If you're considering guaranteeing a loan to your corporation, you should be aware that acting as a guarantor, endorser, or indemnitor of one of your closely held corporation’s debt obligations may come with possible tax consequences. You’ll need to be prepared if your corporation defaults on the loan, as you may be required under the guarantee agreement to pay principal or interest.
Bed debt deductions for business and nonbusiness debts
In the case that you’re required to make good on the obligation, making a payment of principal or interest in discharge of the obligation will usually result in a bad debt deduction, which may be either a business bad debt deduction or a nonbusiness bad debt deduction.
Business bad debts can be either totally or partly worthless and are deductible against ordinary income. Nonbusiness bad debts are deductible only if they’re totally worthless and are deducted as a short-term capital loss, which means they’re subject to limitations on deductions of capital losses.
A guarantee must be closely related to your trade or business in order to be classified as a business bad debt. The guarantee is considered to be closely related to your trade or business as an employee if protecting your job is the reason for guaranteeing the corporation loan, but only if employment is the dominant motive.
If your annual salary is greater than your investment in the corporation, this will usually serve as evidence that protecting your job was the dominant motive for the guarantee. By contrast, an investment in the corporation that is substantially greater than your annual salary is usually taken as evidence that protecting your investment was the dominant motive behind the guarantee, rather than protecting your job.
If guaranteeing the loan was not a case of job guarantees, demonstrating that a guarantee was closely related to your trade or business might be difficult. In this case, you’ll need to demonstrate that the guarantee was either related to your business as a promoter or related to another trade or business you carried on separately.
If you’re required to pay off a loan that you guaranteed for your corporation and your reason for guaranteeing the loan wasn’t closely related to your trade or business, you can take a nonbusiness bad debt deduction—but in this case, you must demonstrate that you guaranteed the loan to protect your investment or guaranteed the loan with a profit motive.
Both business and nonbusiness bad debt is only deductible if it meets the following criteria in addition to satisfying the requirements above:
- The guarantor entered into the agreement before the debt became worthless
- The guarantor has a legal duty to make the guaranty payment, despite there being no requirement that a legal action be brought against them
- The guarantor received reasonable consideration for entering into the guaranty agreement (though this reasonable consideration does not necessarily have to be cash or property)
Unless local law or the terms of the agreement provide for a right of subrogation against the corporation, any payments made on a loan you guaranteed are deductible as a bad debt in the year the payments are made. If you have a right of subrogation against the corporation or any other right to demand payment from them, you won’t be able to make a bad debt deduction unless the rights become partially or totally worthless.
Guaranteeing a loan to your closely held corporation may also come with other possible tax consequences. To learn more about the possible implications of your situation, contact us.