveyed: (i) in order for a guarantee to be respected, it must serve a bona fide economic purpose – it cannot be undertaken only to generate a beneficial tax result (for example, additional basis); otherwise, the guarantee will not be given tax effect until the occurrence of the contingency to which the guarantee is directed; and (ii) the IRS’s treatment of a guarantee will depend in no small part upon the direction of the guarantee – for example, upstream, as in the case of the CFC described above, or downstream, as in the case of partner and a partnership – and the fiscal policy sought to be enforced.
Therefore, before agreeing to guarantee the indebtedness of a related person or business entity, a taxpayer should consult their tax adviser, lest any hoped-for tax consequences turn out to be unattainable, or lest the taxpayer incur an unintended tax liability.
[i] 1969. The Jets, the Mets and the Knicks won championships. The Rangers made it to the playoffs, losing to the Bruins (my then hero, goalie Eddie Giacomin, had a great regular season).
[ii] These guarantees may be joint and several, or they may be capped at a certain amount per owner. Sometimes, a lender will require that the owners secure their guarantee (perhaps by agreeing to maintain some minimum amount on deposit at the lending institution).
[iii] There are many permutations.
[iv] A contingent liability.
[v] OK, actually three questions. Have you ever known a tax person who stops at one question?
[vi] See IRC Sec. 482. The purpose of IRC section 482 is to ensure taxpayers clearly reflect income attributable to controlled transactions and to prevent avoidance of taxes regarding such transactions. It places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining true taxable income. Transactions between one controlled taxpayer and another will be subject to special scrutiny to ascertain whether common control is being used to reduce, avoid, or escape taxes. In determining the true taxable income of a controlled taxpayer, the IRS’s authority extends to any case in which either by inadvertence or design the taxable income of a controlled taxpayer is other than it would have been had the taxpayer been dealing at arm’s length with an uncontrolled taxpayer.
[vii] A controlled foreign corporation (“CFC”) is defined as “any foreign corporation if more than 50-percent of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation is owned by U.S. shareholders on any day during the taxable year of such foreign corporation.” IRC Sec. 957.
[viii] In the Tax Cuts and Jobs Act world, this would include its “high tax” income, as well as the amount representing the “reasonable” 10-percent return on the investment in tangible personal property. IRC Sec. 954(b), Sec. 951A(b).
[ix] IRC Sec. 956(d); Reg. Sec. 1.956-2(c)(1).
[x] IRC Sec. 951, Sec. 956. For a recent decision involving this issue, see the Third Circuit’s opinion in SIH Partners: https://www.bloomberglaw.com/public/desktop/document/SIHPartnersLLLPExplorerParvCommissionerofInternalRevenDocketNo180?1557583279 .
[xi] IRC Sec. 1366(d); Reg. Sec. 1.1366-2.
[xii] Cash and the adjusted basis (i.e., unreturned investment) in other property.
[xiii] Basically, amounts that remain subject to the risks of the business.
[xiv] For a recent decision involving this issue, see the Eleventh Circuit’s opinion in Meruelo: https://www.bloomberglaw.com/public/desktop/document/HomeroMeruelovCommissionerofIRSDocketNo181190911thCirMay072018Cou?1557602950 .
[xv] Reg. Sec. 1.1366-2(a)(2). But if a shareholder engages in genuine “back-to-back” loans – in which a lending entity loans the shareholder funds that he then loans directly to the S corporation – those loans can establish bona fide indebtedness running directly to the shareholder.
[xvi] See, e.g., PLR 9113009, which involved a parent’s guarantee of business-related loans for his children. Although the ruling concluded that the guarantee constituted the completed gift transfer of a valuable property right, it did not explain how that right was to be valued. The IRS later withdrew the ruling as it related to the guarantee. PLR 9409018.
[xvii] IRC Sec. 704(d). Any excess loss is carried forward.
[xviii] IRC Sec. 752(a).
[xix] A partnership obligation is a liability for purposes of IRC Sec. 752 only if, when, and to the extent that incurring the obligation (i) creates or increases the basis of any of the obligor’s assets (including cash); gives rise to an immediate deduction to the obligor; or gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital. Reg. Sec. 1.752-1(a)(4).
[xx] Reg. Sec. 1.752-2.
[xxi] For purposes of this hypothetical liquidation, the partnership’s assets are assumed to have no value, its liabilities are deemed to have become due and payable, and its assets are deemed to have been sold for no consideration other than relief from any liabilities that they secure. Reg. Sec. 1.752-2(b).
[xxii] Irrespective of the form of a partner’s contractual obligation, the IRS may treat a partner as bearing the economic risk of loss with respect to a partnership liability, or a portion thereof, to the extent that the partner undertakes one or more contractual obligations so that the partnership may obtain or retain a loan; the contractual obligations of the partner significantly reduce the risk to the lender that the partnership will not satisfy its obligations under the loan, or a portion thereof; and one of the principal purposes of using the contractual obligations is to attempt to permit partners to include a portion of the loan in the basis of their partnership interests. Reg. Sec. 1.752-2T(j)(2).
[xxiii] Contrast this to the S corporation shareholder.
[xxiv] Reg. Sec. 1.752-2(b).
[xxv] Prop. Reg. Sec. 1.752-2(j).
[xxvi] Who may also be forgetful when it is convenient.