Category: Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer A and Taxpayer B are equal owners of FP, an S corporation. FP called on the shareholders at various times for additional capital. As equal shareholders, Taxpayer A and Taxpayer B were supposed to bear the burden of contributing additional capital (or making additional loans to FP) on an equal basis. Because Taxpayer A did not have sufficient funds to meet his share of FP's additional capital requirements, Taxpayer B put in all the necessary funds. The parties intend that the amounts contributed to FP on Taxpayer A's behalf should be treated as loans by Taxpayer B to FP and guaranteed by Taxpayer A. The parties further intend that Taxpayer A's stock stand as security for the guaranty. Documents will be drawn up to appropriately reflect the intention of the parties. At some point, Taxpayer B may call the loan, and FP may not have sufficient cash to repay Taxpayer B. Accordingly, it is possible that Taxpayer A may be required to make good on his guaranty. If that happens, Taxpayer A is unlikely to have sufficient funds to pay Taxpayer B, and as a result, Taxpayer A will forfeit his stock under the security arrangement provided for by the guaranty agreement. The treatment of a taxpayer required to perform under a guaranty obligation is controlled by Regulation Section 1.166-9. In general, a guaranty made in the course of the taxpayer's trade or business gives rise to a business bad debt deduction, and a guaranty made in a context other than the taxpayer's trade or business gives rise to a nonbusiness bad debt. Reg. Sec. 1.166-9(c) speaks explicitly about guarantors of corporate obligations to the effect that no bad debt deduction is allowed if, at the time the guaranty was made, the facts and circumstances indicate that the guaranty is tantamount to a contribution to capital. In making this latter determination, the courts seem to be concerned with the party to whom the creditor looked for repayment of the debt at the time the guaranty was entered into. See, for example, Lair v. Comr., 95 TC 484 (1990). In this case, FP was undercapitalized and losing money heavily at the time the guaranty was made. It seems unlikely to me that the IRS or a court could be convinced that FP was really the intended source of repayment, in light of the security arrangement and particularly in light of the intention that each shareholder equally bear FP's capital needs. In any event, if Taxpayer A is required to perform under the guaranty, he will have either a capital contribution or a nonbusiness bad debt deduction, presumably the former. If one uses appreciated property to satisfy a guaranty, how much of a bad debt or a capital contribution is available? Is it the guarantor's basis in the property, in this case zero, or is it the fair market value of the property? Bad debt deductions are limited to the taxpayer's basis in the debt. IRC Section 166(b) and Reg. Section 1.166-1(d)(1). Based on that general principle, presumably it is the case that a guarantor's bad debt deduction would be limited to the basis of the property relinquished in performance of the guaranty obligation. Where the guarantor pays cash, there is no issue as to basis. On the other hand, if the guarantor pays with appreciated property, thereby triggering a gain on the appreciation element, is the guarantor entitled as a result of the gain to deduct the full fair market value of the property relinquished? I can find nothing that addresses this issue directly. Clearly, if the guarantor sold the collateral for cash, thereby triggering the appreciation, and then used the cash to satisfy his guaranty obligation, the bad debt amount would be the cash so paid. Since a foreclosure is clearly a sale of the collateral, I can see no reason at all for a different result. If a separate sale of collateral for cash followed by payment of the guaranty yields a bad debt equal to the amount paid, why should a foreclosure against the collateral, which is also a sale, be treated any differently? Accordingly, it is my view that a guarantor who relinquishes appreciated property securing the guaranty obligation should have a bad debt deduction equal to the amount of the guaranty. What happens if instead of bad debt treatment, the present transaction is viewed as a capital contribution (which I think is likely)? In general, if appreciated assets are contributed to the capital of a corporation, the contribution is viewed as a sale of those assets in exchange for stock unless Section 351 applies. The fair market value of the assets relinquished would become the cost basis of the stock received in exchange. Of course in this case, there is no stock received in exchange for the capital contribution. Indeed, Taxpayer A's stock is the very property relinquished as a capital contribution. Moreover, Taxpayer A ceases to be a shareholder as a result of performing under his guaranty obligation. There is no question, it seems to me, that a capital contribution results from Taxpayer A's performance under his guaranty obligation. Consider the effect on FP's balance sheet: as a result of Taxpayer A's performance, the debt to Taxpayer B will disappear, thereby increasing FP's net worth correspondingly. Economically, this is a capital contribution in my opinion. I believe that Taxpayer A's forfeiture of his stock under the guaranty agreement is no different from any other situation in which an appreciated asset is used to discharge an obligation. The discharge of Taxpayer A's obligation in this case represents a capital contribution to FP. What happens if appreciated property is used to pay a deductible business expense? Clearly this is a taxable disposition of the appreciated asset causing the appreciation to be recognized for tax purposes, but what is the measure of the resulting deduction? The answer is the fair market value of the asset relinquished. The most obvious example of this principle is that of a barter club in which members exchange goods and services instead of cash. The barter club recognizes income based on the fair market value of the goods and services it receives and takes an ordinary deduction for the value of the goods and services it provides to its members. The ability to deduct the fair market value of the goods and services provided flows from the club's having previously taTaxpayer A the value of such services into income and thereby obtained tax basis in those items used to discharge its obligations to its membership. See, for example, Barter Systems Inc., (1990) TC Memo 1990-125, PH TCM ¶90125, 59 CCH TCM 72. Also see Kate Baker Sherman v. Commissioner, 18 TC 746 (1952) in which the taxpayer was allowed an interest deduction corresponding to the value of collateral taTaxpayer A by the lender in foreclosure. I feel that although I can find nothing that directly addresses the situation facing Taxpayer A and FP, the principle is clear through other somewhat analogous transactions that use of an appreciated asset to satisfy an obligation gives rise to a deduction (or basis) equal to the fair market value of the asset relinquished.
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