Tax lawyer Bill Purdy and I shared a client with a small interest in a failed corporation with a huge SBA loan. Could our client escape the tax consequences should we be able to settle his liability on a million dollars in unpaid loan. Was the client looking at a million dollars of cancellation of debt income? Here’s the marvelous result that Bill’s caper through the IRS regs returned. Cathy
Ever guarantee the debt of another? Ever meet anyone who has?
Chances are if you’re in business and the business is a C-corporation, an S-corporation, an LLC , or a partnership, when that business borrows money, the lender will require one or more persons who own/control the entity to personally guarantee the business debt.
See how guarantors of consumer debts fare in Chapter 13
It seems harmless at the time. But signing a personal guarantee is as serious as a heart attack.
It can feel just like one if the lender tags you to actually pay the debt. Institutional lenders including but certainly not limited to, the SBA, don’t hesitate to demand payment from guarantors when the actual debtor fails to pay.
When regulations are your friend
Against this backdrop Treasury Regulation §1.6050P-1(d)(7) might take your breath away:
Guarantors and sureties. Solely for purposes of the reporting requirements of this section, a guarantor is not a debtor. Thus, in the case of guaranteed indebtedness, reporting under this section is not required with respect to a guarantor, whether or not there has been a default and demand for payment made upon the guarantor.
Did I read that right?
The regulation just cited is the official US Treasury guide for issuing (or NOT issuing) Form 1099-C when a debt is settled for less than the amount owed. And that’s critically important since the usual consequence of a 1099-C is the inclusion of that amount in taxable income.
The regulation’s language is careful to limit its reach solely to the issue of whether or not a Form 1099-C should be issued.
But unlike so many other regulations and provisions of the Internal Revenue Code, it is NOT followed by endless provisos, exceptions and intricacies.
A lender who settles a debt for less than face is not supposed to issue a Form 1099-C to a guarantor because none is required. It doesn’t matter if the debt was settled with the actual debtor or if the lender demanded payment from the guarantor upon default by the debtor.
Given that reporting financial institutions are
- responsible for issuing Form 1099-C in a timely and accurate fashion,
- often fail to do so correctly and
- face no consequences if they don’t,
this is potentially a very important rule to know.
What is much more important is to know why.
Love letter from the IRS
The “why” is found in Internal Revenue Service INFO 2002-0024 (released 3/29/2002).
In it, the IRS flatly states that a guarantor is not debtor who recognizes Form 1099-C debt relief, whether or not the creditor formally looks to guarantor for payment or settles with the actual debtor.
Once again the Service’s conclusion is sweeping and admitting of very little wiggle room ( which is hardly characteristic of that organization).
Unlike many attorneys and some court cases, the IRS DOES NOT ground its statement in the warm and fuzzy idea that the taxpayer received nothing of value in the way of loan proceeds or other benefits at the inception of the loan.
Instead, the Service bases its position on the idea that what the guarantor potentially gives (pays) is the basis for exclusion from debt relief.
This conclusion rests squarely on statutory law. IRC 108(e)(2).
Where payment by the guarantor would have given rise to either a business bad debt deduction or a capital loss deduction, the Service blesses the guarantor with an exemption from taxable debt relief.
Full stop. End of story.
Escape hatch for homeowners, too
Ordinary homeowners who receive Form 1099-C(s) are supposed to get the benefit of Section 108(e) (2) as well.
Any interest forgiven by lenders which would otherwise be deductible if paid by the homeowner are supposed to be removed from the calculation of taxable debt relief on the Form 1099-C.
Indeed the interest amount is supposed to be separately stated on that form in Box 3.
Given the massive number of defaulted loans with accrued interest, and negatively amortized loans that were “modified” with the accrued unpaid interest added to principal to make a “new modified principal balance” your guess is as good as mine as to whether lenders handily disguised hundreds of billions in interest income by transmuting it to “principal” on which they NEVER paid taxes.
There is little doubt this accrued interest was not correctly removed from modified debts when Form 1099-C(s) were issued on foreclosure or short sale.
Down the rabbit hole
And then, there’s Bullock.
A tax court, no less, held held that the taxpayer who actually signed a direct promise to pay as debtor did not incur a bona fide debt and was actually a guarantor. Bullock TC Memo, 2017-219.
One would assume the IRS was less than amused by the result in this case.
The judge actually references the idea that there was no net accretion of wealth to the taxpayer and then likens her situation to that of a homeowner where a tornado misses the home and thus she has no real net economic benefit.
Eh? Gadzooks!
Please don’t rely on Bullock as authority for the idea that a guarantor is not a debtor and thus no form 1099-C should be issued. Here the Tax Court emptied the baby’s bathwater out on the courtroom floor and started over.
Then much hemming and hawing ensued with citations to Dixie Dairies Corp. v. Commissioner, 74 T.C. at 494 and the existence of no bona fide debtor creditor relationship. (Sharp intake of breath…) Bullock manufactures a de-facto guarantor out of what was clearly direct debtor paperwork signed by the taxpayer, a high risk legal result at best.
Walk the Walk
The Bullock court may have felt great deciding as it did, but don’t count on any court to decide no real debt existed where your client signs on as a named debtor.
Especially here in California with some of the most obsequious and deferential judges alive when it comes to supporting lenders and the financial industry.
To get the one of the very few benefits of being a guarantor for tax purposes, be a guarantor in writing and in fact.
More Bill
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Guest author Bill Purdy is a tax and real estate lawyer with Simmons and Purdy in Soquel, California. I’m always tickled to share Bill’s pointed perspective on places our practices overlap.
Bill and his partner Pam Simmons are my go-to resource for all matters of tax and mortgage law. Bill assists clients with outstanding federal and state income tax liabilities, Form 1099-A and 1099-C related issues, collection resolution, failure to file returns and employment tax related liabilities.
