Postliquidation payment on loans guaranteed by a shareholder.

• Author: Ellentuck, Albert B.

Facts: Dr. Linda Morris is the sole shareholder of BioTech Solutions, Inc., an S corporation. The company performs medical research in anticipation of obtaining patents on medical devices. Two years ago, the corporation borrowed $1.5 million from First National Bank for its biotech research business. The bank required Dr. Morris to guarantee the loan.

Due to unforeseen circumstances, the corporation suffered reverses and was liquidated. The loan balance at liquidation was $900,000. Several months later, Dr. Morris paid $1 million ($900,000 principal + $100,000 accrued interest) to the bank under the loan guaranty.

Issue: Can Dr. Morris deduct the $1 million payment on her personal return?

Analysis

Under the doctrine of subrogation, when the guarantor of a corporation's debt makes a payment under the guaranty's terms, the guarantor "steps into the shoes" of the corporation's creditor. The corporation's debt becomes the guarantor's obligation. Thus, the loss the guarantor sustains is a loss from the worthlessness of the debt; see Putnam, 352 US 82 (1956).

A payment under a loan guaranty is treated as a worthless debt under Regs. Sec. 1.166-9(d) if the agreement:

1. Was entered into in the course of the taxpayer's trade or business or a transaction entered into for profit;

2. Is legally enforceable; and

3. Was entered into before the debt became worthless.

   The guarantor must have received reasonable compensation for guaranteeing the loan. When an S shareholder guarantees a loan to the S corporation, the compensation can be indirect. Indirect compensation occurs under Regs. Sec. 1.166-9(e), for example, when a guaranty is given in accordance with normal business practice or for a good-faith business purpose. In addition, Regs. Sec. 1.166-9(d)(3) and (c) provide that the guarantor must have had a reasonable expectation that he or she would not be required to make any payments under the guaranty. Further, the payment must not constitute a capital contribution.

   In Rev. Rul. 60-48, the IRS ruled that the noncorporate guarantor of a corporate obligation required to make payments on the obligations of an insolvent or liquidated corporate debtor that he or she guaranteed can take a Sec. 166 bad-debt deduction. The deduction will qualify as a business or nonbusiness bad debt depending on the facts of each case.

   According to Sec. 166(d)(2), a business bad debt arises from:

1. A debt created or acquired in the ordinary course of the taxpayer's trade or...