Individuals with sound credit standing are often asked to provide credit enhancements to banks or other lenders for loans made to another person.
These credit enhancements might be required for entities in which a person has invested, in trades or businesses they operate, or for friends and relatives they wish to assist. They can lead to co-borrowers, personal guarantees, collateralization agreements and/or indemnification agreements with borrowers.
“Although the particular laws differ from state to state, when a debtor defaults on a debt that some other party has guaranteed, the debtor becomes obligated to the guarantor in an amount equal to his or her guarantee,” says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Selecky PC. “This is often referred to as subrogation and has significant tax implications.”
Smart Business spoke with McGrail about guarantees and what you should consider before serving as a guarantor.
Can making good on a guarantee result in a tax deduction?
If guarantors make good on their guarantees, the tax benefit of doing so generally depends on the reason for providing the guarantees.
A guarantee of a debt incurred in a taxpayer’s trade or business results in an ordinary loss. If the guarantee was provided for an investment that is not the taxpayer’s trade or business, the loss is a short-term capital loss.
If the guarantee was strictly personal, there is no tax deduction available to the guarantor.
In order to get an ordinary or capital loss, the taxpayer must also be able to demonstrate several facts. The obligation to make good on the guarantee must have been enforceable by the lender before the original debtor defaulted on the debt.
Also, the guarantor must have received some benefit as a result of making the guarantee, such as secured financing for the guarantor’s trade or business, or a fee from the original debtor.
If an individual taxpayer meets the criteria for obtaining a deduction, he or she may claim the related deduction in the year that the taxpayer actually made payment of the underlying debt that was guaranteed. If an individual guarantor signs a new note with the lender to make payment, then the guarantor takes a deduction each year equal to the amount that he or she actually paid during the year.
In the case of someone other than an individual cash basis taxpayer, for example, if the guarantor is an accrual basis partnership, corporation or LLC, such a taxpayer would be entitled to take the deduction in the year that such person becomes primarily liable for the debt.
Does a taxpayer have to pay income tax if he or she defaults on a guarantee?
Once the lender informs the guarantor that the lender intends to collect a debt directly from the guarantor, the guarantor must decide whether he or she is able to make good on such debt. If the guarantor defaults on all or a portion of such guaranteed debt, the guarantor may be responsible for income tax on this default.
Generally speaking, if a taxpayer is relieved of an obligation to repay a debt (sometimes called debt discharge), the taxpayer recognizes income to the extent that it pays less than the face amount of the debt. There are several exceptions to paying tax on debt discharge income available to most taxpayers, such as discharge of debt in bankruptcy or insolvency.
However, guarantors of indebtedness are entitled to a unique exception. They do not have to pay tax on discharged debt to the extent the payment of this debt would have entitled the guarantor to an income tax deduction. When the original debtor defaults, subrogation results in a liability due from the original debtor to the guarantor. When the original debtor does not pay this subrogated liability, the guarantor becomes entitled to a tax deduction.
So, as long as the guarantor would have obtained a deduction, he or she will not recognize income. This exclusion applies regardless of whether the deduction would have been an ordinary deduction or a capital loss.
Finally, when a taxpayer serves as a guarantor for the debt owed by a partnership, LLC or S corporation, care must be taken to avoid income tax on forgiven debt. Remember, when subrogation occurs, the entity becomes a debtor to the guarantor.
However, if the guarantor forgives this subrogated debt, the entity may have income from discharge of indebtedness. Such tax consequences flow through to individual owners, including owner guarantors.
What should someone consider before agreeing to serve as a guarantor?
First, consider the creditworthiness of the original debtor. Is the debtor financially viable, or is the risk of viability an acceptable risk? Second, is there a way to ‘buy down’ the guarantee? Could the debtor incur a little higher interest rate and avoid the necessity for a guarantee?
Finally, especially if it involves guarantees of family member loans, consider whether the guarantor should charge a guarantee fee of 100 to 300 basis points to document the benefit required to obtain a tax deduction.
WALTER M. McGRAIL, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or firstname.lastname@example.org.